VC Perspectives

At the end of the day, for a VC it is all about exits. We are in the business of building companies and then selling our shares at a (hopefully much) higher value than we originally purchased them for.

As a VC in the Nordic region, we wanted to understand if the market in which we operate is attractive enough in terms of if it is producing enough exit value. We also wanted to improve our knowledge of:

• are there differences between the Nordic countries
• in which sectors value creation has occurred
• impact of VCs both local & international
• exit market in terms of IPO vs M&A and important geographies for exits
• the time it takes to build companies that get exited

As a result, we have over the last few years collected information about more than 250 Nordic technology exits relating to the areas in which we invest. The focus has been on VC & angel investments plus companies that Nordic VCs or angels had the opportunity to invest in.

I have included a presentation of some of our findings which you are most welcome to make conclusions from. In general, it is not easy to make conclusions on what works and what doesn’t, but it is usually very beneficial to have discussions around some of the pieces of data that we have collected.

Here are some of the conclusions we drew:

• The Nordic region is an attractive market - relatively much larger exit value than rest of Europe
• Technology sector is maturing - more substance, less expectation exits
• IPO & exit to US companies are vital for large exit value BUT IPO dried up after 2001 and US economy is not as dominant any more - what will the impact be?

There are many reasons why US has been more successful than Europe in producing fast-growing startups and good returns for investors. And although Europe has caught up the last years, it still falls behind the US in terms of having a well-functioning ecosystem of investors.

Ultimately, we’re all in one way or another striving for the same thing - building great companies. To support this, it is important to have a well-functioning ecosystem of investors ranging from angel to late-stage investors.

The system must have money AND liquidity in all phases. That’s why I really dig the initiative of ArcticStartup to include angel investors in their ArcticIndex database. Angels are often the best resource for startups in the very early stages. In pretty much all of our investments, we have either invested together with angels or provided follow-on investment for companies that already have angel investors.

So, I hope that angels and entrepreneurs can meet more easily through ArcticIndex!

Guy Kawasaki (ex-evangelist at Apple, venture capitalist, entrepreneur, blogger etc) is one of my favorite reads. Some time ago I read his book Reality Check which is basically a do’s and don’ts plus helpful tips and insights to building successful startups. One of the entertaining parts is his lists of top lies that VCs, entrepreneurs, lawyers and partners et al tell.

I have now worked as a VC for a bit more than 2 years so I figured it would be fun to look back and give some of my thoughts on the top-10 VC lies that Guy mentions in his book.

1. I liked your company, but my partners didn’t

Guy argues that if the VC really believes in your company, he/she will make sure to get the investment through.

I don’t really agree with this. We have had several cases where one partner really believed in the investment but we still decided not to invest (all investments need to pass a vote of the whole team). However, I fully agree that this should not be used as feedback to the company because it doesn’t help the entrepreneur in any way. It is much better to give the reasons why ultimately not everyone in the firm believed in the company.

2. If you get a lead, we will follow

Yepp, this is a cop-out. We think your company is interesting but we’re not fully convinced. However, if a big-name VC is willing to invest, so are we.

For a Nordic VC, one of the biggest challenges is to figure out if a local company really has the potential of making it globally. So if a VC outside of the Nordics decides that they think so, it naturally makes us more convinced as well. The drawback is that if a local company manages to attract e.g. a US VC, it may be too late for the local VC to get in anyway. Ironic, isn’t it…

This one shouldn’t not be mixed up with point 4 below.

3. Show us some traction, and we’ll invest

The lie here is that even though you have traction, we may not invest. But traction is often fundamental for a VC. Firstly, faced with the option of a company with traction vs a company without traction, the answer is pretty obvious. Secondly, especially for consumer-facing products & services, it is close to impossible to “know” what millions of people will like and how they will behave so traction in the form of user growth or conversion becomes essential for making qualified investments rather than throwing darts.

4. We love to co-invest with other venture capitalists

Guy argues that if a VC really likes a deal, no way someone else would be let in. I don’t agree. Especially during the last 12-18 months it has been very clear that most companies need more money than expected and that it is really hard to raise money even for great companies. At Creandum, we prefer to syndicate and it shouldn’t be mixed up with point 2 above. This genuinely means that we like the company, would like to invest but think it is better for the company and for us to co-invest with someone else. It gives additional financial capability and also more resources to allocate to the company (see further point 6 below).

5. We’re investing in your team

Yes, we invest in teams. But it doesn’t mean that the team will have our support forever. Most successful startups change some or all of the original team members along the road. A hard-earned experience is that once we think it is time to change key people at the companies, usually it should already have been done.

6. I have lots of bandwidth to dedicate to your company

Many VCs say that they are active investors. And most are compared to many other type of investors. But I think that VCs tend to exaggerate the time they actually spend on an individual company. A VC cannot really sit on the board of more than 3-5 early-stage companies and still be heavily involved. If you are looking for a VC that really can allocate time and pull up the sleeves, my advice would be to a) check how many companies they are involved in and b) take references from companies that they are or have been working with.

7. Do you mind if one of our associates accompanies me to your board meetings?

Guy argues that although this isn’t a lie per se, it doesn’t necessarily mean that you’ll get lots of extra support. As an entrepreneur, I wouldn’t be too worried about this request. Usually it means that someone young, ambitious and usually smart person will help out with various tasks and sometimes this person actually have much more time to allocate than the senior partner at the VC-firm. But of course, if you decided upon a certain VC due to that senior partner and an associate is what you get, you might feel a but cheated.

8. This is a vanilla term sheet

Guilty. It is true that most VCs have quite similar terms and that some terms almost have become industry standards. However, a standard term sheet is more of a set of items that a VC would like to have in place. Most individual items makes sense but the total may not be applicable for your company. And usually there is room for negotiation at least if your company is attractive enough.

9. We can open up doors for you at our client companies

Guy argues that since a VC cannot get a customer to commit to your product, it’s just a slick pitch. Well, I agree to that VCs can’t really make anyone buy your stuff but VCs definitely can and do open doors and make introductions and I think this actually can have great value to entrepreneurs.

10. We like early-stage investing

Usually VCs don’t want to limit themselves so why say you don’t like early-stage investing. Best way to check this is to see what investments the VCs have done. If a VC hasn’t done an early-stage investment in several years, it is usually a sign that you’re not getting any investment either. Sometimes, it can still make sense to get to know a VC at an early stage, VCs like to follow the development of companies even before they are ready to invest.

Finally, I would like to add one lie that I think is quite common. One of the main reasons why a startup gets a no is because the VC doesn’t think the team is strong enough or that we don’t get a good feeling of the entrepreneur(s). Now, I think this is sometimes a pretty difficult thing to say so I have a tendency to rather communicate other reasons.

As much as a VC meeting is a chance to convince the VC to invest in your company, it can also provide an opportunity to get some perspectives on your business. VCs work with lots of companies and meet even more, and although we ask stupid questions at times, we hopefully also ask questions that can provide food for thought and maybe even push you to better define what your business is about or what actually is important.

On this note, I found a pretty amusing post on TechCrunch by Redfin CEO Glenn Kelman who lists the best questions they received when fundraising. Not all may be applicable to your business but I think most of them are pretty fundamental for any startup.

Last week we gathered our portfolio companies for a network day. This is something we do every year with the aim to connect our portfolio companies with each other. It’s a chance for our portfolio companies to get to know each other, and exchange experiences or views on topics and challenges that they are faced with as entrepreneurs. It’s also a chance to come together and discuss matters outside the daily routines and hopefully get some new perspectives or insights to bring home to the organization.

This year we had two very impressive speakers to add to the mix. One speaker was Måns Hultman who is the Chairman of the Board and previous CEO of QlikTech - the fast growing Swedish business intelligence software company that is one of the very few European software companies that have managed to grow revenues to more than €100M revenue / year.

Måns told an engaging and inspiring story of how QlikTech at several occasions was close to going down the drain but came back stronger every time. What I found particularly interesting were the company’s strong attention to details and very heavy sales focus. They have developed a strong sales process and every employee is taking part in sales training. QlikTech works hard with building the sales pipeline and then knows exactly how to work the process to get as many customers at the end as possible and they know in detail how many percentage of potential customers leave at given phases in the sales process.

The other speaker was Gurra Krantz who’s one of the most well-known Swedish sailing skippers. He’s been competing in 2 America’s cup and 4 around-the-world races. Gurra was speaking about what it takes to win, the determination that goes into being out at sea competing for 9 months, and how to create a winning team that is ready to be focused on the matter at hand for such a long time. A lot of it comes to really knowing why we are doing things and then relate most matters to this. As an example, since the sailing boat won’t go faster just because you have clean underwear, then it is not really a question for discussion wether or not to bring extra underwear for the race. Because it’s all about how fast the boat can go. This sounds extreme of course, but Gurra’s determination, focus and ability to get everyone on board for a common purpose is probably something which relates him to many successful entrepreneurs. Unfortunately, I don’t have the presentations available for upload but I did find a short excerpt from Gurra talking about team performance which I hope you will enjoy.

According to a recent comScore report, social networking sites now account for more than 21.2 percent of all US online display advertisements. And out of that chunk, Facebook and MySpace account for more than 80%. On one hand it positively underlines that where people spend time, money will eventually follow. On the other hand, it also underlines the very high dominance of a few successful sites/services/communities grabbing an extraordinary high portion of the total revenue.

In a couple of previous posts, I have talked about methods for company valuations. But regardless of what method to use, it is perhaps even more interesting to think about what actually can be done to impact the valuation.

Yesterday I was attending a conference with Swedish Trade Council and among the presenters was Niklas Edler from an M&A and valuation institute called Skarpa who mentioned the following factors:

1. Transfer human capital to structural capital - reduce dependence on key individuals
2. Bridge the information gap between the seller and the buyer - the seller knows more than the buyer who as a result will discount the price based on the uncertainty
3. Create foundation for positive development - revenue growth, margin improvements
4. Financial transparency - reporting, follow accounting rules etc
5. Formalize the company - don’t mix personal and company business
6. Minimize owner dependencies - the buyer don’t want the company to be depending on previous owners
7. Clean up the balance sheet
8. Minimize risk in company - avoid depending on one product or customer
9. Show profitability - cut costs, improve margins etc

Looking at the various points they all pretty much come back to two things:

• Financial results (which impact all the valuation methods)
• Risk (buyers don’t like risk)

Another way of looking at it is that the financial results is the basis for the valuation. Strong, profitable growth is often the most important component to drive up value.

Then the risk relates to various amount of discount. Try to remove the risks and make it easy for someone to buy your company by for example having things in order, decrease dependence on key people and owners.

However, most really successful exits have that extra component which is not only attributable to financials or risks. It is that strategic value that some or several buyers may see in your business or technology. Oftentimes this is even more important to the end-valuation but it is really hard to foresee and build a company on. So my advice would be to work hard with the general value drivers and make sure they are top-notch. Then if you on top of it can navigate yourself to a valuable position with tons of strategic value that’s fantastic.

In my post about valuation of a startup, I mentioned a few different methods for trying to assess the valuation of a young company. As I was trying to find other good sources of information, I came across this interesting perspective by Paul Graham at Y-Combinator.

This is an interesting way of looking at things in the early stages for example when you’re inviting your first investor or thinking about providing ownership to an early recruit. Basically, if you think your outcome increases with more than you’re giving away, you should be fine.

Y-Combinator are sometimes accused of paying too little for the 5-7% ownership they request, but one should think about if the money plus what else you receive by being an Y-Combinator company is worth the 5-7% of dilution. I am pretty sure that the answer in most cases is yes! However, would it be the same if they only provided office space as some incubators do. Not very likely!! So, the valuation exercise often really is about valuing what you’re getting as much as at what price you’re giving it away.

Really cool way of showing how pieces of news are connected: The News Dots Network

Valuating a startup might be one of the trickiest thing to do and yet it is needed in any financing event. Here are a few different methods that we use at Creandum:

Multiple comparables

The most common method for evaluating startups is probably to find comparable companies and look at how they are/were valued. Usually the valuation multiples are expressed in terms of P/S (price-to-sales ratio) or P/E (price-to-earnings). There are several varations of for example P/E where one could look at P/EBT, P/EBIT or P/EBITDA.

Some issues/challenges:

• Difficult to find relevant comparables. Maybe the data points are old (multiples can fluctuate a lot) or maybe the business model or sector is different. For example, recurrent revenues are typically worth more than one-off revenues.
• Comparing your startup with listed companies introduce a discrepancy due to the lack of liquidity of non-listed shares (you can’t sell them at any time). We typically factor in  a 25-35% discount towards listed companies’ multiples.
• When using M&A multiples, there may be a strategic component specific to the case which may not apply to your startup (or the other way around).

Established valuation methods

There are several established ways of determining the value of a company. The most common one is probably DCF (Discounted Cash Flow).

Some issues/challenges:

• The DCF method (and similar ones) presumes that it is possible to accurately predict the future cash flow and is reliant on finding a steady state not too far away in the future. This is rarely the case with startups. So, this method should be used with caution and always in combination with other methods.

Target ownership (or the cap table approach)

Many VCs are looking at getting a certain target ownership in the companies that they invest in. At Creandum, we typically like to have an 20-30% initial ownership to make it worthwhile spending time and money while still making sure founders have enough ownership to cope with additional dilution in the future. Combining the target ownership (=dilution of founders) with money raised actually indirectly gives the company valuation.

This method is quite wide spread in very early cases. For example, Y-Combinator and similar seed investors are using it heavily.

Some issues/challenges:

• This method does not really account for any aspects of how attractive your startup is, how fast it will grow, how much anyone will be willing to pay for the company etc. Still, it is an important component to make sure that the ownership structure (=cap table) is attractive also after an investment so it makes sense to use it together with other methods.
• Money raised becomes an important valuation factor. The more money raised, the higher the valuation could have to end up at to get a balanced ownership structure. Naturally, capital requirement per se does not say anything about the value of your company.

Counting backwards

A VC wants to make a good investment. Knowing the VC, you probably also know roughly what they expect in terms of returns. At Creandum, we are looking at 10x our investment in seed & early-stage cases and maybe 3-5x in more mature cases. Depending on the likely time horizon to exit, it is possible to define what kind of exit value is likely to achieve. For example, if you project a revenue of $100M in 5 years and a P/S of 2 at the time of exit means that the company will be worth $200M at exit. So to give the investor a 10x return multiple in 5 years, the current value of the company would be $20M.

Some issues/challenges:

• The return multiples that VCs are looking for do not really reflect your specific startup. The VCs have learned (the hard way) what multiples they need for good exits to balance the bad ones. And of course, your startup will be great so in that sense you’re paying the price of other failures.
• The investor typically is looking at getting on average 10x on the money invested. So if you need more money to get to the exit in 5 years, this may be factored in to a lower valuation of the startup today.

Important aspects

As you may gathered, there is no right way to value a startup and we are typically using a combination of most or all of the above methods.

A few things to remember:

• Liquidity: an equivalent listed company is (and should be) valued higher than a non-listed company.
• Absolute returns are usually more important than IRR for a VC meaning that it is better to get big exits even though it takes more time.
• While there are many ways to try to pin down the right valuation, the value really is determined by what the buyer and seller can agree upon. More competition among investors usually means higher valuation.
• Getting a high valuation early on may feel great but it can turn out to be very challenging when things are not going as planned. Also, new investors coming in at a high valuation will peg their expected exit according to the multiple on invested capital which in turn may force the founders to be locked in longer to get that big exit.
• The valuation is only part of the deal, other terms may be at least as important.

It would be interesting to hear what others think about this interesting but difficult subject!