By Philip Mershon with Brian Bernstein and Sebastian Gomez-Puerto
The 2018 NVCA report just came out a few months ago. I couldn’t care less. It is, for some, interesting to know about the macro state of the Venture Capital industry. Data on funds raised, total capital invested, exits and IPOs all make a difference en masse, to the industry as a whole. The difference this information makes to individual LP’s and smaller funds is limited at best. As was pointed out in Brian Bernstein’ last post, industry level metrics are almost meaningless when analyzing the performance of individual funds, companies, or LP’s, and what is true for the industry generally does not help to drive investment performance in specific instances.
That said, I want to move away from discussions of survivorship bias, uneven distributions, paper markups, and fee structures. For myself as much as anyone, I want to present a short note on basic business truths as applied to early stage financing. Specifically, I want to discuss common sense business ideas that can help drive venture investment success. These are not sophisticated philosophies or technical strategies, they are just important reminders based on my experience and conversations with very seasoned private investors. While what is below may seem patently obvious, or overly simple, great investing must start at the very beginning. It’s imperative that we focus on the basic fundamentals of good investment practice. Being a great investor is not about executing something complex or difficult, but about consistently keeping in mind these basic ideas at all times.
Income – “When will I get my money back?”
This is so obvious: we need cash, burn cash, count cash and hopefully we one day return cash. In the near term, we often need to get lost in the cumulative IRR, valuation markups, and projections. These data points are all useful and necessary in pre-revenue or high growth endeavors. Even so, income can help us evaluate an opportunity because its mere presence is instructive in a few ways:
- Cash Flow Positive – Rare, but positive cash flows are like fuel on the fire of early stage growth.
- Predictable Cash Flow – Consistent sales at predictable losses are a good indicator of product market fit. Especially if the short fall is due to simple causes such as lack of scale.
- Indication of cash – From where do we get the expectation of sales? Market research, beta clients, letters of demand, hearsay orders…let’s not just plug random numbers into excel. That said, the next point speaks to this as well.
Real Information – “Who are you and what are you doing?”
We cannot read the future. In early stage, projections are all we have. We all know that they are made up. That does not excuse fanciful guesses. When raising money we ought to do our research, pick up the phone and maybe even poll a potential customer list or marketplace. This fact is true for the entrepreneur starting a business, and the investor doing research. Bottom line, we should use data and information that are not solely products of our imagination. The following are 3 types of information that we should focus on logically and reasonably estimating:
- Market data – Addressable market, competitor matrix and even simple tools (Porter’s 5 forces, SWOT, other b-school basics.)
- Sales Projections – We should talk to someone or count something. We can take a survey, call a customer… We need to show potential investors that there is some market that might be interested in our solution. The most elegant solution to nobody’s problem generally doesn’t sell. Also, a market demanding a product at a lower price than we can deliver is important feedback.
- Cost/Production info – How do we know if we can scale the business or have the possibility of free cash flow one day? Sales are only one side of the coin. How much does it cost to make this product or provide this service? How many suppliers are there? Are there economies of scale? What is the capacity of each producer? This is the easiest to research. Even if it is a rough or round number, suppliers are often happy to give guidance, if not quotes, even on prototypes.
“The most elegant solution to no one’s problem generally does not sell”
What Do We Own? – “How much money can I make?”
No really, what do we actually own? Real, protectable and valuable Intellectual Property is rare. It exists in only the best deals, and often requires the most capital. Here are a few reflections about IP:
- On Burn – IP is very expensive and the only real reason to run long term losses. Most businesses won’t ever have the competitive head start and product differentiation to justify or recover many years of significant burn. Remember, the iPhone wasn’t a new idea. The iPhone was a new execution of other companies ideas with tremendous talent, resources, and marketing behind it. It is my belief that first movers often spend a fortune so that their competitors can later be successful.
- High Barrier vs IP – High barriers to entry doesn’t mean no barriers. See: LYFT. Uber’s platform and user base is greatly superior but not unassailable. They had a short window of dominance after which their core business will largely drift towards a commoditized service.
- The Brand – It is hard to include “brand” or marketing as IP. The expectation of brand recognition does not justify the goodwill such a brand will occupy on the balance sheet of a more developed business. We’re not Coca-Cola yet. Many young companies hope to charge a premium based on branding. Even when they are successful, the costs of establishing and defending a brand can outweigh the benefits, and new brands are incredibly fragile. As such, we shouldn’t over-value them.
- Litigation Risk – Even real IP does us no good if we can’t afford to defend it. Lawyers are not free and fighting is not always worth the cash and opportunity cost. This is particularly true for investors, but for entrepreneurs as well.
- Just because you have the tech, doesn’t mean you own the idea. If someone else can have the same thing by spending money, you have nothing.
Why My Money? – “How can I help you to get me my return?”
Entrepreneurs with oversubscribed deals often ask why an investor adds enough value to deserve a piece of a hot round. They don’t realize that the question goes both ways. When someone asks me for money, I never ask why they need money, I specifically ask why they need MY money.
“I specifically ask why they need MY money”
Once the deal is financed, how does the investor uniquely add value? I want a deal that has a lot of people who want to put money in, but where I create a positive impact through my unique subject matter expertise as applied to the particular startup. Early stage business is difficult and risky. We have macro, operational and strategic threats on all sides. We need all the help we can get. A short list of obvious value adds are:
- Time – Does the investor have time to consult or help guide the business? Is this desirable?
- Experience – Does the Investor have experience or a network in our business that can grease the wheels of growth and progress? Maybe, especially if we are category or product experts, a more general experience in “Business.” For example: management, marketing, sales, finance and M&A.
- Synergies – Is the investor already vested in complementary businesses? Are there synergies within his or her portfolio? Future M&A possibilities? Quick Exit or opportunity to combine forces?
Exits – “Did I mention that I need liquidity at some point?”
The startup funding market is a double sided marketplace where companies are invested in, and hopefully later DIVESTED OF. But you wouldn’t know if you talk to a lot of founders and VC’s. They all focus on the entry of the trade, and simply mention a vague, hazy, and undefined notion of an exit. They mention the very word “exit” with the kind of religious overtones one would reserve for an article of faith. It is out there, it exists, they believe in it, and it is hard for mortals to comprehend.
We should have some concrete idea of where investor liquidity is likely to come from. We all want a unicorn IPO, but we should have a backup plan. Reasonable expectations for our exit can help guide entrepreneurs as they build the business, and help investors evaluate the amount of time and capital to commit.
Exit options are multifaceted. They can be anything from an acquihire, debt recap, equity recap, secondary sale, to a lateral PE M&A or an IPO. A good founder should know market terms on all of them, and should have an entry price based on the weighted probability of exit consideration. A good VC should not only do the above, they should have the experience and ability to create exit proceeds through their affirmative actions to that effect.
Nothing here is conceptually difficult. It is actually very simple to understand, but it is hard to practice. The reason it is hard to practice is everyone wants to raise or invest money, but no one wants to spend the time in thoughtful diligence or post investment management. If we focus on the basics, and apply them well, we will ultimately earn IRR, proceeds, and the trust of our business partners and investors.