Friday, February 10, 2017

Don't Ask For Too Much Money

A common mistake that founders make when raising a venture round is to anchor high and ask for too much money, at too high a valuation, with the hope the VC will bid them down. This is a common failure mode that prevents people from raising money successfully when they otherwise could. Asking for too much money is driven by misunderstanding the nature of a fundraise negotiation. When fundraising, you are trying to create an auction dynamic - not a 1:1 negotiation.

In a traditional negotiation, you want to anchor high and then have people bid you down. In a venture round, you actually want to do the opposite - you want to anchor low and pull multiple VCs into an auction around the company. Once a VC is emotionally engaged in the auction they will want to win against their peers. This will drive up the dollar amount you are raising and along with it your valuation (as VCs tend to want to buy a certain % ownership). In other words, the VCs will start to bid against each other and drive up your value.

A tangible example of this - suppose you want to raise a $10M series A. Rather then telling VCs you want to raise $15M (and an implied valuation of $60M to $75M post-money for 20-25% of the company), you should tell VCs you want to raise $6-7M (and thus a $24M to $35M valuation)[1]. VCs will view this as a potentially cheap company and kick off diligence, multiple meetings, and will get emotionally invested in the business and excited about the team and their prospects. Once the VC is emotionally engaged and excited, they are more likely to drive up your valuation so they can win the deal and you will get to $10M. In contrast, if you ask for $15M they will never put in the effort to get to know you and will just pass up front.

It Is Hard (Close To Impossible) To Go Back Once A VC Passes
Once an investor passes on your round it is almost impossible to go back at a lower price / dollar amount. You have already burnt that bridge. The VC has moved on to other potential investments and your company is seen as a "stale" or unattractive deal. After all, you could not convince anyone to give you money before, so that means the herd of other VCs is not interested (and therefore your company must not be great).[2]

What To Do If Everyone Passes On Valuation
If you get a consistent message that VCs are passing on you due to valuation you should:
1. Ask for additional feedback on what your company is doing and your story. Sometimes it is purely valuation, but sometimes VCs also use valuation as an excuse to pass if they don't like something else. Incorporate this feedback into your pitch and iterate on it. If at all possible, ask for this feedback over the phone. VCs will be less willing to be up front with you over email then on a call[3].

2. Add more people into the pipeline for your fundraise and go to them with a lower valuation then before. Even a $3M-4M drop in requested dollars raise can make all the difference (e.g. raising $6-7M versus $10M).

3. Iterate on (1) and (2).

If you can not raise money even after dropping your up front ask, there may be something more fundamentally at issue. Dig in and see what is turning investors off about your company.

[1] VCs tend to try to buy between 18-30% of the company in a series A with most falling between 20-25%. So, a rough rule of thumb for valuation is to multiple your capital raise by 4-5X to get your post money valuation.

[2] You can always engage with the VC at a later round e.g. 6-12 months later. You just can not go back to them for the same round.

[3] You can of course, ask a VC for 5 minutes by phone to get the feedback. Tell them up front on the call that your company culture is one of continuous improvement and getting feedback on your pitch is part of it.

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Lead VC Vetos

Monday, February 6, 2017

Market Caps & The 2% Rule

One way to assess whether a startup idea is in a good market is to ask what are the market capitalizations of the biggest companies in that sector. For example in consumer internet, Google ($560 billion) and Facebook ($370 billion), and in enterprise software Microsoft ($460 billion), and Oracle, ($167 billion) are all large, high margin businesses.

Market caps in a pre-existing industry[1] tend to be proxies for the potential of the idea you are working on. There are three reasons for this:
1. The market capitalization of a set of companies reflects revenue in the market, growth rate of revenue and earnings, and the margins of the companies.
These core metrics used by wall street to value a stock are all metrics that help you understand whether a market is overall large, growing and profitable - all signs of a good market to enter.

2. Often, potential competitors are also potential acquirers. 
Having a large number of high valuation potential buyers in a market creates strong exit opportunities for a startup. For example, for Google to pay $1 billion for a company, it is only 0.2% of its overall stock or market cap. In other words, Google can afford a lot of acquisitions in the $100 million to $1 billion range.

In contrast, the US car rental business is a tougher one. There are 4-5 major players. The largest by far is Enterprise, with $20 billion in global revenue and a $20 billion market cap. The remaining players are much smaller ranging between $1 to $5 billion in market cap. The key characteristic of these companies is that they trade at a low multiple of revenue (e.g. Enterprise trades at 1X revenue) suggesting low growth and a competitive, low margin, market.  Starting a traditional car rental company therefore may be a tough endeavor. Starting a software company that only sells its product to car rental companies also seems like a bad idea - you only have a few potential customers who will each have lot of bargaining power.

3. Strategic investors.
Large, high market cap, cash rich companies tend to be great strategic investors at the later stages for a company. This valuation-insensitive capital can help accelerate a company by giving it a large war chest to act on. For example, GRAIL, an early cancer detection company is raising over $1 billion for its series B. I would not be surprised to see a number of pharmaceutical companies, payors, and health networks participating in this investment round and investing e.g. $100M+ each.

Early Markets Can Be Misleading
The hard part about this approach is defining the real market you are in and the companies that make it up. You can also be fooled by smaller, nascent markets that grow really fast. These are the best types of markets to be in. For example, the consumer cloud storage market when Dropbox started was itself not a large market yet, but clear potential buyers like Google (who had a cloud storage product internally for many years that never quite could launch for some reason), Microsoft and Apple were clearly relevant and in the same general market area. Dropbox recently claimed $1 billion in revenue.

At founding, was Uber a black car company? A taxi company? Or a replacement for transportation and buying a car? If you thought Uber was just a black car company (which in some sense it was at founding) the overall market size seemed middling. Even as a rental car replacement the market size is small and the potential buyers for it like Avis, Dollar, and Hertz range in market cap from $1.5 to $5 billion. This means, with the exception of Enterprise, it would have been tough for any of these other companies to pay $1 billion for Uber. In contrast, thinking of Uber as a replacement for cars (GM alone has a market cap of $50 billion and car makers in general are worth hundreds of billions in aggregate) means Uber has enormous potential especially given its lower fixed costs and higher margins. If reframed as a technology company, Google et al. become potential acquirers and potential market value is even higher. It is therefore no surprise Cruise was bought by GM for around $1 billion - this is 2% of GM market cap and therefore worth the dilution by GM relative to the potential upside (and cataclysmic downside if self-driving cars happen and GM is not a player).

New, high growth markets are also hard to assess. For example, when Google was founded the internet was a much smaller place. So looking at the market capitalizations of search engine companies would be a bad proxy overall. However, if you viewed Google as an ads business, or as a technology business, it became more attractive due to the market caps of companies back in 1998 such as Microsoft, IBM, Time Warner, and others.

M&A: The 2% And $1 Billion Rule
In general, you want to be in markets where multiple companies could afford to buy you for $1 billion, or where 2% of their market cap is at least in the hundreds of millions of dollars.

For example, Walmart's acquisition of for $3.3 billion was around 1.5% of its market cap, Cruise's $1 billion acquisition was 2% of GMs, and Unilever's acquisition of Dollar Shave Club was slightly under 1% of market cap. Above a few % of market cap, the nature of an acquisition and its approval by the company's board becomes a dramatically different conversation.

Thanks to Ali Rowghani for comments on a draft of this post.

[1] Versus a new industry, which is addressed above.

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Saturday, February 4, 2017

Building VC Relationships

A common mistake founders make is to try to meet VCs to "build relationships" a month or two before going out for a series A or series B fundraise[1] . I explain why this is a mistake below. If you do not have strong VCs relationships and plan to fundraise in 2-3 months, wait to talk to VCs until you go out to raise. Do not do a separate "get to know you" tour. If you plan to go fundraise in 12 months, you can start to build select VC relationships early with a handful of firms.

VCs Remember Most Early Interactions As Pitches
Investors at top tier VCs are constantly deluged with a stream of companies wanting to pitch them. If an investor meets *only* 3 to 5 new companies a week, she is meeting with literally 150 to 250 companies a year. As such, it is unlikely she will remember every nuance of why and how you are meeting - and will default to remembering your meeting as a pitch. Additionally, relationship-building meetings a month or two before a real fundraise in reality often turn into a half-cocked fundraise. You are not really fundraising, but you really sorta are, even if you tell yourself otherwise.

For a VC round you need to have a well-rehearsed, pressure-tested pitch ready to go. You not only need to wow the investor in the first 5 minutes, but create momentum around an active fundraise. Going in half-baked will only backfire.

You also want the timing dynamics of a fundraise properly in place - e.g. if the VC is super excited about you, she will press for you to come meet with the partnership and your company will not have a competitive process in place. If she is not super-excited, she will think of your company as a "pass" and will decline to engage 2 months later when you have your materials and pitch honed. Either outcome is a loser from a fundraise perspective.

If You Want To Build Relationships, Do It 6-12 Months Before A Fundraise

If you want to build VC relationships early, choose a small number of select firms you want to get to know. If you talk to them 6-12 months before a fundraise, enough will have changed with the company since you last spoke that they will want to engage for your actual raise. Some general rules of thumb:

  • Choose which partner you would want to work with eventually - and get introduced only to her up front. VC firms have a relationship management system where the first person who meets a company becomes that company's lead (in some cases in perpetuity). This is crucial, as you are largely stuck with that person as point of contact going forward. If she ends up being a bad advocate for you, you will not get funded by that firm. Ask for intros only to the partner you would want to work with at a given firm.
  • Don't meet with too many VCs. Meeting VCs can become a full time job. Between the travel time to Sandhill / SOMA and the meeting prep VC meetings can take a lot of time. Choose the 4-5 people you really want to stay in touch with, and then meet with them every 6-12 months.
  • Learn to say no. Once you make the VC relationship, that investor may want to meet more frequently then you do, to introduce you to their portfolio companies[2], or otherwise engage. It is OK to reply with "I am heads down on product right now but happy to engage later when I come back up for air".

VCs (Usually) Won't Invest Preferentially In Friends
I have seen entrepreneurs build incredibly deep relationships to firms - who then never invest in the founder. A common message from a VC to an entrepreneur who is not fundraising is "my partnership loves you, and loves what you are doing - we want to fund you anytime". Unfortunately, this message often ends in tears when you go out for an actual fundraise if your startup does not have the traction to get funded. VCs make business, not personal, decisions around investing. They also need to convince all their other partners to invest in you and do not have unilateral decision making. It costs them nothing to emphasize how much you should really talk to them when you decide to raise money. Would you give any friend of yours $10 million just for being a friend? If not, why would a VC do that? Don't be deluded by the VC friendship.

[1] I truly mean series A and later venture funds here. Angel fundraises are different and you can talk to them early if you want to suss out the landscape. Even there, I would limit conversations to a handful of folks. You do not spend all your time in meetings instead of building a product and team.
[2] VCs may sometimes do "blind intros" to other companies in their portfolio for you and that company to partner or work together. Most startup to startup intros are a total waste of time from a partnership perspective.

Lead VC Vetos