I have been sitting on the buyside for a while – quant/risk driven 600bn+ AUM asset management and activist PE/VC 1bn AUM – and scrutinized companies inside out on their financials, business acumen, technology stack, go-to-market strategy and all that Jazz. Now I am sitting on the other side of the table and am facing the value propositions offered by many investors and enjoying the ride with a clear set of board members. So while I studied the term sheet mechanics for quite a while and became savy in understanding how a cap table and the milestones and valuations made at every made or broke a founder vision, I am now taking this a bit deeper.
The risk appetite and power game of Venture Finacing
This part was covered in other articles either on LinkedIn or my blog. But understanding life cycle, maturity, LP mix and political dynamics in a VC fund is a first step to get the allocation strategy of a VC fund and to assess if going with a particular fund vs another is accretive or dilutive to the ROE and the success of th company.
The power of the people that back you
Everything comes down to traction, sales once you hit the market with your product. Right? Right. And wrong. There is a new learning that I made now on the other side and talking to peer that really changed my thinking on how the game is played.
The power and network of the people on your board, advisory positions and the angels you get are making or breaking your business.
The simplest example is if your Series A EMEA investor is buddy-buddy with the top tier Venture Capital dude in the Valley. If you do have the potential, traction and all that Jazz, this investor will make this intro happen. There is no way you will make it happen on your own without anything but stellar traction and a pitch deck that you typically don’t dare to compose if you are from EMEA – talking about cultural differences. And chances are if you have an EMEA tier 3 investor leading your last round who doesn’t know this tier 1 venture capital guy in the valley, you are not having the valuation and money to make that happen. You will simply not get access to this investor if you don’t have the connection and hence you will raise from a tier 2 fund and your valuation and money to play will suffer from it, further putting you into a lower growth spot. If you go to crunchbase and look at the unicorns and all those other slowly fading and trade saled companies – if you ignore your lack of confidence that you can’t raise a 10 million angel round – and you just look a the numbers, you can clearly see that your Angel and Seed round make or break you already. Every financing round has an impact on the path you are going to go down. And the only way to really have a powerful impact is pre-numbers, pre-product in your angel and Seed finacing. Mastering that is crucial. If you failed it and got he learning, rinse and repeat. Don’t ride a dead horste for 5-10 years. IF you understand risk reward and you understand that you should start your unicorn no later than 35 – 40 years old, you shouldn’t focus on building mediocre companies for too long. Head for a graceful exit. never lose investor money. but never dream of things that don’t happen on your fund raising trajectory.
So I mentioned it already, it’s crucial to look at the quality of your angels. If you are doing enterprise sales, you will in no way have the network to talk to the CEOs, CIOs, CTOs of major NASDAQ corporations. But you will have this opportunity if your angel can make that intro, because he is buddy buddy with him. And you will be more likely to sell your product in a very young stage if that Angel is sitting next to you in the initial pitch and sale with that NASDAQ Executive and plays the trust card. You will not play the politics and strategic complex selling game as well in the corporate sales cycle and strategic selling arena if you don’t have that angel fully behind you and sitting at your side, hunting the whales. So your angels should really believe in you, help you in this arena by partnering with you – fully believing in the ROI you will give the mfor that – and they should invest 7 to 15 million for a decent and low equity amount. Things will be hard enough with employee stock and Series Seed and Series A dilution, they shouldn’t be greedy. It’s better to take 10% and grow you to a billion than taking 25% and sell you at 200 million.
Example: How much dilution is there?
Let’s say you start with 1000 common shares. And the game is over if you reach 0.5% ownership of your company. You are at maximum issuing 200.000 shares (Assuming no new shares are issued or granted to the founders). If the angel gets 10% for 10 million, – assuming for simplicity 100 new shares -, he will have 0.5% of a billion. So 50 million. And you might exit after 5 years. That’s 5x and 37% IRR. Compare this to a 5 million investment for 20% equity (200 shares) and an exit at 300 million, 7 years later, that is 6x at 28% IRR. Clearly an idiot.
The problem here is that the angel isn’t a trillionaire, and he only can allocate 100 million, and he doesn’t believe in his investment selection ability. And if he does this bet with every investment, he can spread his investments only to 10 vs. 20 investments. Risk averse as he is, he prefers to buy smaller tickets and get the lower IRR to hedge against a desasterous portfolio. But the good thing: the more the angel knows about investing and the more impact he has on you and the better networked he is, the more likely he will select class over mass and the more likely he will invest well. Veeery simply? Yes it is. But that’s why you should win the best angels. Not just any angel.
And even later stage, the chances that you get Blackstone, Carlyle and KPCB in your Series C and D is far higher if you have that network, too. Driving your valuation again with active investors trying to stay in the lead position on the deal.
So truthfully, your investor set-up matters from the very beginning when you are grouping your family and friends to your first angels to youjr Series A investors to the very end.
The value add positions of investors
Investors must be measured not only by the doors they open when you want to raise the next round. Venture Capital investors are by nature active investors. They offer the following set of input:
- Big pocket investors that get the game and like you – and do not drop you – will teach you about how to drive your valuation and when not to take a bad bargaining positions and they will fight this to the end with you, knowing they are able and willing to go pro rata and when a valuation advances your strategy and when it does not.
- Strong venture capitalists will be outstanding in wearing three hats: the investor hat protecting the interest of their fund; the advisory board member protecting the interest of the company and reacting it its risk; and the coach that listens to information beyond board and investor information and partners with you on the road. Weakest investors only take the investor hat and typically are the ones from the financial background. They protect their assets and their network against failures from your side. Experienced investors will manage to take the board position and typically have an entrepreneurial background, providing their feedback in the formal background. Superior investors with a good trackrecord, established positions in their management companies and funds will coach you and members in your team on a 360° degree view and add value wherever they can. Listening also to the very high risk items and concerns you have in your daily operations without ratting you out to the other hats they are wearing.
- Strong investors will give you access to sales opportunities and will help you actively grow your sales pipeline. If they have the network, that is the cheapest return on their investment they can offer.
- Strong investors come with massive networks of access to mentor and advisor networks and will give you operational support independent of the stage and scale of your organization. Those are the ones that actively grow their ecosystem and brand in the ecosystem and they will build such a strong brand that they provide value through the network they acquire through this. But of course, they must be very good at maintaining and nurturing low-touch relationships and be quick to identify ROI in a favor-for-a-favor environment.
- Strong investors get calibre A talent in for you and will convert even the most senior and risk-averse individuals into your company by telling a compelling story. Recruiting a VP or SVP position from Google for your hot start-up costs them 3 weeks of engagement and a life long prospecting as part of their job to boost the efficiency of your organization for the years to come, leaving a mark on the success of your organization. Also a simple ROI for the investor.
- This typically comes with the age of the investment entity, with the number of deals done and successes and wins. The more companies were built into large global enterprises with partners on the board, the larger the outreach to the top talent in the industry. The better the track record and the more social and likable the investor, the more likely such people are betting their lifes savings, career and income potential into the hands of you.
- Some investors are ridiculously good in pooling equity and mezzanine investments for you when you are in a crisis and help you especially in the young years. In the later years, they might get your foot into the door of financing environments that you cannot even think or dream of pre-IPO. Financing guys typically are stronger here as well as high networth individuals. They know people that know people that can support on this end.
- Some investors are nieche players. If you go-to-market wants to build on capturing a particular nieche, these guys get you in. They build portfolios of actionable talent and technology for their network out of their minority stakes and nurture the value-add between network participants. Some of the very big guys that are good at other things are not particularly good at this, because the nieche might be too far out of focus.
- So far talked about activist investors that have a clear value add story. But there is more to it. There are some passive investors that just support you as well on your way to growth. Family offices for example come with a potentially higher risk appetite and take a far less strict diligence and market hypothesis around you than activist investors. These guys can be used to drive your valuation by increasing ticket sizes – which squeezes activist investors out of the mix as you are sure how much money you want to raise and there is only a limited set of room in every round. This increases the pressure on activist investors that want to buy at the current opportunity level, see you as a best option in their capital allocation strateg and have the room to go for a higher valuation. Driving your valuation and ability to increase the valuation on a particular subscription. They also might come with a higher risk appetite and may drive your valuation simply by being willing to invest more money for a lower stake.
- Strategic investors with a clear interest in getting access to your technology and potentially buying you out are another part of the game. Strategic investors like to take you in and role you out in their organization. They believe in your technology and its value add to their strategic interests.
Don’t forget that the game still requires a few other things to consider
The rule of thumb is that you should not raise more capital than you are ready to deploy. If you are on a fundraising schedule on a YoY basis, so one round every year, the investor believes the following things:
- You are able to run for another 3-4 months if you delay in fundraising after this year. That is a basic rule of thumb and acknowledges the difficulty of raising funds. Etc.
- Your top line projections are reasonably correct and the runrate in months you have is realistic and factors in revenue growth. Because investors don’t want you to raise more money than you need. You always must have a sober self-financing via revenue structure in place. Because only idiots raise funds externally if they are able to finance themselves at no cost. But this also implies you and your investors believe into the top line story. The model assumptions behind this must be plausible, numbers given must be plausible and actuals and past data must drive these assumptions. At least from Series A onward.
- This also means you must reasonably plan your costs. This requires a few things to bear in mind.
There are a few errors that entrepreneurs and start-ups can do.
(1) First of all, top line can be completely invented and this will be a big issue in board discussions and is a key component of facing a downround down the road.
(2) Believing that finance and operational excellence and organizational planning is something that can be delayed to later. Even though the requirements from capital market authorities are fairly low for private companies, an underperformance in this section will lead to insufficient ROI on a given cost base compared to expectations which will kill investors trust in the business and lower valuations. If you only focus on sales, marketing and product, you might get higher revenue to apply a multiple, but your multiple wil go down as your planning and management skills are being questioned.
(3) The bottom line is not just bottom line. It reflects a growth strategy that is either aligned with industry best practices or not. Only if you are seasoned and experienced, read the right stuff and havfe a strong set of advisors to guide you in organizational and other opex scaling and setting priorities and if you are willing and able to execute on that strategy, you opex + HR planning + scaling efforts will give the ROI on top-line and only if your investor network or your HR function and brand gives access to highest ROI on dollar invested on HR and if the organizational and management structure is optimal, you will get the results from deploying the operational costs. This is a hard mix to get the bottom-line right and that is the only way you will survive a discussion around a favorable valuation that gives you money and capital to deploy to succeed on your market taking and positioning efforts.
THis is also the reason why it is easy to land in the sales trade instead of IPO land. If you consistently underperform in dimension 1 to 3, this will reflect your capital available, the growth and marketing positioning on capital available and the overall positioning of the organization.
So networks and investor choice isn’t everything. But it opens a lot of doors. If you as an entrepreneur are mentally flexible, coachable and the organization and hiring strategy you create allows your capability to translate into measurable execution and performance.
Question now for me is, as a stock investor and someone taking the view from the VC and PE side, too. How do I incorporate this in understanding a company when reading public records and IR statements? Especially after sitting on a stock for over year that failed to deliver even the most basic task of reporting to investors for 8 frigging months. Is it a clear bearish drop? Or is my hypothesis on the upside still a pop? The insight here is what I am holding a strong belief since several years, that you cannot understand an investment deal without understanding networks. Companies are not only a function of Ouput = F(Input), but they are an expression of networks operating on a solution domain.
Opinions are my own. Thanks for liking and sharing. I express my views this openly, because I believe in sharing and collaboration among the community as a means to drive the success in mankind in flawed systems that operate our status quo.