Off Balance #13

???????? Hi friends!

The older I get, the more I open myself to moments of planned serendipity.

Yes, I know that is a contradiction in terms. But hear me out.

When I go to events, I usually get overwhelmed by the sheer number of people there are. Having conversations in rooms where it’s so loud you can hardly hear yourself think isn’t really my cup of tea.

So I flipped the script at last week’s London VC Network event that EmergeOne sponsored.

I ran a podcast studio – in amongst the flowing free drinks – and ended up having ten super high quality conversations with VCs, founders and operators.

It was valuable one-on-one time to get to know each of them and form an actual connection with the added bonus of getting some super cool ‘podcast on the move’ content.

And I had never met most of the folk I ended up interviewing.

So you can rely on serendipity… or you can simply engineer your own.

In this weeks Off Balance, I’ll be chatting about:

???? How the Metaverse just got interesting
???? Early stage predators
???? VC Fund metrics worth understanding

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and drop me a note 🙂

(If you are trying to connect with me on LinkedIn, maybe read this post I wrote and make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????)

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

This edition of Nothing Ventured is brought to you by EmergeOne.

EmergeOne provides fractional CFO support to venture backed tech startups from Seed to Series B and beyond.

Join companies backed by Hoxton, Stride, Octopus, Founders Factory, Outlier, a16z and more, who trust us to help them get the most out of their capital, streamline financials, and manage investor relations so they can focus on scaling.

If you’re a CFO working with venture backed startups and want to join a team of incredible fractional talent, drop us your details here.

If you’re a growing startup that knows it needs that strategic financial knowhow, drop your details here to see how we can support you as you scale ????

Crossing the Rubicon

If you only consume two pieces of content this week, it should be this:

Read the rest of this newsletter ???? 

Watch Lex Fridman’s interview with Mark Zuckerberg ???? 

And in that particular order.

I’ve no doubt that many of you will have seen the cartoony style Metaverse adverts Zuck and the Meta team made a year or so ago. You may have even rolled your eyes and laughed at its absurdness like I did.

This interview, however, is anything but absurd.

Lex and Mark have a conversation in the Metaverse as photorealistic avatars.

But, as you will see from the video, photorealistic feels like a bit of an understatement.

All I can say is that, we will continue to see technology such as this and AI improve almost exponentially with mind blowing speed (anyone see that ChatGPT can now write code by looking at a sketch you upload?) whilst at the same time costs continue to move to zero… we are going to see some pretty incredible stuff that most of us probably haven’t even imagined.

Here’s my conversation with Mark Zuckerberg, his 3rd time on the podcast, but this time we talked in the Metaverse as photorealistic avatars. This was one of the most incredible experiences of my life. It really felt like we were talking in-person, but we were miles apart ???? It’s… twitter.com/i/web/status/1…

— Lex Fridman (@lexfridman)
Sep 28, 2023

How can did I add value?

Recently one of my team reached out to me for a steer on a situation they had come across.

Here are the facts:

➡️ Founder had engaged an agency to build their product.
➡️ Agency had invested £150,000 into the business.
➡️ For the £150,000 investment, they had bought ~16% equity.
➡️ Which would value the business in the region of £950,000.
➡️ The agency had then taken £300,000 to build the tech.
➡️ i.e. an additional £150,000 over their investment.
➡️ The founder also had a non executive director (NED) on board.
➡️ The NED was associated with the agency that built the tech.

This sort of thing REALLY gets on my last nerve.

Here’s why:

✔️ Market salary for decent full stack dev (below CTO) – £80k p.a.
✔️ Market salary for decent front end dev – £60k p.a.
✔️ Market salary for decent product person – £70k p.a.
✔️ These numbers could be reduced if equity on offer.
✔️ If they’d hired a co-founder / CTO on salary + equity it would have cost less.
✔️ £100k salary reduced to £80k with say £20k in equity x 2 years.
✔️ Based on £950k valuation, this would have been 4.2%.
✔️ So they have spent more money and sold more equity than necessary.
✔️ Future investors coming in would have massive issues with the cap table.
✔️ This much equity to an external agency? Massive ????.
✔️ Not to mention, £300k for a product build? Sounds very high.
✔️ And who owns the IP? And who’s going to maintain the product?
✔️ Oh, and let’s not forget the ‘NED’.
✔️ They have essentially had their cake and ate it.
✔️ And whilst I don’t know this, I bet you they had advisory equity too.

Moral of the story?

At the earliest stages of your business there are A LOT of sharks out there looking to prey on unsuspecting founders.

It is worth finding and taking the advice of a few people who are:

a) completely impartial

b) experienced in early stage businesses

c) preferably founders themselves, because they are the most likely people to give you proper guidance – warts and all.

And of course, read this newsletter – I have a habit of being open to the point of it costing me business because I refuse to take money from folk that can’t afford it or don’t need it.

Image generated by AI using Dream Studio

Off Balance

Having trouble separating your DPI from your IRR?

Got your MOIC in a twist?

Well, I’ve got you covered.

Now you may be asking yourself why I’m expending all this time helping you to understand how VCs work.

I mean, if you’re a VC you know this (hopefully) and if you’re a startup founder, you care out the metrics that startups care about.

But whilst a lot of time is spent by various writers on one or the other, you need to understand both to be able to really be able to navigate the whole ecosystem.

Plus I just love geeking out on this sort of stuff, so you’re just going to have to put up with me ???? 

Let’s get into it – VC Metrics Explained.

VC Metrics Explained

Internal Rate of Return (IRR)

Calculation: IRR is the rate at which the net present value of all cash flows (both inflow and outflow) from a particular investment becomes zero. It’s essentially the rate of growth a project is expected to generate.

OK, lot of words there I know. Let’s unpack.

Present Value (PV) and net present value by extension is a concept that is used in a lot of financial analysis to help users of financial information allow for the ‘time value’ of money (the fact that money today is normally worth more to you today than it is to you tomorrow.

To get to a present value of some future amount of cash, you discount that future amount back using a discount rate (often called a hurdle rate, because it’s the minimum rate that you would want the investment or project to beat because you can get it elsewhere with less risk). So:

PV = FV (1 / (1+r)^n

PV is Present Value

FV is Future Value

r is the discount rate

n is the number periods to discount back from

When you have a series of cashflows over a series of time, you would discount them all back and sum them to get to a Net Present Value.

We would normally say that an investment is viable if the NPV is greater than zero (i.e it’s worth something in today’s money).

OK but wait, what’s this got to do with IRR?

Well IRR is essentially the discount rate where the NPV would be equal to zero.

In today’s spreadsheet driven environment, it’s easy to do this using a formula. But back in the day I remember having to work it out using trial and error – i.e. you would play around with different rates going between positive and negative NPVs until you got as close as you could to zero to get the IRR.

Example:

Let’s use a simple (albeit unlikely) scenario:

$100m fund but only does 2 capital calls – 50% in year 0 and 50% in year 2.

Deploy evenly over 5 years.

Money returned between 6th and 11th year.

I have shown the PVs and NPVs at at hurdle rate of 5% as well as 10%. You can see that they sit either side of an NPV of 0 (though the distance between the NPV and zero is closer at 10% than 5%).

I’ve then, through a process of trial and error, gotten an IRR of 8.83% (NPV of 7 – i.e. as close to 0 as I was going to get). And have then used the spreadsheet calculation to work out the actual IRR, which as you can see is 8.831%

Now, the largest inflow happened in the 10th year ($100m) in this example.

Let’s see what happens if I change the timing and have it happen in the 8th year instead, keeping everything else the same.

Even though the total cash returned remained the same at $180m, the IRR has increased to over 9.6%.

And this is the beauty of IRR – it gives you a way of evaluating a return whilst taking into account the time value of money.

Implications: A higher IRR would indicate a potentially more successful fund and portfolio of investments.

It is a measure of the profitability of the fund over its lifetime and takes into account the different periods during which investments are made and returns harvested.

Limitations: The biggest problem with IRR is that it doesn’t consider the scale of the investment. Two funds might have exactly the same IRR but vastly different net cash inflows – this is is easily illustrated by looking at a the same numbers but reduced to a tenth.

Now we have the same IRR, but instead of $180m returned, $18m is returned. Both are good results from an IRR perspective, but obviously one is far less capital than the other.

Or, indeed, if under the original scenario, less cash is returned, but it is returned sooner, once again you will arrive at the same IRR, but you have substantially lower overall ‘profit.’

Multiple on Invested Capital (MOIC)

Calculation: Multiple on invested capital, better known as MOIC is a way of evaluating the performance of a venture fund. It’s used as a fairly easy-to-understand shorthand, providing a snapshot of fund performance at any single point in time.

MOIC = (Current Value of Investment + Distributions) / Invested Capital.

Implications: MOIC essentially indicates how many times an investment has increased in value.

It’s normally expressed as Yx:

Y is the multiple

x stands for times

If you had an original fund value of $50m pre investment and currently the total value of all realised and unrealised assets in the portfolio is sat at $100m, you would have achieved a MOIC of 2x. This means the investment has doubled.

Limitations: There are a few issues with using MOIC to gauge fund performance, even if it is a very simple way to understand how well a fund is doing at a specific point in time.

The first issue is that MOIC doesn’t take into account the time value of money.

We saw this with IRR, especially the fact that cash in hand earlier will lead to a higher return in today’s money.

Equally, you could have a 10x fund, but what if it took 20 years to get to 10x?

If you were a Limited Partner (LP or investor in the fund) you might not be that happy that your money has been tied up for so long before getting a return from it.

The second (and in my opinion bigger) problem is the fact that it uses unrealised gains as part of the calculation.

Why does this matter?

Well one only needs to look at what’s been happening over the last few years in private markets to understand why.

We have seen lots of businesses raise at hugely inflated valuations that have now had to raise at much lower valuations.

This is a problem in venture capital and other private market asset classes (e.g. property) where there is a regular flow of liquidity and buying and selling of shares that can help you ascertain true value of an particular business as you can in public markets.

This means that MOIC is driven by so called paper valuations (i.e. based on last round size) as opposed to an analytical approach that is substantiated by the market and can mask problems in how those valuations are derived.

It should also be apparent that it drives the wrong sort of behaviour as early investors are always incentivised to push up valuation and encourage ever larger rounds even where the business doesn not warrant it.

Distribution to Paid-in (DPI)

Calculation: Distribution to Paid-in or DPI is what I would look at most closely if I were trying to evaluate fund performance – especially funds that had been fully deployed or were reaching the end of their life cylce.

Why?

Well, as I am fond of saying, cash is both reality as well as king.

DPI essentially looks at the cash returned to investors versus the amount of cash they’ve already put in. In fact, it’s often called the cash on cash return.

It’s the purest representation of the actual return on LPs’ investment into a fund and is calculated as follows:

DPI = Cumulative Distributions / Paid-in Capital.

Implications: Like MOIC, this is a simple and easy to understand way for LPs to understand how their investment into any given fund has performed.

Like the old saying goes, a bird in the hand is worth two in the bush – or cash in my pocket is more valuable to me than cash in yours!

Limitations: Similar to MOIC, there are a couple of limitations, the first one, just like MOIC, is that DPI does not take into account the time value of money.

If, as an LP, my cash is returned only after a couple of decades then that isn’t great – though at the very least, if my DPI remains pretty low for several years after the fund has been fully deployed then it’s a pretty good signal that I need to have a conversation with the fund managers.

The second problem and one that runs contrary to what I have said earlier, is that it doesn’t consider unrealised gains or potential future distributions. So even if some of the investments made have had legitimate lifts in their valuations, this is not reflected in DPI.

Total Value to Paid-in (TVPI)

Calculation: Total value to paid-in is very similar to MOIC, with one fairly large difference.

The denominator.

So whilst MOIC divides by investment value, TVPI uses paid-in capital as the denominator.

Essentially, MOIC is looking at the return on money actually invested into portfolio companies whilst TVPI looks at the return based on the total money an LP has put into the fund.

The reason these two numbers are different is that in a General Partner (GP) / Limited Partner (LP) agreement, the GPs will draw fees based on the total fund value (normally 2% of the total fund over each year of the fund lifetime) – so a 10 year fund of $100m would result in $2m of fees per year for 10 years – i.e. $20m.

That means (in theory) that only $80m is available to GPs to put into fresh investments even if the LPs have paid in $100m.

TVPI = (Residual Value + Cumulative Distributions) / Paid-in Capital.

Implications: This arguably gives a truer representation of the return on an LPs investment into a VC fund (than say MOIC) as it is the return on their cash invested.

But, as always, there are limitations.

Limitations: We again have the same arguments arising with TVPI as we did with MOIC.

Firstly the fact that it does not allow for the time value of money and secondly it relies on paper valuations which can be manipulated in private markets.

One way around this issue of valuations would be to mark the investments to market on a regular basis and outside of a funding round.

This can be done by taking into account recent funding rounds of competitors as well as public market valuations to see what valuation might be achieved based on today’s multiples.

Of course, this would lead to issues of inconsistency as it isn’t always easy to get to a market valuation today and it would be imprudent to mark up the valuation if the market is tending towards a bubble.

Residual Value to Paid-in (RVPI)

Calculation: Residual value to Paid-In, or RVPI, is a useful metric for investors to understand what the outstanding value of their investment in a fund is worth.

It tells them how much unrealised capital there is left to potentially distribute if all the investments could be realised for cash today.

Over a fund lifetime, RVPI moves to zero, either because investments have exited and funds distributed or because the value of the investment has been written off as the business has been wound up.

It is calculated as:

RVPI = Residual Value / Paid-in Capital.

Implications: It is a simple way for LPs to understand how much value is yet to be returned by the fund and can be used with other metrics to evaluate overall fund performance.

Limitations: Again RVPI ignores the time value of money and is reliant on paper valuations to calculate which, as already discussed, can be highly objective.

And finally… 

There are a few other things that an LP might look at to understand fund dynamics, which I’ll cover briefly here:

Vintage Year: This is the year in which the first influx of investment capital is delivered to a project or investment and is used to categorise investments by the year they were made. This helps if you are trying to compare performance across different periods. Of course, it in no way provides insights into the performance of the investment itself.

Capital Called: This is the amount of committed capital that has been requested by the fund (let’s say you have a $100m fund, the total $100m isn’t requested up front, but via a series of capital calls). The total capital called indicates how much of the committed capital has been put to use, either by way of investment or by ways of fees. Again, it doesn’t provide any insights into the performance or returns of the fund or, indeed, the called capital.

Capital Distributed: This is the amount of proceeds from the fund that has been returned to the investors (i.e. where a portfolio company has exited or wound up and cash has been returned first to the fund and then back to the LPs). Obviously this gives an absolute number that indicates the returns generated from the investments. But it doesn’t tell you how the investment has performed relative to the initial amount invested, nor does it account for the remaining value of ongoing investments.

Bringing it all together

Let’s consider a fund with the following dynamics:

The total fund size is $100m of which $70m has been paid in to the fund via a series of capital calls.

$55m of the $70m has already been invested and the current portfolio (excluding distributions) is valued at $90m.

On top of this, $15m has been harvested from a couple of early exits.

Can you work out the MOIC, DPI, TVPI and RVPI?

How did you go?

Hopefully it was pretty clear and the maths shouldn’t have been too complicated.

The only real red herring is the actual fund size which is not relevant in any of the calculations we’ve looked at.

Here is a breakdown of what you should have gotten back – notice the variation in results across all of these which is why it’s important to look at them together, not in total isolation.

And there you have it, a deep dive into VC fund metrics and why they’re important from the perspective of an LP.

From the perspective of a startup, if you are able to do this sort of research, then it will give you an important understanding of how the fund performs.

If you see funds with poor MOIC it possibly means that they’re not that great at picking high growth potential ventures, and if they have a low DPI (whilst being quite advanced in their fund) it could mean that they’re not great a creating exit opportunities for their LPs.

You may only be concerned about getting an investment today, which is valid, but you have to think about whether this fund will be around to follow on in future rounds or, indeed, whether it will be able to convince other VCs to invest in those future rounds and provide the markups that it (and, let’s face it, you) need.

It always pays to be aware of these things when you’re evaluating which fund you want to work with because as one of my previous guests on the podcast – Marcus Love – said, the average VC / founder relationship lasts longer than the average UK marriage. ???? 

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you would love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish

Off Balance #11

???????? Hi friends!

Last week was a little bit of a milestone for me.

I’ve been seeing a therapist for over a year, working through a bunch of stuff that I had been carrying with me for years – scratch that – decades.

A few weeks back, I had said to my therapist (one of the most empathetic, awesome guys I have ever met), that the work that we done had left me feeling the equivalent of several kilos lighter psychologically.

And that’s been shining through in my approach and attitude to pretty much everything these days.

So much so that when we sat down to talk last week, he suggested it might be time to wind things down.

I had been wondering what the next step was going to be as part of my therapy, and it turns out, the next step is more exploration of myself – it’s just that I have the tools to do it myself now.

Gif by Bounce_TV on Giphy

In this weeks Off Balance, I’ll be chatting about:

❓ Intrinsic vs Option Value when valuing a startup
???? What framework might an investor use to evaluate your business?
???? VC Fund Portfolio Construction and why it matters for you

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and drop me a note 🙂

(If you are trying to connect with me on LinkedIn, maybe read this post I wrote and make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????)

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

This edition of Nothing Ventured is brought to you by EmergeOne.

EmergeOne provides fractional CFO support to venture backed tech startups from Seed to Series B and beyond.

Join companies backed by Hoxton, Stride, Octopus, Founders Factory, Outlier, a16z and more, who trust us to help them get the most out of their capital, streamline financials, and manage investor relations so they can focus on scaling.

If you’re a CFO working with venture backed startups and want to join a team of incredible fractional talent, drop us your details here.

If you’re a growing startup that knows it needs that strategic financial knowhow, drop your details here to see how we can support you as you scale ????

Intrinsic vs Option Value

Having written about valuation a few weeks ago, I have continued to think about this topic as we continue to see changes in the market and large swings (typically downward right now) in valuations. Just look at The Lowdown last Friday – it explores Getir’s likely down round which may mean a drop in valuation of almost 80%.

And the problem that one obviously has to answer is: How can a business in a short period of time be valued at two massively disparate valuations?

The answer, as elegantly explained in this thread by Frank Rotman (@fintechjunkie on X), comes down to the two ways that businesses are valued, intrinsic value vs option value.

Here’s the short definition of both for context:

Intrinsic value = Valuing the business based on fundamentals such as performance, cash flows, assets etc.

Option value = Valuing the business based on expectations taking into account intrinsic value, volatility, timing and interest rates.

As Frank discusses, public market investors have become great at valuing companies based on intrinsic value.

The earlier stage a business is (and the less data it has) it will have some intrinsic value, but it should be the option value you are trying to assess when investing at these stages.

Going in depth into defining option value and valuing a business using tools like Black Scholes is pretty out of scope of this post, but you can get some more detail in this article on the former, and more on the latter in this one.

For now, this thread should provide a gentle insight to understanding the issues that go into valuing early stage business, and why it’s important to hold the option value in mind.

The great debate: What is a startup worth?

It’s a contentious question that’s widely misunderstood.

What follows is a framework that cuts to the core of the issue:????????

— fintechjunkie (@fintechjunkie)
Sep 16, 2023

How can did I add value?

I have been reconnecting with some people from my past and it has been incredibly fulfilling to see where they are in their lives today.

Occasionally, that reconnection goes deeper as we realise that we have been operating in the same space; whether with startups or in the wider venture ecosystem.

Recently I’ve been speaking to one such friend who is launching something that, I think, is super interesting and he asked for my advice on it.

He wanted to know if I could pick apart his model and give him some pointers around where investors might poke holes in his deck and what he’s offering.

Now, clearly, I’m not going to go into the specific details of what he’s doing and what I suggested, but I think it is valuable to think through what investors might be looking for when they’re assessing an opportunity.

The key to much of what happens in the venture ecosystem is learning to think from the perspective of the person on the other side of the table.

And as far as getting funded is concerned, it might just make that difference between being wired the investment or not.

I don’t have all the answers, nor can I tell you precisely what every investor looks for, but what I can tell you is that most will have some kind of framework that they will work with.

I’m by no means the most prolific angel out there – and only write £1k cheques at that – but I developed a framework that works for me and won’t be miles away from how others think.

I look at:

Thesis

Team

Tech

Traction

Transcendency

Let’s dig into each of these one by one:

Thesis
Does the opportunity fit in to my overall thesis?

An investor’s thesis may cover such thing as sector (though some may be generalists / agnostic), stage, geography, business model, team composition, impact and any other number of things.

So the point is, make sure that if you are reaching out to an investor, you fit into their general thesis.

For example, you wouldn’t go to Notion Capital with a pre-seed e-comm business because they invest at growth in B2B SaaS.

Team
Some would argue that this is the most important thing that investors look for, but as I’ve previously discussed, market size will trump team every time.

Nonetheless, the team is always important for investors as they would like to know that they can execute on delivering the sort of outcome that an investor is looking for.

Ways of “demonstrating” this may be:

Having been founder or senior in a well known startup

Having completed a doctorate

Been part of an elite school or company

Has an obviously useful network

Things to avoid are obviously brazen attempts to build an online profile and assuming that will be sufficient – you might find yourself a mile wide but an inch deep.

Also, it’s worth noting that some of these heuristics can be quite exclusionary – i.e. not all stellar founders will come from great schools, or have access to amazing networks.

This is often argued as one of the reasons why venture remains overly exclusive to the detriment of under represented groups.

Tech
This is my short hand for whatever it is that serves as a moat for the business.

This could indeed be the technology, but it could equally be a patent, or a brand moat.

Because I prefer investing in technology first businesses, for me, it tends to be technology in its simplest sense. But even there we may see variations between software or hardware led businesses that still fit into my overall thesis.

The reason this is important though is that if the business is easily replicable, or doesn’t have any proprietary technology or moat, then it could be relatively easy for a better capitalised business or even a competitor with better marketing capability to come and take the market from under you.

Traction
Traction doesn’t have to mean revenue. It doesn’t even have to mean users (though users and paying customers are pretty good forms of traction!)

The traction should be commensurate to the stage of business you’re at.

For example, at pre-seed, traction may include having sold a non-technical solution to the product you’re building, or having conducted significant primary research. Whilst at seed expectations are more likely to include having gone beyond MVP, having customers and showing growth.

Traction is essentially a way of telling an investor whether you will use their money to meaningful progress towards your milestones.

Are you able to get to revenue in a scrappy way without burning through too much cash? Can you build a product in a lean way? Are you able to execute?

This gives investors a useful yardstick by which to measure your progress against other ventures at similar stages.

Transcendency
OK, stay with me here!

This is a bit of a grandiose word that I use to capture a couple of things that for me are really important:

Is there a massive market to capture?
Is there ‘something’ special about the business or what it’s trying to do?

The former is easier to ascertain, and ultimately one of the most, if not the most important points when investors are considering an opportunity.

The business will need to have the potential to capture a large portion or a massive market and return cash to the fund and its LPs.

The second is a bit harder.

It’s that part of investing that is way more art than science which comes from muscle memory, gut and intuition. I’m still on that journey so am still making mistakes and learning, but that’s the point – if everyone could do it, there’d be very little upside.

(and yes I know Transcendency is a bit poncy, but I couldn’t find another ‘T’ other than TAM and that just felt a bit on the nose).

Bringing it all together
Now you may have strengths in some areas but be weak in others. That doesn’t necessarily mean you won’t get investment.

The point about venture is that it should be about outliers, not businesses that conform.

But the reality is that venture is a game of numbers and you need to be able to satisfy the basic calculus of venture math to have a chance of getting funded.

For me, my main takeaway over the years is that investors are driven by two things – some index more to the first whilst others will index more to the second:

Returns

Emotion

And you have to be able to tap into both for them to bring their money to the table.

Image created by AI on DreamStudio

Off Balance

I’ve talked a lot about how VCs might think about any one investment in particular, from valuing it to understanding the sort of return it is likely to provide for the fund.

But the problem with this approach to understanding venture is that it misunderstands two of the fundamental concepts that apply in VC – Portfolio Construction and Power Law.

Now I have mentioned the Power Law of returns a few times, and even I’m getting a bit annoyed that I haven’t gotten round to covering it yet – but patience my young padawan, it’s coming soon!

Today, I’m going to explore the equally important question of portfolio construction because, as a founder, you need to understand how a VC is thinking about their entire portfolio of companies – not just yours.

So strap in and let’s get going.

Portfolio Construction

Why does it even matter?
Portfolio construction is all about allowing VCs to think about balancing risk and reward in their fund.

It may seem obvious that you just want to build out a portfolio of the most successful startups out there, but in reality, the stage you invest at, the amount of ownership you hold, the number of companies that sit in your portfolio will all have an impact on the success of your fund.

Essentially it is about building a diverse portfolio in a high-risk environment to give you the best chance at meeting the fund’s objectives.

If a fund doesn’t have a solid plan around how they would like their portfolio to look, they may end up overly concentrated at a certain stage and putting all their eggs into one basket, or conversely have taken so many bets that it becomes impossible to make the sort of returns expected from VC.

For startups, it’s important to understand how a VC thinks about this so that they can understand where they fit into the mental model the VC might have about their overall portfolio.

Tackling Risk

There are many different types of risks that startups face. Here’s the top 4:

Market risk – Is there a need for this product or service?

Product/ service risk – Are there technical moats, or is this easy to replicate? Does it have a strong USP so it beats the competition?

Operational risk – Do they have a strong founding team? Can the team they’ve built execute their plans?

Financial risk – Will the company have access to sufficient capital to grow?

All of this to say that it is exactly the unpredictability of startups and the risks associated with them that makes it important to build a portfolio that dampens out the adverse impact of these risks being present in one or several companies you’ve invested in.

For startups, you will want to look at the specific risks that you have in your business and try and understand whether other companies in the portfolio already face these sorts of risks. If they do, it would not be a smart move for a VC to invest in your business.

What are the key themes in Portfolio Construction?
There are several themes that a VC fund looks at when developing their portfolio construction thesis with several factors (which we’ll discuss) that play into the decision making process.

But some of the key themes that a VC will want to decide when they are structuring their fund.

Should the fund be diversified? 

This means spreading investments across across stages, sectors and even potentially being flexible on cheque size.

It is sometimes called the spray and pray approach, but oddly the high diversification can lead to some interesting outcomes.

For example, according to Moonfire, as the fund approaches 200 companies in the portfolio, the likelihood of returning less than 1x drops to close to zero.

But conversely it means that the probability of returning a massive multiple reduces significantly.

Again according to Moonfire, the likelihood of returning 10x becomes almost impossible with portfolios over 110 companies.

Or should it be concentrated?

As you might expect, a concentrated fund is one that makes larger bets on fewer, high-conviction opportunities – potentially with less diversification across sectors and stages as well.

Clearly the risk here is if, as a VC, you are not great at picking winners, there is a strong possibility there aren’t enough ventures in the portfolio with sufficiently strong outcomes to provide acceptable returns.

Should we reserve for follow-on investments?

Follow on investing is where you may take up your pro rata rights in future rounds. Typically the data would suggest that you should only do this if the subsequent investment (the follow-on) would have been the right decision on a stand alone basis.

However it is also worth noting that VCs are always looking for a target ownership stake in the businesses they invest in, and this may mean that having a good follow on strategy and reserve makes sense.

For startups, it makes sense to understand these strategies, as whichever one your target investor follows will have a direct impact on their likelihood of investing in your company.

If you are going to need a lot of capital to scale and exit, picking a firm that generally doesn’t follow on may not be sensible, for example.

So what’s the right portfolio size then?
There are a several factors that go into answering this question:

How large a fund are we targeting?
If you target a $100m fund with a 2:20 fee strategy, this means you’ll have investible capital of $80m.

Cheque size?
If you only have $80m to invest, you aren’t going to be writing $10m cheques into your portfolio. This would leave you way too under-diversified and less likely to return capital. Normally, the most sensible strategy is to write the same size cheque into each investment.

So what stage can I invest at?
Based on the above, you would either be looking to lead at pre-seed / seed or follow at seed / series A.

What’s my investment horizon?
Clearly, if you’re investing at pre-seed, you’re going to have a horizon of 7 to 10 years before you start harvesting. If you’re investing at later stage, you would expect to earn returns much earlier. This then leads to the question of whether you recycle the returns back into the fund.

Expected Returns
If you expect potential returns to have no upper limit, then it makes sense to have a larger portfolio. If you expect them to be capped, you would be better off with a more concentrated portfolio so that your losses don’t wipe out the impact of your winners.

Investment Thesis
Clearly your investment thesis will have an impact on the size of the fund. If you are investing in a very niche sector, you may simply have fewer opportunities to look at leading to a more highly concentrated portfolio.

It is clear that when you build your thesis, you may not have sufficient data to be confident in the outcomes you’re predicting.

So it’s very important for VCs to keep adjusting their assumptions as they start deploying based on what outcomes they see.

For a startup, understanding all of these factors will help them target investors for whom the opportunity is going to make the most sense.

That’s not to say they’ll always invest (or even that, if you fall outside some of their core areas that they won’t – VC is after all a game of outliers), but it’ll give you a strong basis to argue your case based on what they are looking for, rather than your own assumptions.

There is a trend for VC to become more data driven, and the team at Moonfire are at the forefront of this. I’ve leaned heavily on some of their findings in this piece – after all… I’m learning too ????????

You can access the outcomes they found simulating nearly one trillion portfolios here and build your own portfolio using their simulator here.

Every VC will have a different approach, and as I have said throughout, as a founder you want to arm yourself with knowledge and understanding to give you the bet chance of targeting those VCs who are looking to build their portfolio with a company like yours slap bang in the middle of it ???? 

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you’d love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish

Off Balance #9

???????? Hi friends!

I’m back in London and the sun has been shining which makes coming home from a month in Tuscany a tad easier.

It’s good to be home though and I’m excited for what’s to come in Q4, not least introducing you to some amazing pod guests that we’ve got lined up ????

3 questions I’m answering in this weeks Off Balance:

???? What bad faith actors can harm the ecosystem?
???? How can M&A help founders when times are tough?
???? What are some of the most common economic terms in a term sheet?

I’ve also got some important news about the future of Off Balance and Nothing Ventured ????

Join my free webinar today with SeedLegals:
I’m looking forward to talking to Anthony Rose, CEO of SeedLegals at 2pm BST today about everything CFO related! If you’d like to understand more about the who, what, when and why of getting a CFO involved in your business, sign up here ????????

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn or Twitter (do I really have to start calling it ‘X’ soon?) and drop me a note 🙂

If you are trying to connect with me on LinkedIn, maybe read this post I wrote. Make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

This edition of Nothing Ventured is brought to you by EmergeOne.

EmergeOne provides fractional CFO support to venture backed tech startups from Seed to Series B and beyond.

Join companies backed by Hoxton, Stride, Octopus, Founders Factory, Outlier, a16z and more, who trust us to help them get the most out of their capital, streamline financials, and manage investor relations so they can focus on scaling.

If you’re a CFO working with venture backed startups and want to join a team of incredible fractional talent, drop us your details here.

If you’re a growing startup that knows it needs that strategic financial knowhow, drop your details here to see how we can support you as you scale ????

Do your research

I remain quite speechless when I see people cropping up on social media with hot takes that really do little more than highlight their own lack of understanding.

There was a recent example of this which I called out in this post on LinkedIn which, to my surprise, got a fair amount of attention.

Essentially someone appeared on Michael Jackson – a pretty well known VC’s – timeline and told him he couldn’t do maths because he had supposedly miscalculated fees based on a standard 2 and 20 structure.

As I have talked about in a previous post, this refers to the fact that VCs take 2% as a management fee and 20% as carried interest (a success fee) once the fund is returned.

I won’t rehash the maths, but the key point was that the 2% is (and this can also vary) taken every year across the life of the fund (or the investment period or higher upfront and then tapering down etc.) which means that a $100m fund generates 2% x 10 x $100m = $20m assuming a 10 year life.

Cue a lot of people (including founders) telling Michael he had screwed up the maths and were essentially doing the equivalent of Nelson from The Simpsons.

Giphy

Given the amount of information that is out there, it is disappointing to see people coming out with uninformed positions. It doesn’t do the ecosystem any good to have these sorts of bad faith actors in it.

Why, you might ask, am I defending a VC – surely they have a tonne of power already?

Well the truth is I am not defending the VC, I am asking all of us to do better.

The sort of people that came on his timeline and gloated over a supposed error which in reality only showcased their own ignorance, are also more likely the ones to be out there complaining that they were not able to raise any money either.

This is a tough market to be operating in, you have to know everything that may be conceivably of value for you to know. And that includes how different funders operate and are incentivised.

It will only help you get to where you’re trying to go quicker.

And, if in doubt, this newsletter is probably the quickest route to bringing yourself up to speed ????

Created with DreamStudio

How can did I add value?

We’re getting to the pointy end of the market right now.

I’ve got a lot of folk in various channels looking at how they can stay default alive.

But sadly for a few this is just not feasible.

And on occasion, as hard a bullet as it might be to bite, it may be time to look for an acquirer.

I’ve had a couple of digital conversations with people recently trying to help them navigate how to think about Mergers and Acquisitions (M&A) when you’re not doing the M&Aing.

Now you might ask me what qualifies me to do this, and I’m definitely no specialist.

But over the course of my time in PNG and here in the UK, I’ve been involved in sourcing, analysing, negotiating and executing deals of various sizes, complexities and outcomes.

And not always from a position of strength.

So, if you have found yourself approaching the end of your runway with no real prospect of raising capital and want the best chance of securing a decent outcome for the business, here are some of the things I would think about.

Get to EBITDA +ve as quickly as you can. If you want (decent) value paid for your business then it needs to be, or close to, generating surpluses. Not only that, but it gives you breathing room.

Your shareholders may prefer no sale. If you have S/EIS investors, they may prefer for the company to wind up so they can get their tax reliefs.

Build out an adjusted income statement. You need to present the business in a way that is attractive to a potential buyer. Re-present your financials for the last 12 months stripping out any one offs or extraordinary items (e.g. redundancy costs) and show them as separate line items after your net profit.

Get a data room ready. Much like a financing round, you will want to have all your documents in order. A buyer isn’t going to want to have to deal with messy cap tables and missing documents. Make sure everything is in place.

Have more than one option. It is always better to have more than one offer on the table. Not only does that give you a range, it allows you to hopefully leverage one offer against the other. But you have to be careful not to annoy either potential acquirer such that they walk away altogether.

Point to your processes. If your startup relies on you to get things done, then it’s less valuable than if you have a bunch of processes mapped out and, preferably, automated.

Acquire or Acquihire. A straight acquisition likely means the business is being bought, an acquihire means someone things your team if the most valuable asset of the business and are buying on that basis. When you’re assessing potential acquirers, make sure you understand what they’re likely to be trying to buy.

Avoid a firesale. This is obvious but a difficult line to tread when you know that the business is out of runway (hence the drive to get to EBITDA +ve a.s.a.p.). But if a potential acquirer smells blood in the water, they will exploit it to extract the best possible outcome for themselves (aka a minimal price). The closer you get to cash out, the more likely you are going to have to sell your business for parts.

Whenever I have these conversations with a founder, my first piece of advice is for them to hire a professional, potentially a broker and certainly a lawyer.

It’s a complex process, with lots of steps and tonnes of moving parts – there’s a whole post about how to even go about identifying potential buyers.

As times remain tough, we are going to see a spate of M&A happening in the ecosystem.

If you’re a founder finding yourself in this situation, I’m rooting for you and if you ever want to bounce anything off of me, just reach out. ????????

Off Balance

Last week we took a deep dive into Valuations, and there is a tonne more I could have written about there. But this week I’ll be taking a look at that most fabled of startup documents – the Term Sheet.

I’ve had to cut myself a little short as there are really two elements to a term sheet that are critical to understand.

Economics and Control. The former deals with the numbers, whilst the latter deals with how the company is run.

One of the reasons we tackled valuations in the previous newsletter was because it’s a critical part of the question of economics.

But all to often founders get fixated on this and this alone.

Founders then get surprised when they are suddenly ousted as CEO or don’t have sufficient voting rights when they need to get things past the board.

And this is why it’s critical to split them out.

So let’s get into the first half of this complicated topic: Term Sheets – Economics.

And you’ll have ‘Term Sheets – Control’ to look forward to learning about soon!

Term Sheets – Economics

You may hear a founders say they’ve received a couple of term sheets and wondered what they were on about.

Equally you may have heard an investor talk about how they have sent a term sheet to a founder and wondered what might be in it.

Whilst there is no ‘standard’ format to a term sheet and two term sheets may even look wildly different from two investors wanting to invest in the same startup, there are some common terms that may be included and some common pitfalls that are worth looking out for lest they catch you out.

With that said, let’s get started with some of the basics.

What is a term sheet anyway?
A term sheet is a non binding statement of the general terms surrounding an investor’s intent to invest in a startup.

Key to this is the fact that it is non binding, i.e. signing a term sheet doesn’t mean that an investor is definitely going to invest, but it’s unlikely an investor would issue one if they didn’t intend to.

Sadly, an investor may pull for a number of reasons:

They don’t actually have the cash to invest (happens more often than you’d think).

Partner that was driving the deal leaves.

Something negative is uncovered during due diligence.

Terms materially change.

Market shifts.

Founder can’t close the rest of the round.

But with a term sheet in hand, this is generally a good sign that things are moving forward in the right direction.

What’s going on when an investor issues a term sheet?
When a term sheet is issued to a startup, it normally starts the clock ticking on a potential investment.

The process is (generally):

Term Sheet >> Due Diligence >> Final terms negotiated and issued >> Share purchase agreement signed >> Monies wired >> Shares issued

Given that lots of things may be uncovered during the due diligence (for example, user numbers may be lower than expected or cash required may be more than anticipated), it is always worth understanding that the final investment may end up on quite different terms than those first set out in the term sheet.

Sometimes people play games on both sides of the table.

Why might an investor issue a term sheet?

An investor may issue a term sheet which they use to lock a startup into an exclusive period (i.e. stopping you from approaching other investors) whilst they do their DD.

There are legitimate reasons to do this, mainly that DD costs time and money. they don’t want to have gone through the pain of DD only to find they’ve been gazumped by another investor.

But there are also slightly less reasonable reasons.

Like they are running down the clock on your round whilst they talk to competitors, or are looking to get intel on the sector and your business because they’ve got ulterior motivations.

This is why it’s critical as a founder to do your own diligence on the investor and their firm.

Check that they do indeed invest in your space, haven’t invested in other startups that may be considered competitive and, if you can, speak to other founders whose startups they have invested in.

Why might a founder issue a term sheet?

Founders sometimes use them to create FOMO.

If an investor is aware that there are other funds keen to invest, it may motivate them to commit earlier, or write a bigger cheque on better terms.

But remember these tactics can fail on either side, and given how much reputation matters in the ecosystem, playing these sorts of games only ends up backfiring in the long run.

Economics vs Control

The terms in a term sheet can be divided into two camps – Economics and Control.

Remember:

Economics = numbers

Control = how the company is run

Many founders focus on the economics and regret it.

But you should absolutely ensure that the economics are acceptable – so that’s where we’re going to focus today.

Key Economic Terms

As I mentioned earlier, there is no such thing as a standard term sheet, however there are some terms that will definitely be included and, others which you’ll want to understand and be aware of.

Firstly, the amount to be invested – this should be a straight forward number stipulating the amount and currency.

Obviously this is the amount that the investor is committing to though they may make reference to the size of the full round.

Second comes the date at which the investment will be made.

This helps give clarity on time lines, obviously if an investor commits to a date 6 months in the future, you may well decline the term sheet.

Next comes valuation.

We covered how a company might be valued in some detail last week, however the term sheet won’t go into any detail on this so you’ll never know how it was derived (unless you ask!)

Instead you’ll get a straight number, but be aware, some will stipulate pre money, others post money and some may not stipulate at all – you have to pay attention and ensure you’re not caught out by these sorts of things.

Sometimes the term sheet won’t include a valuation because the investment is being made under a SAFE or other convertible instrument – be clear if this is the case, there are other terms that come into play here like valuation cap, collar, floor and discount – we’re not going to get into the details here, but I’ll cover them in the future.

Up next we have share class.

Ordinary shares are typically the same class as founders and most early investors.

But VCs (especially in a market like today’s) may ask for preference shares.

With preference shares comes a liquidation preference.

This may be structured as 1x, 2x or Nx where N is the number of times their investment is to be returned IN THE FIRST INSTANCE before other investors are paid out in the event of a sale – this is downside protection.

It will be participating or non participating.

If participating, after having taken the liquidation preference, they are still entitled to further value alongside other investors pro rata to their shareholding.

Think REALLY HARD about what this means to you as a founder.

Quick example:

A VC invests $5m in $20m post money valuation round with a 2x liquidation non participating preference.

On paper it looks like they own 25% of the business.

Things seem to be going ok, but something significant happens and the business ends up getting sold to a competitor for $30m.

Now under ordinary circumstances, that investor would have only taken 25% x $30m = $7.5m.

But their liquidation preference actually means they get to take 2x the value of their initial investment – i.e. $10m.

This would be equivalent to owning a 33% stake in the business.

Remaining investors and founders would then receive the balance $20m as the VC held non participating preferences.

But, if they instead had participating preferences they would receive $10m (the 2x liquidation) and they would be entitled to participate in the balance proceeds on an ‘as if converted’ to ordinary shares basis.

So they would also get 25% of the $20m balance, another $5m.

On a $30m exit, this investor would have walked away with 50% of the proceeds even on an upwards valuation.

This is really due to the nature of the business of VC which is predicated on businesses being able to return the full fund.

Liquidation preferences act as downside protection for them.

(It is worth noting that VCs with liquidation preferences are able to convert their shares to ordinary shares if participating in the exit proceeds on an ‘as if converted’ basis is more lucrative than exercising their liquidation rights).

It is likely that investors will ensure they have pro-rata rights in future rounds, pre-emption rights in case of sale of shares and insolvency and if they feel like really going for it, they may include anti-dilution language (watch out for this one in particular, it’ll mean investors ownership % is protected even if they don’t invest in a future round).

It is likely that VCs will ensure that Tag Along and Drag Along terms are included.

This means that in the event of a shareholder selling their shares, all other shareholders may also sell theirs, or if the VC decides to sell theirs, they can force other shareholders to sell.

This ensures that minority shareholders can’t create circumstances where they can hold up a critical action or outcome that would be in the interests of ‘most’ of the shareholding body.

It would also be quite normal in an institutional round for a VC to ask for an option pool to be carved out of the pre-money capitalisation.

This has the impact of diluting existing shareholders further whilst protecting themselves.

Let’s run through an example:

At incorporation, the founders of FakeCo Ltd (they sell Glucci bags naturally), each own 5 shares of $1 nominal value each.

In preparation for a fundraise, they’re advised to do a subdivision (also called a share split) and their cap table now looks like this:

Note how they still both own 50%, even though they own a lot more shares each now?

At Pre-Seed, they take on some angel investors and their cap table grows to look like this:

Remember that when you’re financing a startup, you don’t sell existing shares, you create new shares and sell those. If you sell existing shares, that would be what we call a secondary financing round and the cash would flow to the existing shareholder not the business.

All pretty simple right?

Well hold your guns cowgirls and cowboys, we’re about to change things up…

At the next round, a VC comes in and says that they’re willing to invest x dollars for 7.41% ownership of the company. Here’s what that would look like ordinarily.

But this VC knows how important it is to incentivise the team in a growing startup and wants to ensure there is an option pool carved out for them.

They say they’d like this to be 10% of the ownership.

But the key is that they’d like it to be 10% of the ownership before they come into the round.

This has the effect of diluting the existing shareholders (founders and angels) whilst the VC manages to retain its 7.41% ownership.

Below you can see the impact of the creation of the 10% option pool if it were to happen before the VC came in, vs directly after them having invested.

Moral of the story?

Every term on a term sheet is there for a reason, make sure you understand why and how it’s going to impact your business.

So there you go, a proper dive into some of the most common economic terms you’ll find in a term sheet.

I know that was a lot to get through so maybe kick back and grab yourself a cold one whilst you digest it all 🙂

Next week, I promise we’ll cover off the other side of Term Sheets when we take a look at everything related to Control.

Hopefully by the end you’ll be well ahead of most folk and prepared to get out there and negotiate your term sheet like a pro ????????

Important Announcement

Don’t adjust your screens guys, but those of you who’ve been following for the last couple of months will know I’d normally be hitting you with The Lowdown right about now.

But in a change to our regular programming, I’ll now be dropping that on Fridays.

On top of that, the entire newsletter will be fully rebranded as Off Balance.

All things podcast related will remain under the Nothing Ventured brand which will go out on LinkedIn, YouTube, Apple and Spotify.

But don’t worry, I’ll still be linking to the pods so you can be sure you’ll never miss a single episode ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish

Off Balance #8

???????? Hi friends!

With only one day left of my summer in Italy, I will soon revert from complaining about the heat, to… complaining about the grey skies and rain in London.

Maybe I’m just a bit of a goldilocks?! ????

In this weeks Off Balance, I’ll be chatting about skin in the game and some of the numbers behind the barriers to entry for people of colour when trying to build a startup (or any business). I’ll also speak about why mentoring matters and we’ll deep dive into valuations.

All of that will be followed by a look at what else has been happening in the world of tech and venture in this week’s Lowdown.

Also, don’t forget to check out this week’s guest on the Nothing Ventured pod, Matt Jonns. He’s founder of Founder and Lighting, a somewhat non traditional dev agency that invests in and builds tech businesses with non technical founders.

You can listen to the Primer episode here with the main episode out on Friday 1st September.

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and now even Threads and drop me a note 🙂

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

This edition of Nothing Ventured is brought to you by EmergeOne.

EmergeOne provides fractional CFO support to venture backed tech startups from Seed to Series B and beyond.

Join companies backed by Hoxton, Stride, Octopus, Founders Factory, Outlier, a16z and more, who trust us to help them get the most out of their capital, streamline financials, and manage investor relations so they can focus on scaling.

If you’re a CFO working with venture backed startups and want to join a team of incredible fractional talent, drop us your details here.

If you’re a growing startup that knows it needs that strategic financial knowhow, drop your details here to see how we can support you as you scale ????

Skin in the Game

I would normally reference an article that had been doing the rounds on social media in this section, but instead, I wanted to draw attention to a recurring theme that I, and my guests, talk about on the pod – often unintentionally.

And that’s representation.

Or the lack there of.

I started thinking about this concept of skin in the game, and it resulted in writing the following post:

You can’t be very serious, you don’t have any skin in the game…

This ‘established wisdom’ within the early stage ecosystem has got me thinking.

A lot of investors, and hence founders, have a belief that if you haven’t put your money where your mouth is, then you haven’t shown the sort of grit / determination / hustle that you should demonstrate as a startup founder.

But here are some facts:

???? Per Crunchbase, funding to Black and Latinx founders in the US peaked at $4bn in 2018, out of a total of $141bn invested in the US that year – that’s 2.8% of total funding at peak.

???? Per Pew Research Center, median household income for Black US households in 2021 was $46,400, a full 40% lower than non Hispanic white households.

???? And as for generational wealth? This quote from Synchrony says it all:

“In the Black community, building generational wealth hasn’t been easy to either attain or maintain, for multiple factors. Comparatively, Black families achieve considerably less wealth than white families, with a median net worth of $24,100 compared to $188,200.”

So let’s think about this… in the US (which accounted for just under 50% of total VC investment in 2021 – $330bn out of $671bn), minority founders are:

– Less likely to receive funding

– More likely to have a lower income

– Less likely to be from families / communities with generational wealth

But yet, we still talk about needing skin in the game.

And this is just one example.

I haven’t mentioned female founders with young children or people from developing nations that are systemically excluded from certain services.

The same could be said for emerging fund managers who are required to fund their so called ‘GP commit’ as part of the total fund.

I am a very lucky individual.

I bootstrapped one of my businesses and, when I ran out of cash in the other, was able to take out debt to leave the business clean. I knew if things fell apart, I’d be able to take myself to my parents place and get back on my feet.

But so many people simply don’t have that option.

So many people can’t raise money from friends, family and ‘fools,’ because their friends and family don’t have money and didn’t go to the ‘right’ schools.

They can’t risk going all in because if they do, they don’t have a parent’s house they can fall back on.

And yet, even though they already come from communities that receive the least amount of funding, they may be further penalised for not having ‘skin in the game.’

This has to change.

Entrepreneurs should not be brought to the brink of bankruptcy, mental breakdown or familial collapse to build a better future.

So how do we encourage more people to take that plunge?

How do we level that playing field and give everyone at least the opportunity to take a risk?

What are your thoughts on this? 

Hit me up in the comments here, or join in on the discussion on LinkedIn – I’d love to get your views ????????

How can did I add value?

I’ve mentioned my friend Rahim before, in fact in one of my first newsletters. And I’m only bringing him up again because, over the years he has been what I can only describe as an informal mentor to me. When I first came back to the UK, he set me on the path I’m now on.

Rahim recently wrote about his relationship with his own mentor who sadly passed a year ago and how, he had found that mentoring – which he does openly and enthusiastically – is one of the core pillars of how he thinks people should build and grow their careers.

OK, so that’s how he was helpful, but what about me?!

Well since that informal mentoring with Rahim, I have acted both formally and informally as a mentor to a number of people myself.

It’s fulfilling being able to help people who are at an earlier juncture in their career than I am. But I’ve also realised that mentoring can, weirdly, help you identify areas where you yourself can also seek more guidance.

One thing that’s worth noting is the difference between mentoring and coaching:
Mentoring – you’re typically giving someone the value of your experience
Coaching – you’re holding a mirror up to someone so they can find the answers they already have

Last week, I was asked to have a conversation with a CFO who had joined a later stage startup.

I won’t go into the details as the conversation was confidential, but here are some of the things we talked about:

How to think about the right metrics for the business

How to manage the stakeholders to get to the right objective

What it means to raise in the current environment

The difference between VC investors that are hands off versus PE investors that are hands on

It was obvious that this CFO was smart and had his head screwed on. But he was in an environment where he didn’t have someone he could easily ask questions of.

Being that person he felt comfortable enough to turn to filled me with so much joy and purpose.

That’s when I realised the best mentors I’ve ever had never feel like they’re actually mentoring me.

And I try to do the same.

Have a conversation, help where you can and show, never tell.

I’d love to hear about your experiences with mentors and if you’d like to have a call with me, just connect with me on LinkedIn and let me know that’s why 🙂

Off Balance

Last week we covered off the last of what I would call the 101’s of VC including:

VC Funding Stage by Stage
What VCs Look For

Today we’re going to get a bit more down and dirty and have a chat about Valuations.

It should be no surprise that this is a topic that most founders will want some guidance on from time to time, not least because there is often no strict template one can follow.

I have to be honest, I was also going to try and tackle Term Sheets in this post as well, but it turns out there is so much to talk about with valuations alone that I parked that till next week – you’re just going to have to hold tight till then I’m afraid.

In the meantime, let’s get into it.

Valuation

If I was feeling cheeky, I would leave this as a one liner – something I have said time and time again on various platforms:

By that I mean, in private markets where there is a lack of liquidity (the ability to find buyers for your shares) valuations are not set by ‘the market.’

I am referring to the market, in this context, as the public market where millions of buyers meet millions of sellers and find an equilibrium price that is satisfactory).

Instead – and I know this is going to blow your mind – valuations in private companies are essentially made up based on a range of factors including some, none or all of the following:

Is this a repeat founder

Is this a massive market

What point am I in in my fund cycle

What’s the next investor likely to pay

What traction has the business achieved

What have others in this sector raised at

What was the last round’s valuation

What business model does it operate

What the cash flows look like and what risk you expect

Essentially valuation in private markets is more art than science. Or as valuation guru Aswath Damadoran puts it:

I personally like to say: if you grab them by the narrative, their hearts and wallets will follow.

But let’s get a bit more specific.

Rather than looking at this on a stage by stage approach, let’s look at some frameworks that you might want to use to figure out where you and your investor may land.

It’s worth assuming that the more progressed your business is, the more reliant on ‘hard’ data the valuation is going to need to be.

Also, as a side note, pre-money valuation means the value of the company immediately before new capital is invested and post-money valuation is the value of the company immediately after new capital is invested.

Berkus Method
Formulated by notable angel and venture capitalist Dave Berkus, the Berkus method takes five elements and prescribes a financial value (up to $500k) to each:

Idea

Team

Prototype

Relationships

Sales

This is a useful framework for when you have low data and want an easily replicable framework to use against multiple ventures at a similar stage.

Scorecard Method
Developed by Bill Payne, another well known angel investor, like the Berkus Method, the approach here is to assign some weightings to characteristics of the startup you’re trying to value. From that, you derive a list of factors and then apply the sum of those factors onto to the average of comparable startups at a similar stage. The method uses the following criteria:

0–30% Strength of the Management Team

0–25% Size of the Opportunity

0–15% Product/Technology

0–10% Competitive Environment

0–10% Marketing/Sales Channels/Partnerships

0–5% Need for Additional Investment

0–5% Other

You would assess each of these characteristics based on being above average, average or below average leading to a range of percentages either below, at or above 100%.

For example, you may decide that the tech stack is below average, say 90%, but the size of the opportunity is massive, say 160%.

You would multiply each of these by the relevant factor:

Size of opportunity = 160% x 25% = 40% = 0.4
Tech stack = 90% x 15% = 13.5% = 0.135

Once you have accessed each of the characteristics in this way, you’d add up the factors (0.4 + 0.135 etc.) and multiply the total by the average valuation of other startups.

In this example provided by Bill Payne himself, you will see that the sum of the factors is 1.0750.

When applied to an average pre-money valuation of surveyed pre-seed businesses of $2m, Bill would value the target company at $2m x 1.075 = $2.15m.

This is a great framework but relies on you having access to valuations of other companies in your target investment’s vertical. still relies on a lot of guess work, gut work and intuition to assess the characteristics.

Comparable Transactions (comps)
This is probably one of the more well known ways of valuing a startup or early stage business.

There are two key factors that are considered when using this method:

The company you are valuing needs to have appropriate metrics to which comps can be applied.

You need to have access to up to date data on comparable transactions – whether that’s for business model (e.g. SaaS), vertical (e.g. fintech) or even stage (e.g. seed versus Series B).

For example it was not unheard of during the feeding frenzy of 2021 for SaaS businesses to be valued on multiples of more than 20x on revenue (normally ARR).

This means that a SaaS business with $1m ARR might have been valued at $20m in those days.

Since the market returned to its senses in 2022, SaaS businesses have been trading at 6 – 8x multiple on revenue (based on my experience). This means that if a business went back to market to raise, it might only be able to raise at a valuation of between 12m and 16m ($2m ARR x 6 or 8). This may even be the case if said business had been able to double ARR. The notorious down round.

Now, traction may not mean revenue only. For example, it may be around downloads for mobile apps. Or for social media platforms, you might consider users and then apply a price per user based on the expected value you can extract from each user based on other competitors performance.

VCs will likely be able to access this data via platforms like Pitchbook or Preqin, but for most startups these resources are too expensive. They will then need to refer to industry reports, blogs, reported transactions in the press and other sources to try and work out how much their business might be valued at.

Whilst seemingly a more data driven method, as you can see from my example, fundamentally there is still a massive element of narrative in the valuation. Otherwise we would not have seen such massive deltas between multiples from one year to the next.

Venture Capital Valuation Method
Understanding this method means getting into the mindset of how VCs think – something I hope you are getting better at doing having read this newsletter.

This method essentially calculates how much a VC would expect to make out of the investment at the time of exit and works backwards from there based on their expected return on investment.

For example:

A $100m fund is considering investing in a Series A venture today, and expects it to exit within the next 5 – 8 years. They would expect to return 10x on the investment.

They are targeting a 10% ownership stake today and expect a further 2 rounds that will dilute them by a total of 30% taking their ownership down to 7% at the time the business exits.

As every investment at a minimum needs to be able to return the fund, a 7% stake at exit would mean the company would need to be valued at $1.43bn ($100m / 7%).

Given that they are looking at returning 10x on the investment, they would divide the exit valuation by 10 to get to the post money valuation of the current round which would be $1.43bn / 10 = $143m.

A 10% stake in a $143m round means an investment of $14.3m.

Behind the scenes there is a fair amount of complexity.

The VC needs to calculate or make assumptions around the resources that will be required to build the business to an exit, it also assumes that an exit at this valuation will be achievable. They also need to be clear on the expected return they wish to make based on the risks involved in the business, competitive situation and other factors.

You can essentially boil the VC method down to the following two formulas:

Value at Exit / Post-money Valuation = Return on Investment

Value at Exit / Expected Return on Investment = Post-money Valuation

Discounted Cash Flow (DCF) Method
Now I wouldn’t be much of a finance guy if I didn’t include the DCF – the go to method for finance pros everywhere – but I also wouldn’t be much of a finance guy if I didn’t include the following caveats.

There are a tonne of factors in calculating a DCF that don’t lend themselves amazingly well to using it to value startups. Not least calculating the WACC (the weighted average cost of capital) which relies on calculating the cost of debt (startups tend to have little or no debt) and the cost of equity (which requires you to know or be able to calculate a stock’s beta).

But the sake of completeness let’s walk through the DCF.

DCFs relies on the concept that the value of a dollar tomorrow is not likely to be the value of a dollar today due to factors like inflation and importantly there is an opportunity cost to me tying up my cash today by investing it in a startup.

Let’s take a really simple example to illustrate this point about opportunity cost.

I’m an investor with $1m available to invest today. My options are:

I could park the money in a bank account earning 6% annually, or

I could invest in a startup with a likely exit in 10 years.

Assuming I don’t withdraw my money and it compounds, over 10 years I would end up with:

$1m x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 × 1.06 x 1.06

= $1m x 1.06^10

= $1,790,847

Given that this is a relatively risk free return (unless I’d parked it in SVB ????????), if I were to invest the $1m in a startup, I’d expect it to at least beat that.

So what?

Well this risk free rate of 6% is what we would use as the discount rate in a DCF calculation. It’s the minimum hurdle that an investment needs to beat to be worth my while given I can earn at least this return in the bank (the discount rate is often called the hurdle rate for anyone that’s interested ????).

So let’s look at how you would calculate a DCF in more detail.

Step 1 – Work out the cash flows associated with the business over the duration of the investment.

Step 2 – Work out the discount rate you’re going to use, you would increase the rate based on the amount of risk you’re expecting to take in the investment. So whilst you might expect a return of 6% from the bank, you may expect a return of 20% from a startup.

Step 3 – Work out the terminal value of the business (i.e. the exit value of the business). This is calculated as {Final Year FCF x (1 + Growth Rate into Perpetuity )} ÷ (Discount Rate – Growth Rate into Perpetuity) where Growth Rate into Perpetuity is the ongoing rate of growth you expect from the business.

Step 4 – Discount each value back to get to a present value and sum together to get a present day valuation.

Let’s take an example where we assume:

Discount rate of 20%

Growth Rate into Perpetuity of 5%

5 year cashflows of:

$10m negative

$2m negative

$500k negative

$10m positive

$50m positive

This gives us a Terminal Value of: {$50m x (1+0.05)} ÷ (0.20 – 0.05) = $350m

Discounting back each of the these cashflows we have:

$350m / (1.20^6) = $117m

$50m / (1.20^5) = $20m

$10m / (1.20^4) = $4.8m

$500k negative / (1.20^3) = $290k negative

$2m negative / (1.20^2) = $1.39m negative

$10m negative / (1.20) = $8.3m negative

And the total of all those discounted cash flows is called the Present Value which in this case would be $132m, et voila, that’s your valuations.

If I thought the business was more risky and upped the discount rate to 30% that would change the terminal value as well as the present value of the cash flows and we would end up with a Present Value of only $51m.

Instead, if I leave the discount rate at 20% but change the Growth Rate into Perpetuity to 7%, we increase the Present Value to $153m.

At the end of the day, the DCF is something that investment professionals use day in and day out, so don’t worry if it takes you a minute (or longer) to get your head around it!

There are a couple of other methods like the Risk Factor Summation method that takes a dozen or so risks and adds or subtracts multiples of $250k based on whether they are risks or opportunities.

Or the Cost-To-Duplicate method which you use to see how much it would cost to replicate your startup elsewhere, but this doesn’t take into consideration intangible (non monetary) aspects of the business.

And finally, the favourite of accountants everywhere – the Net Assets method. This takes the monetary value of the assets on your balance sheet, deducts the value of the liabilities and presto changeo gives you a valuation. Sadly it’s not particularly valuable in asset lite software businesses where development costs are not always capitalised.

And there we have it, some of the basics (yes I really do mean basics) of startup valuation, and for each of these there are many more heuristics that founders and investors alike will use to value a company.

So if you’re feeling a little bit like Homer right now, don’t worry. After all, figuring this stuff out is precisely what I’m here for, right? ????

Next week, I promise we’ll dive into the murky world of economics and control when we speak about Term Sheets, so hang tight, it’s going to be a good one!

The Lowdown

Let’s check in with what’s been happening in the wider tech and venture ecosystem this week…

This thread has been doing the rounds, with one VC (and future Nothing Ventured guest ????) Francesco Perticarari saying:

My simple answer to this was… yes, yes we are.

It was a reminder as to how small the ecosystem actually is and how much cross over there is in content. Especially when that content is good, we sure are quick we are to add our own 2 cents.

So here are mine ????:

This thread from David Clark is an important one to digest, because it took actual data across a long timescale and worked out a returns profile based on that data.

Essentially it is a masterclass in showing the Power Law at work.

Let’s break it down:

Data from 11,350 companies

Backed by 259 funds

Across 30+ years (1986 – 2018)

Includes realised and unrealised investments

6,000+ (53.2%) are at <1x (if liquidated would return less than initial investment)

2,500+ of these (22.6%) are write offs

2,157 (19%) returned between 1x and 2x of cost

1,813 (16%) returned between 2x and 5x of cost

1,342 (11.8%) returned at least 5x

Only 614 (5.4%) returned 10x or more

Only 121 (1.1%) generated sufficient exits to return all the committed capital of the fund (in theory what each startup invested in is expected to be able to do).

And this is the thing that a lot of people struggle to get their heads around.

VC is not a game of averages, it’s not a game of good enough, it’s a game of outliers. And if you’re business doesn’t have the possibility of being a massive (positive) outlier, then this is not the source of capital you should be looking for.

Ladies and gentlemen, see the power law in all it’s glory…

Data from David Clark / VenCap

Here’s the original post from David.

I’ve seen a few threads recently about the power law in venture capital and what this means for individual company returns.  We looked at our data on 11,350 companies backed by 259 funds from 1986 to 2018. /1

— David Clark (@daveclark85)
Aug 22, 2023

Next up, the UK is onto another project it hopes to have “world changing impact” with.

Only this time, it may actually have a chance.

The country has set up an Advanced Research and Invention Agency (ARIA) and though it has a small budget, it has some incredible people leading the charge.

After so much (personal) disappointment around the direction the country seemed to be taking after the 2016 Brexit vote, this at least feels like a step in the right direction.

It looks like the IPO market is starting to come back a little bit. The biggest news being ARMs intention to list on the NASDAQ for somewhere between $60 bn and $70bn.

But as this article from Crunchbase suggests, the more interesting transaction is the potential IPO of Instacart which took a hatchett to its internal valuation potentially giving it a more realistic chance when it hits the public markets.

As we saw earlier, valuations are as much about art as they are science, but literally everything gets thrown out the window once you list – then it’s just you and the market baby.

And finally, in other news, India landed a spacecraft on the moon ????????????.

As a proud person of Indian origin, all I can say is that it feels like the moon looks a bit different since we got there…????????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish

Off Balance #7

???????? Hi friends!

I’ve been busy melting in the heat, exploring some of the beautiful spots that Tuscany has to offer whilst keeping an eye on the doom and gloom cycle that a slow news cycle in venture over the summer tends to lend itself to.

In this weeks Off Balance, I’ll be chatting about whether VCs are wasting your time and money, how I suggested one founder think about the current funding environment, breaking down VC funding on a stage by stage basis as well as discussing what it is that VCs tend to look for when funding a business.

All of that will be followed by a look at what else has been happening in the world of tech and venture in this week’s Lowdown.

Also, don’t forget to check out this week’s guest on the pod – Maya Moufarek – who scaled Pharmacy2U by delivering an acquisition rate equivalent to opening a brick and mortar pharmacy every 2.5 days ???????? You can listen to the Primer episode here with the main episode out on Friday 25th August.

Remember, if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (before it implodes?), Instagram and now even Threads and drop me a note 🙂

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

This edition of Nothing Ventured is brought to you by EmergeOne.

EmergeOne provides fractional CFO support to venture backed tech startups from Seed to Series B and beyond.

Join companies backed by Hoxton, Stride, Octopus, Founders Factory, Outlier, a16z and more, who trust us to help them get the most out of their capital, streamline financials, and manage investor relations so they can focus on scaling.

If you’re a CFO working with venture backed startups and want to join a team of incredible fractional talent, drop us your details here.

If you’re a growing startup that knows it needs that strategic financial knowhow, drop your details here to see how we can support you as you scale ????

Sitting on the Dock of the Bay, Wasting Time

The one article that has been shared more than just a little bit over the last week is this “provocative” take from the Financial Times’ Alphaville section.

It does a magnificent job of both being incredibly accurate whilst also being completely wrong.

It argues that VC requires an investment strategy that relies on moonshots and returns are driven by Power Law (Pareto Principle / 80:20 rule) – i.e. that a small number of successful businesses drive all of the returns.

And that as a result LPs allocating into VC funds are equally at risk of finding themselves being woefully outperformed by the S&P 500 (because obviously investing in stocks that just keep going up is a no brainer right?).

The point is that in over 20 years, many individual stocks have outperformed the median VC fund. The challenge is predicting which ones. Using factors like growth and momentum might enhance the chances of spotting these outperformers, but such methods aren’t easily applied in private markets.

And not only that, if you are chasing “median” in venture, you’re doing it wrong.

At the end of the day, VC is an industry that is predicated on outliers, as with any asset class money can be made, and money can be lost – but ask yourself this, how many advancements

How can did I add value?

I am a member of a number of communities whether for VCs, angels, CFOs or founders (variously – bar one – all hats I have worn) and try to be as supportive as possible.

Recently, a founder in one such community reached out after having spoken to another founder who, despite being this being their third startup, was struggling to get straight yes / no responses from the VCs they had been speaking to, something they were not used to having raised in the “good ol’ days” of the last few years.

The founders question was: “How different is raising capital today versus the previousl 12 or 24 months”.

Whilst I have said it before, I responded with the following (as you know I love me a good list):

LPs are pulling back so VCs are having to too.

Lots of well funded startups yet to come back to market with tails between their legs having ‘frittered’ away lots of cash at high valuations.

I therefore expect some VCs to be preserving cash for special situations / recaps (ie promising businesses with bad cap tables).

Time frames are now 9 months to close a round rather than 6.

Need to show both growth as well as strong unit economics to raise from good funds.

Lots of companies should NOT be raising venture (previously they could though) and so no doubt that is also playing out.

Expect next 6 – 12 months to be painful.

If pre seed experiment quickly and with capital efficiency and get metrics for seed (a 50 person waitlist is not metrics for seed).

If post seed see point 5. SaaS should be growing at 33222 year on year as rule of thumb (more on this below).

Be pragmatic. Find solutions. Don’t wait for funding. Valuations are not “coming back” in fact they have now RETURNED to where they should have been.

Simply put, in the past you could use other people’s money to run your experiments and you could find that money pretty easily. Today, for most of us to raise money, you need to be smart about where you spend your time, focus on what you can do without a tonne of capital behind you and show traction before going after any significant investment.

Off Balance

Last week we covered off a fair amount covering a range of areas within VC including

A Brief History of Venture Capital
Meeting the VC Players
Understanding the GP / LP Relationship
How VCs Make Money

So this week we’re going to tackle two topics that still trip lots of people up:

VC Funding Stage by Stage
What VCs Look For

Now obviously there are always exceptions to the rules so take the below as a guideline that you can then use to sense check your own progress and milestones – but always look for what makes sense given your vertical, your business model, your stage and your traction.

Marketplaces will have a different set of metrics to a B2B SaaS play after all.

Over the next couple of weeks, we’re going to tackle some biggies including term sheets, valuation and due diligence – so strap in, it’s going to get interesting…

VC Funding Stage by Stage

If you’re not a founder or investor and come across one, they may talk about a round they’re currently involved in.

What they are talking about is a funding round, or an investment event into a particular business.

These funding rounds (rounds from here on) are typically aligned to the growth stage of the investee company and tend to follow a general pattern.

It is worth thinking about each round as a level in a computer game and the investment as the energy the player (in this case the founder) needs to reach the next milestone and unlock the next level.

The first and most common round after launching a business is typically called the Friends and Family round (sometimes unkindly the Friends, Family and Fools round).

This is the riskiest stage of the business and it’s potentially nothing more than a deck, an idea and an excited founder (or founding team).

Obviously given the lack of anything concrete to gauge, more formal investors are unlikely to get involved at this very early stage. The only exception to this rule is where you have a repeat founder at the helm who has a proven track record.

With that in mind, the investment from the friends and family round is typically used to test out the hypotheses the founders have and see if there is a viable opportunity ahead.

At this stage it’s likely that there won’t be much built and the business is running on manual processes.

If the team proves that there is something there, then they may move to a pre-seed round.

This is still a pretty risky stage of the business. But there are at least some proof points that there may be something viable ahead.

This round is likely to be several hundred thousand dollars, and as such, is most likely to involve more traditional angels.

Whilst some VCs also invest at pre-seed, there tend to be fewer of these funds and, especially in the UK with tax incentivised investing, angels are keen to get involved so VCs leave them to it.

The cash from this round is likely going to be used to build a Minimum Viable Product (MVP) and securing early revenue.

Next up we have the Seed round. By the time a company is ready to raise its Seed, it has likely shown that it is on its way to achieving $1m in revenue.

This is normally when you’ll see the first “institutional investor” (read VC) get involved. The business is still early but has proven that one or several VCs think it’s worth making an investment, and the investment is likely to be in the low-to-mid 7 figure range.

Cash from this round is most likely going to be used to build out the product and prove out early signs of Product Market Fit (PMF). This is when it’s clear there is demand for the product from (paying) customers and that the business is able to scale.

Assuming the business is able to do that, it’s likely to get to the next round once it is at around $1 – $2m of annual revenue and has clearly got PMF.

This round is called the Series A and at this stage the startup is starting to resemble a more traditional business.

A Series A round is typically in the high 7 to low 8 figure range, and cash from this round will typically be used to scale up quickly.

Where getting to Series A was about proving Product Market Fit, getting to the next round (as one of the VCs I interviewed – Annalise Dragic – would say), is about proving Go To Market Fit.

What this means is the business should have a playbook by the time it is getting ready to raise its Series B round (as the next financing event is called) that they can roll out with new products and new territories. And they should be scaling rapidly.

Hereafter the rounds continue down the alphabet, but post Series B you could almost lump them all together as Growth Rounds. Typically large amounts of capital invested in now well established startups with a view to funding growth be that through organic, acquisition, product or M&A.

And from here on in, an exit is always potentially on the table.

Whether that’s being acquired by a corporate, or by private equity or going through an IPO and listing on a stock exchange.

But there are some nuances…

Firstly whilst previously rounds tended to follow a general pattern in amounts invested in any particular round, that largely went out the window over the last several years.

Additionally, there are a variety of smaller rounds that might take place between the rounds I’ve talked about above. These may “bridge” from one financing to the next, may be top ups to the last event or may be to fund an opportunistic acquisition to name a few reasons.

And finally, I haven’t brought things like secondaries (discussed above) or venture debt into the picture, nor have we talked (yet) about different instruments that might be used like convertible loan notes, warrants or options. These may be used during a financing round, or equally in between rounds as well.

At each fundraising event, the company should have removed some of the risk from the business. They should also be showing decent signs of growth if they’re looking for investment from most players in the VC ecosystem.

What VCs Look For

Everyone assumes that there is some sort of template that will tell you exactly what you need to have proven in order to secure your next round of financing but sadly this is just not possible in most cases.

Why?

Because every startup has a different business and business model, vision and execution ability. So whilst there can be some general guidance, here’s what I know having talked to almost 100 investors on my podcast and numerous investors and founders beyond.

Time and time again, two themes keep arising at the early stages.

How big is the market

How likely is it the team will execute

A couple of weeks ago I quoted Andy Rachleff on the interplay between markets and teams. In case you missed it, here it is again:

If you can get comfortable knowing that there is a huge opportunity, everything else is down to execution.

And by huge opportunity we’re essentially talking about a multi billion dollar market size.

After all, to command the sort of valuation that makes sense for venture investors, you have to capture revenues and value in the 100s of millions and into the billions.

If the market is small(er), you’d have to capture a higher percentage of the market to secure a venture style outcome – and unless you’re a Google which commands over 93% of search as late as May 2023 per Oberlo, monopolies are still pretty hard to create.

Next up comes the founder and team’s ability to execute in the market. Often VCs are looking for signals that the early team has some form of unfair advantage which makes it more likely for them to “win”.

This may be deep expertise in the area they’re tackling, evidence that they have scaled a business (or been part of a team that has) in the past – which is why repeat founders often find it easy to raise funding, even if their previous business has ended up washing out (Adam Neumann anyone?)

At later stages, focus moves on to traction, evidence of being able to build a product, take it to market and scale it.

For example in B2B SaaS, a number of investors look for the 33222 pattern – simply put the company should scale revenue 3x year on year for the first two and 2x thereafter. Assuming starting revenue of $2m, this would result in $144m in revenue by the end of the five years, which on a reasonable SaaS multiple of 7x on revenue would value the business at $1bn.

Obviously at the time the VC is investing they won’t know for sure if the company is going to hit those numbers, so it’s relying on indicators of the same:

‘Can they demonstrate PMF?’

‘Have they been growing at expected pace on a month on month basis?’

‘Have they built a flywheel that drives growth?’

‘Are their gross margins and unit economics healthy and sustainable?’

For example, many VCs will look for LTV:CAC ratios (the relationship between customer lifetime value and the cost to acquire them) or a minimum of 3:1.

Any lower and there is a risk that you will end up destroying value (as customers tend to get more expensive to acquire over time). Whilst higher LTV:CAC is a good thing, at earlier stages, it may suggest you aren’t spending as aggressively as you could on growth.

And that’s really the crux of it: VCs are looking for businesses that will be category winning companies that can scale quickly to a valuation that allows the VCs to exit and return the fund.

Anything your business is able to show that allows a VC to get comfortable with this premise will make them more likely to invest.

Side note – only a tiny percentage of startups are suitable for or receive venture capital funding. They are either businesses with small markets, mediocre teams, poor growth or poor unit economics.

VCs will likely look at something like 3,000 decks before meeting with 50 founders and maybe investing in 10 companies (we’ll talk about portfolio construction in a future edition). That’s 1/3 of a percent that raise from VCs.

So you can imagine how good your proposition needs to be to attract interest…

And, if you can believe it, we’ve still only just started to scratch the surface of just the basics of what you need to know if you’re involved in the VC space. There’s plenty more to come in the future, but I hope you’ve found this valuable in the meantime.

The Lowdown

Let’s check in with what’s been happening in the wider tech and venture ecosystem this week…

If you’ve been paying attention to what’s happening on social media as of late, there is probably one thing that hasn’t escaped your attention.

The hyper masculine peacocking going on between Elon Musk and Mark Zuckerberg that is meant to culminate in a cage fight that, frankly, would be less interesting than the idiocy that has come before it.

I was even more bemused to see this piece in the Times of India slamming the tech bros for this stupidity and find it hilarious that a country (or at least an author from that country), that is known for churning out 1,000 movies a year watched by 3 billion people, is completely disinterested in this spectacle of toxic masculinity.

Even the Italians are disavowing they ever offered up the Colosseum as a venue. If only these two guys could sort their stuff out and maybe make their platforms a bit better for their users, they’d probably get a lot more bang for their buck.

Next up, it turns out that all the buzz around LK-99 – the material that some South Korean scientists had claimed was not only superconductive but was able to be so at both room temperature as well as pressure.

Judging by the number of supercondutivity experts that sprang up on Twitter (X) overnight, this was clearly a big deal.

Except it’s not.

Or at least not the big deal people thought it might be.

There had been a fair amount of scepticism already and scientists have independently tried to recreate the material and its properties unsuccessfully (this is kind of necessary for something to be adopted by the scientific community).

But, it may be that the material has other, magnetic, properties which could be interesting in other applications.

One thing it’s worth saying is that this is the beauty of the scientific process – the ability to challenge findings in positive ways and, for the scientific community collectively to work towards substantiating or disproving a theory. Something that seems to be missing all too often in other areas of our debate.

Finally, I’d previously written about the conservative activist that is suing the Fearless Fund – a fund focussed on investing in women of colour – for discrimination under US civil rights legislation.

I was glad to see that this has garnered the sort of attention that it deserves, and as of writing, over 70 VC firms have signed an open letter denouncing the lawsuit.

It bears repeating that less than 2% of VC investment goes to women and people of colour, and a suit like this does more damage (in my opinion) than good.

It unwinds decades of attempts to improve peoples’ access to things as fundamental as education to less universal rights such as access to capital.

You can read the full Open Letter and show your support here.

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

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That’s it from me so until next time…

Stay liquid 🙂

Aarish