VC Perspectives

A few week backs I spent some time in Boston and New York with fellow Nordic VC colleagues meeting US investors, VCs, entrepreneurs and academia. It as a great week and here are some thoughts and remarks from the trip.

The state of VC

In general, the views on VC is pretty pessimistic. As in Europe, US investors and VCs are debating the poor returns from VC during the last 10 years: on average, VC returns have been zero or worse.

There are several explanations to the situation, the most common one being that there’s just been too much money injected into the VC market. Many VC firms grew in fund size and many average VC firms received lots of capital as well (the total amount of yearly VC investing doubled or tripled from mid-90s to mid-00), while at the same time the IPO-market has been much worse compared to the boom years.

Most agree on that what will happen is a healthy readjustment with fewer, smaller funds & teams and total VC investment levels down to what they used to be before the millennium.

There’s also self-criticism on behalf of how the VCs have been investing, throwing money at companies to grow (too quickly) and get a quick exit. Now, the VCs are now even talking about finding capital efficient companies.

Capital efficiency

Maybe not something you would expect to hear from US VCs; it is often said that European VCs are not providing enough capital for the companies early enough but there’s definitely much more focus on investing in capital efficient companies. Or as Axel Bichara at Atlas Ventures put it: Prove-Build-Scale.

The LP (VC investor) perspective

The classic VC approach is to have a few home runs providing the returns and cover for the bad ones. However, this approach has meant high volatility (how much the returns fluctuate) with a few good exits creating almost all positive returns. So when the exits weren’t as many and as big as before and the failures increased, it became difficult to get consistent, good returns. From an investor perspective, this creates a problem because they want consistent, good returns. As a result, LPs are more and more appreciating stable returns and fewer failures which few VC firms have provided, alas LPs’ appetite for VC has gone down.

Dare to invest early

I was surprised to find that most of the VC firms we met (large, top-tier funds) still are doing early-stage investments, even seed investments. The problem is normally that when you have a billion dollar fund, it is hard to justify small, early investments because of time and resource aspects - it is more efficient to invest large pools of money at the same time. So it was very encouraging that the VCs are still regarding it important to continue to do early deals as well.

Terms

A typical A-round is 1x participating liquidation preference where the VC invests x dollars on x pre-money valuation. This means that the VC owns 50% after the investment, the founders 30% and 20% is usually allocated for options. This is quite different to the Nordics where VCs typically would own less after the first financing round and where much lower amounts of shares are allocated to options (partly due to tax issues of course).

Here’s a good article about what’s wrong with the venture capital.

VCs usually use various forms of preference shares when investing. As an entrepreneur, it is important to know what this means since it will affect things such as how proceeds from an exit will be distributed.

Through Fred Wilson, I found this good link to a description of how VC terms affect the proceed distribution in various cases. Here it is.

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?

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.

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.

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!

Every year SVCA puts together a report of VC & PE-related activities from which I have picked out a few interesting data points.

Although total amount invested from Swedish VC-offices (into all geographies) went down in 2008, the amount invested in startup companies was at its highest amount ever. The investments in startups have actually gone up pretty steadily since 2001 whereas expansion and seed investments are much more tightly connected to the economic situation (click for larger picture).

It could also be interesting to look at how much as been invested in Swedish companies independently of from where the money came. Here the development is quite unambiguous with investments increasing also in 2008 despite the financial crisis.

Finally, an interesting point is to look at what happens to the various investments, i.e. what is the hit rate for VC-backed companies.

To simplify, in 57% of the exists, the VCs made a relevant exit meaning that it sold its shares to an external party. This is actually a bit higher than I had expected; it will be interesting to look at the numbers for 2009.

The case of selling back to founders can be a relevant exit but often it is a sign of that it was not possible to sell the company to anyone else.

In a previous post, I discussed the issue of betting on the idea or the team. Although research suggested that the idea was more important, especially in early-stage when so many things are yet to be defined (even the idea), the team is absolutely critical and often the most important aspect for the VC. But how can entrepreneurs convince a VC about the strengths of the team?

When I am evaluating teams I tend to look at:

Managerial and organizational skills

A team means more than one person. At Creandum we don’t invest in single individuals and we prefer teams of more than two people.

Building a great business has a lot to do with being able to scale the organization. This means recruiting great people as well as creating frameworks for people to perform. The more complete the team is in terms of complementing talents and experiences, the better it is and previous experiences of building organizations are clearly beneficial.

Vision vs execution

Great teams manage to be both executive and visionary. To have a sense of where you are going is important but making sure things happen is even more important. Previous achievements that show executive skills are important and could range from previous ventures to extra-curriculum activities.

Entrepreneurial mindset

Things that I look for include drive, ambition, seeing and seizing opportunities, and being able to create things with limited resources. 

Sales skills

In a startup, almost everyone will or should be involved in sales in one form or another. The sooner a company realizes that products do not sell themselves the better. But you’re not only selling to customers but also to suppliers, investors, banks, and future employees, advisors & board members. The best way to show good sales skills is to have paying customers but how you handle the VC-relation could also be a good indicator (e.g. preparation, presentation, issuing good news at the right time, professional and timely deliverables, over-delivering etc).

The spike

The spike is an area where the team is especially strong. It could for example be technology or specific industry experience/insight. Understanding the industry dynamics and what it takes to be successful is often critical to evaluate market opportunities as well as how to beat the competition. In some cases, patents and IP-rights are valuable but more often it is all about making sure you are better than everyone else at delivering value to your customers.

Integrity and trustworthiness

I want to invest in people that I can trust. Who are not afraid of breaking bad news and who are genuinely interested in building a great business. This is perhaps the toughest part to prove but getting a recommendation by a trusted person is usually helpful. Also, make sure to not overpromise and under-deliver e.g. in terms of falsification of numbers, contacts and relationships, and previous achievements.

In the VC community, there’s an ever-ongoing debate about if the business idea (=the horse) or the team (=the jockey) matter most.

I would say that the most common viewpoint is that the team is more important for several reasons:

• A great team can make also a mediocre idea successful or they will come up with a new more successful one
• A mediocre team can mess up even a great idea
• As markets change (and they do), a great team will adapt to the required changes

However, when Steven Kaplan (one of the leading researchers on private equity) and his research team studied VC-financed firms from early business plan to initial public offering (IPO) to public company (three years after the IPO) they found that on the margin, you should bet on the horse.

Why? First of all, the study showed that it rarely happens that a good team is successful with a poor idea. Secondly, it showed that you can have a good idea and a poor management team and still end up winning (VCs change management teams frequently). In other words, a bad management team does not necessarily kill a good idea, but a bad idea is rarely overcome by a good management team.

Personally I think that in early-stage venture you need to bet on both. The idea has to be good enough and it needs to be in an interesting enough market. Also, if the idea is not very good, it says something about the team as well. But the earlier you invest, the more the jockey matters. In the early stages, a good idea is only a rough diamond that needs polishing. It is hard to recruit new management in an early stage and get the same commitment and hard work as from founders. Also, no idea or product sells itself so you need a great team that can sell the idea or product to customers, employees, advisors, and investors.

Link to the study