A few weeks back, I wrote a post entitled The Tweetstorm that Spawned the 10,000X Startup where Dave McClure of 500startups lamented about the state of early stage, that valuations were way too high, and that early stage investors will lose money.
But, really, how risky is seed investing in today's world? Are we paying too much for early stage startups?
Over the years that I’ve invested in early stage companies, I’ve heard numerous claims that valuations should be this or that, and if they are not, we will lose money. But I have never been presented with a model or math to show that this or that was true or what would happen if you were to invest at certain valuations.
So with one of our research team members, Tom, we set out to build a model using today’s data sources and see what would come out of it.
First, we took the famous CBinsights Venture Capital Funnel, which is a great way to show the path of startups through their lifespan to future funding rounds, M&A exits, or a death or self-sustaining state.
Then we melded that with data from PitchbookVC’s latest 1H 2015 Venture Capital Valuations & Trends Report. There is some really great information on current valuations, rounds, and exit values there, and we used the median values to model where most of the activity would be. Thus, the following analysis looks at what returns would look like if your portfolio performed at that median level.
Dilution via option pools is also in the model, although we estimated the numbers based on our own experience.
The model itself is available for download here.
You can set the investment amount, portfolio size, and pre-money for the seed round.
On a relative basis, the investment amount doesn't matter as the resulting return percentages and multiples will be the same for any amount you enter. For the purposes of this post, we entered our usual $150K investment per startup.
Entering the portfolio size does matter as it shows the quantity of startups you'd have to invest in, at a minimum, to yield startups out the other end of the funnel. For example, to exit the funnel with at least one remaining startup who has gone through 6 full rounds of financing, you'd need a minimum portfolio size of 25.
The pre-money inserted in the model is $6M, which is the typical market rate seed round valuation you'd find out here on the West Coast.
If you invest into rounds at the typical market rate valuation of $6M, you are essentially short by 22.6% after your cohort goes through 5 years of life and 6 rounds of financing.
If your portfolio is large enough, the model calculates that you still need to make a multiple of 5.65x on your last remaining startup in order to make back that 22.6% shortfall and break even: a tough goal under any circumstances. (Note that the bigger your portfolio is, the more startups you will have out the end of the funnel. However, to breakeven, you will need to make back 5.65x per startup that is remaining. For example, if you have a portfolio of 100, then you’ll be left with 4 startups remaining, and you need to make back 5.65x on each your startups, or 5.65 x 4 = 22.6x on only one of those startups.) For most angel investors, having enough cash to create a large enough portfolio to have a chance at breakeven or even do better is very difficult.
If we take this model as-is, investing at today's market rates as an angel investor sure looks like a losing proposition. Of course, any investor worth anything would be arrogant enough to think they had what it takes to beat the market and this model. Let’s dive further into the model.
The CBinsights database is made mostly up of companies who have done equity rounds. Given that the world of seed seems dominated by convertible note financings which don’t show up in the CBinsights database, what does this dataset mean? Equity financings typically include a seed fund or something similar like an angel group. So you can be sure that most of the companies all have an entity behind them to help them with their progress. They have an advantage with this help over those who do party rounds of only angels. Still, despite the help of these funds, the funnel ends up negative for those who invest in these companies at seed.
Note that the majority of financings out there aren’t even taken into account here, which are note financings. I'm not sure one could make the argument that note financings are better than equity financings when viewed across the entire set of startup financings. So you'd have to be at the very least able to invest only in rounds that are also supported by a strong seed or angel fund to be on par with the results of this model. But as the model shows, it is not enough unless you are able to move the odds of successful outcomes in your favor.
What is this model a representation of really? It's an index fund of startups who got equity financings; if there was a mutual fund that allowed you to do that in 2009, this is what would have happened, assuming the fund could invest in every startup that got an equity financing. You would have lost money for sure. So "spray and pray" is a terrible strategy if you are just investing at market rate valuations. If you could "spray and pray" at much better valuations, the model results in positive returns - think accelerators where they deploy very little money for large chunks of their companies at very low valuations.
Despite the bleak overall outlook of the model, we dove into some of the more prominent seed funds to see how they performed against this model. For example, First Round Capital was a fairly large seed fund back in 2009. According to the same methodology used to build the CBInsights funnel, they managed to have 33% of their 2009 cohort exit via M&A versus the 20% level assumed in the model; they also showed consistently higher follow on rates. Obviously they are doing something right, and better than average.
What are better seed funds doing that make them so great? Pandodaily wrote a post entitled Why Jeff Clavier Insists There's No Series A Crunch which has a good list on what Jeff Clavier does to help his portfolio companies and take them to success. So there is ample support for being able to invest in rounds which include one of the strong seed funds out there.
Bear in mind what I mentioned before - the CBinsights funnel ALREADY assumes you are investing alongside a seed or angel fund. The likelihood of that happening is pretty difficult, unless you are doing a lot of work to become friendly with the seed funds. And then, not all seed funds are alike; some are definitely beating the funnel in returns but there are many that are lagging.
Suppose you had a portfolio large enough to result in some startups surviving past a 6th round of financing. Our model says that with a portfolio of 25, you'd have one left, and you'd have to make at least a 5.65x to come out positive on your portfolio. With a larger portfolio, there would be more companies surviving after the 6th round to return money and then some; in today's world, it is likely these would be the unicorns of legend.
Ordinarily, we would all celebrate the unicorn-esque status of one or more of our portfolio, on their way to great heights and potential IPO. However, consider this recent post by Tomasz Tunguz of Redpoint Ventures, The Runaway Train of Late Stage Fundraising. These late stage financings seem to be a current fad and are proliferating while the number of IPOs languishes. However, one thing that is not talked about much are the terms in which these financings are done. A recent post by Ben Nasarin entitled Big Valuations Come with Dangerous Small Print highlights the problems that come with late stage financings. You can guarantee there are many preferences (see liquidation and participating preferences) in the distribution of exit capital. You may end up in a situation where the company seems to exit well, but the preferences result in little or no capital being returned to early investors; that includes an IPO situation (see Ben's post regarding the Box IPO). While unicorns are definitely good for bragging rights in a portfolio, they may not return as much capital as you like, or need, to breakeven or make money.
The presence of preferences which could stifle your returns requires you to really think through what your strategy might be for dealing with these situations. It may mean you would take the first opportunity to sell your shares at a secondary offering, for example, and take the early exit versus waiting for something bigger later that may never come (In stark contrast, late stage investors nearly always make their money back even in a losing situation).
This model doesn't take into account follow-on investments, which is true for most angel investors and non-fund entities who don't have the resources to follow on. So we only account for one investment at seed and no more investments afterwards. Mark Suster has done a great job showing how Founders are diluted in subsequent rounds, but this topic hasn’t really been tackled when talking about angel/seed investors and plays heavily into understanding returns. Preliminary looks at follow-ons increases the deployed capital substantially and take you further from breakeven. Following on precognitively in only the winners does help - ESP anyone?
One might ask - couldn't we calculate actual exit results from information in their database? Unfortunately not - of the 2009 dataset, there are exit values for only 9 out of the 49 total exits that year. M&A numbers are still pretty secret overall. The best we can do is insert median exit values as a proxy.
The Dead/Self-Sustaining number/% is a bit deceptive. Some of the companies in this number that are surviving could be big companies who simply didn’t need to raise another round, and digging into the companies that did not raise a large number of rounds is needed. Also, indication of death in the CBinsights data unfortunately isn't all that complete at this time- yet another place for improvement in the data. However as time passes for the 2009 cohort, we should see the final results of those surviving companies.
In examining breakeven, I asked the question, at what starting valuation could I break even according to the model? Using Excel, I calculated the break even valuation to be $4.08M pre-money. Unfortunately, with current West Coast market rate valuations for seed stage startups hanging around $5-6M, you’d have to do something very special to be investing at $4.08M pre-money. Investing at lower than $4.08M valuations means you’d be positive with the model - great job finding startups that early and negotiating awesome deals!
We then compared this model to investing in the public stock market. Using a Cambridge Associates report from last year, we used their calculated return multiple from 2009 for the Russell 2000 (they have a proprietary method for calculating a return multiple to compare your investment in venture capital and private equity against other traditional investments). In order to match the return of investing into the Russell 2000, your last startup must yield a 19.4x! So you would need a 5.65x return to merely break even, but an additional 13.75x to beat investing in the public markets, which is by far a safer investment than startup investing. Why was I angel investing again ?
Using the median values doesn't appreciate what you might individually do or what actually happened for each round and any preferences that may come with a round. We just made the assumption, right or wrong, that most things would happen at the medians of all the values.
The model is just a model. A reflection of reality, yes, but still not reality. It still communicates some interesting things about today's investing world and how you might alter your strategy in investing to beat the model.