by Krishna Mony
Throughout my career in Investment Banking for the past few years, and later in my careerist Private Equity / Venture Capital consulting avatar, I have often come across people seeking to explore our methods and processes. Here is a primer.
Our investment process is optimized to realize substantial returns from early-stage firms developing high valued-added core technology. Our process phases are:
1. Deal Flow
2. Evaluation
3. Selection
4. Decision
5. Value Creation
6. Liquidity Planning
These phases provide timely responses to entrepreneurs, ensure quality portfolio companies, and set the stage for our value-added model post-investment.
1. Deal Flow comes from our entrepreneur network, syndication partners, and later stage venture capital firms. These deal flow sources are attracted to us by our ability to perform due diligence and assist portfolio firms in achieving critical time-to-market milestones. Obtaining most of our deal flow from such qualified sources frees up more resources for building portfolio value.
2. Evaluation begins with the introduction of a business plan through one of the members of our network followed by a face-to-face meeting and subsequent investigation. We assesses the strength and completeness of the team, the company's technology, competitive advantage, target market, marketing plan, financial history and projections, and capital needs. The due diligence will include reference checks with customers, industry experts, and management references.
3. Selection is based on input from our Advisory Committee and analysis of team industry knowledge, technology development capabilities with a "deep science" orientation, portfolio fit, time-to-market focus, target market sizing and dynamics, competitive landscape and entry points, capitalization table, revenue projections and sales cycles, and recruiting capability.
4. Decision rests on discussions on perceived valuation, roles of both current and potential co-investors, and deal terms. A unanimous decision by the managing members is required to proceed with each investment.
5. Value Creation is achieved by assisting the portfolio company's management team in implementing and utilizing methodologies that manage and monitor time-to-market strategies using proven process models. Important ingredients in these models are a strong emphasis on early and frequent customer involvement in product development, concentration on differentiators, and recruitment of key contributors (advisors, executives, strategic partners).
6. Liquidity Planning is approached as a continuous process integral with value creation that provides multiple options. All management decisions are analyzed for strategic impact on liquidity paths with the intent of maximizing investor returns.
What do we do ?
1. These days, I head my consulting outfit Sequel Ventures based at Mumbai, India which hunts for the next wave of growth companies , where we syndicate investments in early stage technology firms from a network of Angels / VC partners. I specialize in finding and funding start-ups that aim at solving specific IT problems for big corporate users, drawing on our extensive network of business contacts, and my own corporate Investment Banking experience , to choose small companies that have the right mix of technology, strategy and leadership to thrive in the real world.
Among the investments that we have spearheaded for Sequel are stakes in a few incubatees in the Non-Conventional Energy Resource based projects, E-Commerce solutions, Commercial Avionics and a host of projects in BFSI verticals. We have also secured VC funding recently for an ITES project in the Telecom / Insurance vertical within a record 3 weeks.
The Challenge
Mastering the mix of business strategy and tech knowledge is the biggest challenge for both Angels and start-ups. That complexity, that diversity of skills and knowledge is what you need to be successful, and for your overall organization to be successful, at any level, according to us.
What are the primary factors that we look for in a company where we recommend a venture investment?
We look at investment opportunities that are oriented toward enabling growth at the companies that will buy the product, early-stage companies that are oriented toward reducing complexity and cutting costs, and companies concerned with reducing threats in the area of security—that kind of thing. It clearly has to be something that's solving a growing problem for potential customers. What we look for is a company that is producing a technology or an idea that can be sold directly to large corporations. Or it could be an enabling technology that gets sold to other technology companies that then produce it and sell it to the public or large technology companies.
Security continues to be a broadly defined growth area, in terms of both investment level and the size of the problem. It's pretty high on the IT budget. Another key area involves the switch-out at the data center from legacy technologies to newer technologies based on things like open-source, blade computing and storage-area networks. Another is a cost-effective management framework for a very different computing paradigm involving application servers and composite applications and Web services. Although certain costs in the new computing architecture have come way down, such as the cost of buying a server and buying a software license, other costs of managing that complexity and managing very high availability and responsiveness in this new architecture are still being worked on.
Do you do due diligence on Promoters / Projects before they are presented to Angels / VC partners ? What are your methods ?
Of course, we do. It makes the Angels / VC's in our network more comfortable since our methods complement theirs and are equally stringent in vetting a proposal. Hence we normally do not face any difficulties in securing funding for a project that we have cleared internally. We have a number of ways of analyzing the market. One is that we actively maintain relationships with IT buyers and senior executives to understand what's on their priority lists. We try to understand which areas are passé and already solved, and which they're really looking to their existing strategic suppliers to solve, versus the areas in which they feel their existing suppliers are unlikely to innovate.
Also, we would never recommend an investment without speaking to existing customers, prospective customers, and customers of competitors of the company, to understand how that market, that technology, that product and team were perceived. Now, having said that, if all you looked at were companies that were capitalizing on ideas and solving problems that were already defined and well known in the market, then you're not looking at things that are maybe five to ten years away.
We try to look at the great teams that are coming up with ideas that are a few generations out, that prospective customers maybe haven't thought about yet. That's risky. I mean, how many years have people been saying that this is the year of Web services, or of service-oriented architectures? And instead of it being a big wave, it's tending to be a very, very slow buildup. A lot of the momentum is going to depend on when the very big established suppliers, the Oracles, SAPs and IBMs, release their new products based on those architectures as much as when some new innovative start-up introduces something. Sometimes an entire market has to help make the move.
Some of the most important things you look for in a Project?
We mainly look for a great team. Brilliant minds, Independent thought leaders having a clear idea as regards their goals.
In investing in a tech start-up, the quality of the team, the quality of the people, is right up there in importance with the market opportunity and the product. So we might run into a market opportunity we think is excellent and a product we think is pretty darn good, but the team is not the right team for us to bet on. We don't think a company like that is going to win.
One of the primary reasons is that very young technology start-up companies rarely have the formula properly defined when they come and look for a first round of investment from VC's.
Any start-up is going to hit big forks in the road—more likely 90-degree turns, and not uncommonly U-turns. The ability of a team to be able to react to those major changes and make the right decisions and implement the right strategies to deal with huge mistakes and missed opportunities and poor analysis of the market is paramount for that company to ultimately succeed.
So the team is absolutely mandatory. And I'll tell you, it's a unique breed of people that will start as a group of three, four, five people and create a successful venture-funded, high-tech start-up. It's not just some good people. Ideally, they've been on a winning team as well as a losing team before, because you learn just as much from failure as from success. A lot of people say you learn more. And it requires just an unbelievable amount of energy and passion and enthusiasm and resilience, as well as business and technology acumen.
Getting the right mix, that magical team that comes together to make a start-up really successful, is not dissimilar to having an IT leadership team and a business leadership team at a much larger company—teams that come together with the right chemistry to result in the company being able to use IT for competitive advantage.
Remember this one thing. If you are not quite sure about your venture, chances are that the VC had already rejected it.
What else do Angels/VC's look for from the kind of companies you recommend funding - particularly on their business model when large corporations are projected as their customers ?
Well, I can tell you what is not on the list. And that is a traditional, high-risk, high-expense, low-rate-of-success implementations of complex application packages. The kind of company where all the money goes to the vendor upfront, and all the risk lies with the customer. A three-year implementation of a monolithic piece of software, with very complex integration, a big up-front license fee, and the risk being on the buyer rather than the seller, does not get a lot of traction. That era is over.
When corporations look at technology from small innovative start-ups, they expect a very different delivery model. They want business solutions to solve business problems, which fundamentally is application software delivered in some way, shape or form. They want it implemented quickly, and they want shared risk between the customer and the vendor, meaning that if the project doesn't succeed, the vendor doesn't still get to run all the way to the bank. They're looking for a more clear return on investment that is going to be easier to achieve without massive business process reengineering, which is high risk. And sometimes they're looking for flexibility—maybe the application being delivered as a managed service.
But are large companies willing to buy directly from these smaller start-up vendors?
I think many companies realize it is difficult for the very large technology suppliers to develop the most innovative solutions. And so companies need to push those large tech suppliers to continue to acquire companies for innovation purposes, as well as continuing to buy directly from smaller, innovative, venture-funded technology start-ups, to solve their most pressing tech problems.
When a small technology start-up goes to market in partnership with an existing supplier, that is often a big plus. It's not the only way to get success, but it's certainly one we like. It gets faster market traction and faster credibility. Customers like it, too. In fact, customers frequently drive it. It's one reason that acquisition activity by the big players is up significantly.
How fast can products actually go from the drawing board at a start-up to regular use at a large corporation?
In areas that are changing rapidly, like compliance issues related to Sarbanes-Oxley, things can happen very quickly. I've seen products in that area move to market within a couple of years. Storage continues to change very rapidly, and there are companies that just in the last three years have gone from idea or initial product to pretty good market traction.
The same is true of enabling technologies such as semiconductors and electronic design automation. Wireless is another great example. We've surveyed a number of companies that are selling wireless applications, and more companies are seeking easier access to critical information and applications through wireless and handheld platforms. So we have a whole host of areas where I would say there's been good business take-up, and some companies that we think are very promising that we've just recommended investing in maybe two, three, four years ago.
At the same time, the cycle from innovation to venture capital funding to corporate use is not even close to what it was the latter half of the 1990s, and I think it would be foolish to bet on that happening again any time soon. I think we're in more of a typical cycle now than in those years, and also more typical than maybe 2001 to 2003, which were very slow and difficult years. I'm not saying that happy days are here again. It's just that it's kind of back to the normal adoption cycles that we've seen over a long historical period of IT.
How can a Corporate Finance / Legal pro like you expect to keep up with all this technology change and still be an integral part of the business team, keeping up with strategy and even corporate politics?
Being a successful Investment Banker is a very complex and underappreciated job. It's a difficult job. You are not purely a technologist, but a Rain Maker; We all have seen during the earlier Tech Boom of the late 1990's that technology-driven CIOs can't achieve the necessary level of business partnership. You may still have to educate business management to look at IT as a key, strategic, enabling component of the successful business, even in this day and age. For that you have to learn it yourself quick. I've been a bit lucky because of my affinity to Math and Science during my School days.
But on top of all that, technology continues to change. Delivering the day-in, day-out performance that comes with the advance of technology, figuring out when to deploy new technologies, not being too bleeding-edge, but also not a laggard when technology can enable the business results you're looking for. There is a balance between being technology-driven and business-driven. It's critical to find that balance, but it is not easy, even today.
It must have been somewhat easier as a Management Executive, right? You didn't have to convince the boss that technology could be useful.
When I started at Coopers & Lybrand, there were not a lot of non-technology companies that were leaders in the use of technology. A non-technology company that was really enabling itself with technology was a new concept. Large technology companies took technology for granted, to be honest. It was often companies in other businesses, such as banking, with the ATM machine, or companies like FedEx, that were the big stories of competitive advantage in IT. They didn't come out of IT companies. They came out of consumer-products companies.
They came out of manufacturing companies, supply-chain companies. That culture had to be created within tech companies, including Coopers. I think that's part of what I was able to do there.
2009/05/14
A whole bunch of seed...
by Josh Kopelman,
I woke up this morning to some interesting news. Charles River Ventures is now investing at the seed-stage. This is a smart reaction on their part to several market trends:
The fact that it costs less to start a software/Internet business these days,
The fact that there are fewer large exits (both via IPO and M&A) taking place, and
The fact that, over the long-term (10+ years), seed-stage investing has had a higher return than any other stage of venture investing.
It also is a recognition of some of the challenges that larger venture funds face. Take a hypothetical traditional $400M VC firm. In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B. Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average). That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%). Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY. Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.
I've only interacted with Charles River a few times (we were co-investors in Odeo together) but think very highly of them. They have an enviable track record and a sterling reputation. I think they are one of a few pro-active venture firms who are proactively seeking new investment models (I've now heard of two other venture firms that are establishing seed-stage programs).
However, I've always thought that there were some inherent conflicts that arose when venture funds moved to the seed-stage. I'd be interested in hearing my readers thoughts on:
I've always believed that one of the key roles a seed-stage investor plays is to help their portfolio companies raise a Series A round. One of the reasons I don't like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur. As a lender, I would convert into the price of the next round -- motivating me to keep the next round valuation low. As a shareholder, my motivation is aligned with the entrepreneur -- we both get rewarded by a higher second round valuation.
When an venture investor has an option (but not an obligation) to take a certain percentage of your next round, I've always thought it created the potential for some bad optics. If they exercise their option, and participate in the round, it could be a wonderful thing for the company. But if they choose not to exercise their option, what signal is it sending to other potential investors? As a small ($<50m) First Round Capital) to be a lead investor in subsequent rounds...But if a larger VC firm has the option anddoesn't use it -- does that cause other venture funds to wonder why?
Finally, as the First Round Capital website states, "we look to take an active role in most of the companies we invest in. We believe our insight and expertise are far more valuable than our capital -- and we look for entrepreneurs who feel the same." Our whole business model is to roll-up our sleeves and actively help the company develop it's strategy/partnerships/business model, etc. In fact, we tend to be far more active in the early-stages of a company than in the later stages. Given the size of larger VC funds, are their partners able to actively get involved in a seed-stage deal?
Thoughts?
UPDATE: Matt Marshall at VentureBeat has interesting insights here and Fred Wilson of Union Square shares his analysis here...
I woke up this morning to some interesting news. Charles River Ventures is now investing at the seed-stage. This is a smart reaction on their part to several market trends:
The fact that it costs less to start a software/Internet business these days,
The fact that there are fewer large exits (both via IPO and M&A) taking place, and
The fact that, over the long-term (10+ years), seed-stage investing has had a higher return than any other stage of venture investing.
It also is a recognition of some of the challenges that larger venture funds face. Take a hypothetical traditional $400M VC firm. In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B. Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average). That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%). Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY. Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.
I've only interacted with Charles River a few times (we were co-investors in Odeo together) but think very highly of them. They have an enviable track record and a sterling reputation. I think they are one of a few pro-active venture firms who are proactively seeking new investment models (I've now heard of two other venture firms that are establishing seed-stage programs).
However, I've always thought that there were some inherent conflicts that arose when venture funds moved to the seed-stage. I'd be interested in hearing my readers thoughts on:
I've always believed that one of the key roles a seed-stage investor plays is to help their portfolio companies raise a Series A round. One of the reasons I don't like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur. As a lender, I would convert into the price of the next round -- motivating me to keep the next round valuation low. As a shareholder, my motivation is aligned with the entrepreneur -- we both get rewarded by a higher second round valuation.
When an venture investor has an option (but not an obligation) to take a certain percentage of your next round, I've always thought it created the potential for some bad optics. If they exercise their option, and participate in the round, it could be a wonderful thing for the company. But if they choose not to exercise their option, what signal is it sending to other potential investors? As a small ($<50m) First Round Capital) to be a lead investor in subsequent rounds...But if a larger VC firm has the option anddoesn't use it -- does that cause other venture funds to wonder why?
Finally, as the First Round Capital website states, "we look to take an active role in most of the companies we invest in. We believe our insight and expertise are far more valuable than our capital -- and we look for entrepreneurs who feel the same." Our whole business model is to roll-up our sleeves and actively help the company develop it's strategy/partnerships/business model, etc. In fact, we tend to be far more active in the early-stages of a company than in the later stages. Given the size of larger VC funds, are their partners able to actively get involved in a seed-stage deal?
Thoughts?
UPDATE: Matt Marshall at VentureBeat has interesting insights here and Fred Wilson of Union Square shares his analysis here...
Seven Lessons Learned for Startups
by David Beisel
"Input not consensus." – Scott K. While many have different views on management styles, I favor decision-making processes being inclusive to all parties who deserve to share their opinion, but having the ultimate decision made by a single person who is ultimately responsible for it. The problem with true consensus thinking isn't that good decisions don't come out of it, but rather that it's unclear when final decisions are made. Startup situations aren't the right place for muddled thinking or unclear directives. Once a decision has been made, owners of responsibility must immediately run off and execute. Although many extremely successful organizations were built on consensus-driven cultures, my opinion is that there isn't time for it in a startup - but there is absolutely time for everyone's input.
"Be authentic." – Mark L. I believe most successful entrepreneurial endeavors are sprung from a genuine idea born from true experience or direct & tangible observation. Companies that emerge out of a team with heritage in a particular market and technology have direct understanding of that realm. Furthermore, when employees act in an open and authentic manner with each other, it helps foster a team environment which is productive for everyone. It is with this authentic foundation that great companies are built.
"Dead cats don’t bounce." – Joe G. Unfortunately, many many startups do not succeed. It takes a strong entrepreneur to admit when a particular project, product, or company isn't destined for success. (Often those failures lead to learning experiences from which new successes are born.) But if something isn't going to take on life, startups must realize when that's the case and move beyond the fleeting hope for it to take off.
"Solid-gold relationships." – Bill A. The most important relationship that any company has is with its customers. And the most important of those are the key large or influential customers. It is with those special constituents - whether they are consumers, SMBs, or enterprises – that should be nurtured and cared for. Not only do they provide the (first) notable revenue, but also necessary market feedback for further refining the product offering. With all of the distractions that arise in a startup setting, it's extremely important to keep focused on cultivating these special relationships.
"Get involved." – John C. I used to have this quote from a former boss hanging above my desk. A daily reminder that when deciding whether to take action, experiment, or try something new, it is usually better to take this route than to not.
"Take time to think." – Kelley M. While action is always a priority, deciding the correct action often requires reflection. Dedicating time during a critical juncture in a project or undertaking to leave time for unstructured individual contemplation of the larger current work situation provides an opportunity for everyone to obtain a richer perspective. It's an underutilized tool to require that people occasionally briefly pause from the task-oriented workday (not just to provide brief respite from the pile of to-do's, but) to contemplate what efforts truly will have the most impact on the company.
"Reward those who deserve it." – Kevin M. Credit should go where credit is due, with the right people rewarded for their efforts. And that doesn't just mean appropriately compensating people financially. Particularly in a startup where there is less cash to share, recognition and acknowledgement of accomplishment goes a long way. A long way.
(The above mantras are obviously not the only, nor are they necessarily the best, words of wisdom which I've ever received. However, they are the ones that have sunk in internally for me the most. While this is a professional post, it is also a personal one as well, as I am extremely appreciative of those listed above who have made a direct impact on my own thinking and direction over the years and will continue to do so.)
"Input not consensus." – Scott K. While many have different views on management styles, I favor decision-making processes being inclusive to all parties who deserve to share their opinion, but having the ultimate decision made by a single person who is ultimately responsible for it. The problem with true consensus thinking isn't that good decisions don't come out of it, but rather that it's unclear when final decisions are made. Startup situations aren't the right place for muddled thinking or unclear directives. Once a decision has been made, owners of responsibility must immediately run off and execute. Although many extremely successful organizations were built on consensus-driven cultures, my opinion is that there isn't time for it in a startup - but there is absolutely time for everyone's input.
"Be authentic." – Mark L. I believe most successful entrepreneurial endeavors are sprung from a genuine idea born from true experience or direct & tangible observation. Companies that emerge out of a team with heritage in a particular market and technology have direct understanding of that realm. Furthermore, when employees act in an open and authentic manner with each other, it helps foster a team environment which is productive for everyone. It is with this authentic foundation that great companies are built.
"Dead cats don’t bounce." – Joe G. Unfortunately, many many startups do not succeed. It takes a strong entrepreneur to admit when a particular project, product, or company isn't destined for success. (Often those failures lead to learning experiences from which new successes are born.) But if something isn't going to take on life, startups must realize when that's the case and move beyond the fleeting hope for it to take off.
"Solid-gold relationships." – Bill A. The most important relationship that any company has is with its customers. And the most important of those are the key large or influential customers. It is with those special constituents - whether they are consumers, SMBs, or enterprises – that should be nurtured and cared for. Not only do they provide the (first) notable revenue, but also necessary market feedback for further refining the product offering. With all of the distractions that arise in a startup setting, it's extremely important to keep focused on cultivating these special relationships.
"Get involved." – John C. I used to have this quote from a former boss hanging above my desk. A daily reminder that when deciding whether to take action, experiment, or try something new, it is usually better to take this route than to not.
"Take time to think." – Kelley M. While action is always a priority, deciding the correct action often requires reflection. Dedicating time during a critical juncture in a project or undertaking to leave time for unstructured individual contemplation of the larger current work situation provides an opportunity for everyone to obtain a richer perspective. It's an underutilized tool to require that people occasionally briefly pause from the task-oriented workday (not just to provide brief respite from the pile of to-do's, but) to contemplate what efforts truly will have the most impact on the company.
"Reward those who deserve it." – Kevin M. Credit should go where credit is due, with the right people rewarded for their efforts. And that doesn't just mean appropriately compensating people financially. Particularly in a startup where there is less cash to share, recognition and acknowledgement of accomplishment goes a long way. A long way.
(The above mantras are obviously not the only, nor are they necessarily the best, words of wisdom which I've ever received. However, they are the ones that have sunk in internally for me the most. While this is a professional post, it is also a personal one as well, as I am extremely appreciative of those listed above who have made a direct impact on my own thinking and direction over the years and will continue to do so.)
The Art of Selling Your Firm
by Matt McCall
Despite the markets' gyrations, 2008 was the best year for liquidity in our firm's history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:
1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it's friend, they will slow roll the process, driving harder terms with each passing month. Don't go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don't push.
2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.
3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don't ever taint this process by pushing or even hinting at selling the firm as it will set you back.
4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.
5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.
6) Strategically Central: if your product or service is a central component to the acquiror's future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.
So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.
Despite the markets' gyrations, 2008 was the best year for liquidity in our firm's history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:
1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it's friend, they will slow roll the process, driving harder terms with each passing month. Don't go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don't push.
2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.
3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don't ever taint this process by pushing or even hinting at selling the firm as it will set you back.
4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.
5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.
6) Strategically Central: if your product or service is a central component to the acquiror's future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.
So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.
Multiples vs IRR
by Matt McCall
I was at a business school today helping judge several business plans. As group after group presented, I saw each make the same mistake as the previous. When they tried to justify the investment from the perspective of the VC, they kept telling us that this was a 40% IRR deal or a 25% IRR as if we had magical IRR thresholds.
The reality is that the venture world is all about multiples and the IRR's are the results. I don't know what the original legacy behind this was, but from a practical perspective, it is driven mostly by the fact that we live in a boolean world. Some is also based upon the high net worth legacy of our business. Originally, because pension law did not permit the large institutional investors in, our business was funded by family offices, endowments and foundations. Multi-generational families, while they want high IRR's, are really looking to double or triple their invested capital.
From a portfolio perspective, if we invest in 10 deals, 4 are tube shots, 2 we fight to get our money back on, 2-3 we get 2-5x on and the 10th deal drives the return (hopefully north of 10x). If we doubled our money in 1 year (100% IRR) but lost all our money on the next deal over 6 years, we aren't happy (net gain is $0). We don't care that we made 2x in 1 versus 3 years or lost all of our money over 6 years versus 4 years (this impacts IRR), because we earned 1x on the capital.
We often see complex financial models with discounted cash flows, hurdle rates and such. These are useless. I have never seen a set of financials in an early stage company that ever reflect what Darwin will allow to happen in reality. So, you start your modeling with unreliable numbers.
Secondly, what is the beta for an early stage biotech deal, a semi-conductor start-up, etc? Can you assess the risk associated with a given management team? How about a new market space?
Perhaps we are too lazy to try and figure this out, but after decades of effort, the only method that seems to work in the venture world is to target 10x on each early stage deal (3-5x on later stage plays). They all look like the next Microsoft, but eventually, the portfolio of these settles down to the profile above. In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR's, don't return enough multiple to pay for the 4 tube shots and 2 break-even deals. Your winners need to deliver 10x.
So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).
I was at a business school today helping judge several business plans. As group after group presented, I saw each make the same mistake as the previous. When they tried to justify the investment from the perspective of the VC, they kept telling us that this was a 40% IRR deal or a 25% IRR as if we had magical IRR thresholds.
The reality is that the venture world is all about multiples and the IRR's are the results. I don't know what the original legacy behind this was, but from a practical perspective, it is driven mostly by the fact that we live in a boolean world. Some is also based upon the high net worth legacy of our business. Originally, because pension law did not permit the large institutional investors in, our business was funded by family offices, endowments and foundations. Multi-generational families, while they want high IRR's, are really looking to double or triple their invested capital.
From a portfolio perspective, if we invest in 10 deals, 4 are tube shots, 2 we fight to get our money back on, 2-3 we get 2-5x on and the 10th deal drives the return (hopefully north of 10x). If we doubled our money in 1 year (100% IRR) but lost all our money on the next deal over 6 years, we aren't happy (net gain is $0). We don't care that we made 2x in 1 versus 3 years or lost all of our money over 6 years versus 4 years (this impacts IRR), because we earned 1x on the capital.
We often see complex financial models with discounted cash flows, hurdle rates and such. These are useless. I have never seen a set of financials in an early stage company that ever reflect what Darwin will allow to happen in reality. So, you start your modeling with unreliable numbers.
Secondly, what is the beta for an early stage biotech deal, a semi-conductor start-up, etc? Can you assess the risk associated with a given management team? How about a new market space?
Perhaps we are too lazy to try and figure this out, but after decades of effort, the only method that seems to work in the venture world is to target 10x on each early stage deal (3-5x on later stage plays). They all look like the next Microsoft, but eventually, the portfolio of these settles down to the profile above. In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR's, don't return enough multiple to pay for the 4 tube shots and 2 break-even deals. Your winners need to deliver 10x.
So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).
Venture Capital in China
By David Hornik on January 5, 2008 1:17 AM Permalink
For the last several years there has been a lot of talk on Sand Hill Road about investing in China. To a certain degree there has been a lot of talk about all the BRIC countries -- Brazil, Russia, India and China. But the most excitement is clearly around China. (Interestingly, while India is a relatively close second, I have yet to hear of a single Bay Area VC exploring investment in either Brazil or Russia). Drawn by huge markets and a rapidly expanding economy, American VC's are heading to China to stake their claims. Go East young VC's. Go East.
Venture Capital investment in China has not, however, been a headlong dive. Bay Area VC's seem to be sending over exploratory parties. By way of example, David Chao from Doll Capital has been in and out of China for some time. Now a number of his partners are getting in on the act as well. Paul Koontz from Foundation Capital spent a year in China exploring the market. And perhaps the best indicator that the Chinese market is hot is Dick Kramlich's pilgrimage to China this year. Kramlich is one of the founding fathers of Sand Hill Road -- a 25 year veteran of the venture capital business. Not one to miss out on a big opportunity, Kramlich has headed over to China for 2008 to catch the wave of entrepreneurship and, perhaps, some of the Beijing olympics. Chow, Koontz and Kramlich are not the only US VC's headed to China by any stretch of the imagination. But these high profile forays into the Chinese market are excellent indicators of the level of interest in the market.
It is hard not to be intrigued by the Chinese market. With 1.3 Billion people, you don't need a huge amount of penetration to hit big numbers. One percent of the Chinese market is 13 million people. As they say, if you are "one in a million" in China, there are thirteen-hundred people just like you. What's more, the Chinese government anticipates that approximately 300 Million people will move from the countryside to urban centers in the next decade -- that's the same number as the entire population of the United States. The combination of massive aggregate numbers, rapid urban migration (and the commensurate increase in wages) and relatively low concentrations of modernized business processes, suggest a market ripe for investment. And that is precisely the conclusion many of my brethren on Sand Hill Road have drawn.
Given all that, I was anxious to check out China for myself. And right before the new year, I had the good fortune to do just that -- I accompanied a group of Stanford Business School students on a ten day study trip to China. We met with senior executives from companies like China Telecom, Alibaba, GM China and Bao Steel, as well as senior government officials and party leaders (yes, it is still a Communist country). But the most interesting discussions, to my mind, were with the leading private investors in China. (Because my meetings with these private investors took place as part of a study trip, there was no expectation that I would blog about the content of our conversations -- thus, I have decided to exclude the names of the specific investors so as not to violate any confidences they may have reasonable expected.) These investors gave a surprisingly candid view of venture capital throughout the country -- the good, the bad and the ugly.
To the mind of the Chinese investing community, the market dynamics described above well outweigh the risks of investing in the current environment. Huge markets with lots of business white space provides for numerous opportunities for economic gain. While American investors are busy debating the degree to which the US startup market is saturated, Chinese investors are having trouble keeping up with the inflow of opportunities. The opportunities in China seem unbounded, making foreign investors starry-eyed. But despite the glories of the Chinese market -- and there is no denying that the demographic trends in China are glorious -- I heard more than enough from Chinese investors to scare me away from the market.
As an initial matter, the biggest challenge that investors find in building Chinese startups is identifying great entrepreneurs. Because there has been all but no startup culture prior to a handful of years ago, there are essentially no seasoned entrepreneurs. A few native Chinese business expats are returning from abroad to take advantage of China's increasingly open economy. But those numbers are de minimis and do nothing to staff the rest of the enterprise. Meanwhile, Chinese executives have been trained to function in a business culture of bureaucracy and Party connections -- not the fast-paced, fluid environment of the startup world. The investors with whom I met lamented the lack of qualified executives and warned about the significant challenges of doing diligence on Chinese entrepreneurs.
The second challenge with entrepreneurship in China is grounded in the laws of China. The legal structures needed to support a vibrant startup economy are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system. One investor with who I met on my trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur. In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.
In many ways, venture capital in China is like the wild west. There are big opportunities, but they are not well defined and capturing their full value may well require manipulating the law to your own devices. One investor with whom I met described entrepreneurship in the United States like a zoo and entrepreneurship in China like a jungle. In the United States, he said, while there is always a lion next to you with sharp claws, driven by self-interest, there is a cage between you and the lion to keep you safe. You can count on the cage to protect you from unreasonable or illegal behavior. In China, on the other hand, there is no cage between you and the Lion -- if you don't take great pains to protect yourself from the self-interested behavior of the lion, you are going to get bitten. Case in point, one Chinese executive with whom I met on my trip described how he was able to leverage his dominant market position to force his competitors to sell at a discount. What's more, the entrepreneur described with pride that once he had bought up all of his competition, he was able to raise his prices three-fold.
Yet another significant challenge for United States VC's seeking to invest in China is the government itself. While China appears to be making huge market-driven strides in its economy, there remains a significant wild-card in all business transactions -- the Communist government. On my trip it was repeatedly pointed out to us that government officials don't make laws, Party leaders do. The government officials are tasked with managing the bureaucracies of their localities, but the party leaders are tasked with making the decisions. The Communist Party single-handedly makes all of the rules in China. For example, by mandate of the Party, no Chinese financial institution may be majority-owned by foreign investors. Thus, the fasted growing segment of the Chinese market is off-limits to foreign investment. What is to stop the Chinese government from making similar mandates in other market segments? This lack of predictability of the fundament legal underpinnings of business in China is sufficient in and of itself to make me take pause.
I thoroughly enjoyed my visit to China. The shear scale of Beijing and Shanghai was absolutely stunning, as was the velocity of the growth in both cities. And the extraordinarily candid conversations we had with Chinese business leaders and Party officials was both surprising and invaluable. But rather than leaving China emboldened to invest in their great economy, I returned to the United States surprised that my fellow VC's could accept the risks inherent in investing in China. I could not. And I don't anticipate that changing any time soon.
some Comments
------------------------
Don Dodge said:
David, Thanks for the thoughtful review of the VC investment situation in China. I know several VCs who are excited about the opportunities in China and who have sent lots of money and people there, but I am with you, I think the risks are too high.
I spent 5 weeks in China on 4 separate trips back in 1997 / 1998. I haven't been back since. I was hoping the situation had improved since then. Sounds like it hasn't.
The prevailing attitude then was that "profit" was evil. Essentially "profit" by a foriegn company was considered stealing money from the Chinese people. Even if you could structure some kind of deal that resulted in a profit...good luck trying to take that profit back to the USA. Money made in China stayed in China. There was no reasonable way to "repatriate" profits back to the USA. Has that changed?
Back then most business deals were structured as partnerships with China based "companies". I use the term company loosely because they were all ultimately owned by a China government agency. Sometimes the company names would make you believe they were a real for profit company, but if you dug deeper you would find out they were really owned by some government agency.
The "partnerships" always boiled down to the same theme...the USA company provides the dollars and technology, while China provides the cheap labor, land, and facilities. Any resulting profit stayed in China.
Selling software in China was difficult then. There were no intellectual property laws, no copyrights, no trademarks. And even if such laws did exist...they were never enforced. Just take a look at any store in China loaded with "Gucci" watches, "Nike" shoes, or "Microsoft" software. It was all cheap knock-offs where the brand, logo, and intellectual property was stolen. Has that changed in 10 years?
It is hard enough to launch a successful startup in the USA with all the laws and protections we have here. Imagine trying to start a company in China with all the additional risks you have mentioned. It is enormously difficult and risky. And if you are extremely lucky and succeed...will you be able to keep your profits and convert them to US dollars?
I hope a lot has changed since I tried to do business in China 10 years ago. Based on your observations it sunds like they still have a long way to go.
--------------------
David,
Having both started and invested in a number of businesses myself, I am not surprised by the anecdotes you heard and can see why you were turned off by them. You certainly went one step beyond the simple fascination with China of "fly-in" Western investors.
On the other hand, the "Wild Wests" and jungles (I would say the defining characteristic of this jungle is not the lack of cages but rather than the lack of rules, compared to the zoo) is where money has been and will be made. In the U.S., many industries emerged out of chaos characterized by the same excess and sometimes fraud, and the same lack of rules and clarity. The Internet bubble of the late 1990s is one of them.
No doubt many investors will lose their shirts in China. Many mistakes have been made due to inexperience (mainly on the part of the local investors) and lack of local knowledge and networks (the foreign investors), or both (a surprising large number).
The lack of good entrepreneurs and managers is a real challenge. It is however relative: the investee's competitor has the same issue. A personal network for recruiting and vetting is important in China, as it is in the U.S. Due to a number of reasons, inexperienced entrepreneurs among them, my view is that in China the good VCs can add far more value than they can in the U.S. Unfortunately very few VCs in China have the experience and inclination to add value, particularly when the prevailing wind is "get rich quick".
The real challenge for me is finding entrepreneurs whom I can trust and who is scalable (can be trusted by his/her employees, among other things), but who can be "flexible" when dealing with the external environment. It invariably involves some compromise.
From the perspective of Western VC firms, success will come from the quality of the local China investing team and whether the local team is empowered. Fortunately it is much easier to empower the local team via the VC partnership structure than, say, via subsidiary structures of publicly listed NASDAQ companies, whose performance in China has been abysmal indeed.
Bo Shao
For the last several years there has been a lot of talk on Sand Hill Road about investing in China. To a certain degree there has been a lot of talk about all the BRIC countries -- Brazil, Russia, India and China. But the most excitement is clearly around China. (Interestingly, while India is a relatively close second, I have yet to hear of a single Bay Area VC exploring investment in either Brazil or Russia). Drawn by huge markets and a rapidly expanding economy, American VC's are heading to China to stake their claims. Go East young VC's. Go East.
Venture Capital investment in China has not, however, been a headlong dive. Bay Area VC's seem to be sending over exploratory parties. By way of example, David Chao from Doll Capital has been in and out of China for some time. Now a number of his partners are getting in on the act as well. Paul Koontz from Foundation Capital spent a year in China exploring the market. And perhaps the best indicator that the Chinese market is hot is Dick Kramlich's pilgrimage to China this year. Kramlich is one of the founding fathers of Sand Hill Road -- a 25 year veteran of the venture capital business. Not one to miss out on a big opportunity, Kramlich has headed over to China for 2008 to catch the wave of entrepreneurship and, perhaps, some of the Beijing olympics. Chow, Koontz and Kramlich are not the only US VC's headed to China by any stretch of the imagination. But these high profile forays into the Chinese market are excellent indicators of the level of interest in the market.
It is hard not to be intrigued by the Chinese market. With 1.3 Billion people, you don't need a huge amount of penetration to hit big numbers. One percent of the Chinese market is 13 million people. As they say, if you are "one in a million" in China, there are thirteen-hundred people just like you. What's more, the Chinese government anticipates that approximately 300 Million people will move from the countryside to urban centers in the next decade -- that's the same number as the entire population of the United States. The combination of massive aggregate numbers, rapid urban migration (and the commensurate increase in wages) and relatively low concentrations of modernized business processes, suggest a market ripe for investment. And that is precisely the conclusion many of my brethren on Sand Hill Road have drawn.
Given all that, I was anxious to check out China for myself. And right before the new year, I had the good fortune to do just that -- I accompanied a group of Stanford Business School students on a ten day study trip to China. We met with senior executives from companies like China Telecom, Alibaba, GM China and Bao Steel, as well as senior government officials and party leaders (yes, it is still a Communist country). But the most interesting discussions, to my mind, were with the leading private investors in China. (Because my meetings with these private investors took place as part of a study trip, there was no expectation that I would blog about the content of our conversations -- thus, I have decided to exclude the names of the specific investors so as not to violate any confidences they may have reasonable expected.) These investors gave a surprisingly candid view of venture capital throughout the country -- the good, the bad and the ugly.
To the mind of the Chinese investing community, the market dynamics described above well outweigh the risks of investing in the current environment. Huge markets with lots of business white space provides for numerous opportunities for economic gain. While American investors are busy debating the degree to which the US startup market is saturated, Chinese investors are having trouble keeping up with the inflow of opportunities. The opportunities in China seem unbounded, making foreign investors starry-eyed. But despite the glories of the Chinese market -- and there is no denying that the demographic trends in China are glorious -- I heard more than enough from Chinese investors to scare me away from the market.
As an initial matter, the biggest challenge that investors find in building Chinese startups is identifying great entrepreneurs. Because there has been all but no startup culture prior to a handful of years ago, there are essentially no seasoned entrepreneurs. A few native Chinese business expats are returning from abroad to take advantage of China's increasingly open economy. But those numbers are de minimis and do nothing to staff the rest of the enterprise. Meanwhile, Chinese executives have been trained to function in a business culture of bureaucracy and Party connections -- not the fast-paced, fluid environment of the startup world. The investors with whom I met lamented the lack of qualified executives and warned about the significant challenges of doing diligence on Chinese entrepreneurs.
The second challenge with entrepreneurship in China is grounded in the laws of China. The legal structures needed to support a vibrant startup economy are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system. One investor with who I met on my trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur. In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.
In many ways, venture capital in China is like the wild west. There are big opportunities, but they are not well defined and capturing their full value may well require manipulating the law to your own devices. One investor with whom I met described entrepreneurship in the United States like a zoo and entrepreneurship in China like a jungle. In the United States, he said, while there is always a lion next to you with sharp claws, driven by self-interest, there is a cage between you and the lion to keep you safe. You can count on the cage to protect you from unreasonable or illegal behavior. In China, on the other hand, there is no cage between you and the Lion -- if you don't take great pains to protect yourself from the self-interested behavior of the lion, you are going to get bitten. Case in point, one Chinese executive with whom I met on my trip described how he was able to leverage his dominant market position to force his competitors to sell at a discount. What's more, the entrepreneur described with pride that once he had bought up all of his competition, he was able to raise his prices three-fold.
Yet another significant challenge for United States VC's seeking to invest in China is the government itself. While China appears to be making huge market-driven strides in its economy, there remains a significant wild-card in all business transactions -- the Communist government. On my trip it was repeatedly pointed out to us that government officials don't make laws, Party leaders do. The government officials are tasked with managing the bureaucracies of their localities, but the party leaders are tasked with making the decisions. The Communist Party single-handedly makes all of the rules in China. For example, by mandate of the Party, no Chinese financial institution may be majority-owned by foreign investors. Thus, the fasted growing segment of the Chinese market is off-limits to foreign investment. What is to stop the Chinese government from making similar mandates in other market segments? This lack of predictability of the fundament legal underpinnings of business in China is sufficient in and of itself to make me take pause.
I thoroughly enjoyed my visit to China. The shear scale of Beijing and Shanghai was absolutely stunning, as was the velocity of the growth in both cities. And the extraordinarily candid conversations we had with Chinese business leaders and Party officials was both surprising and invaluable. But rather than leaving China emboldened to invest in their great economy, I returned to the United States surprised that my fellow VC's could accept the risks inherent in investing in China. I could not. And I don't anticipate that changing any time soon.
some Comments
------------------------
Don Dodge said:
David, Thanks for the thoughtful review of the VC investment situation in China. I know several VCs who are excited about the opportunities in China and who have sent lots of money and people there, but I am with you, I think the risks are too high.
I spent 5 weeks in China on 4 separate trips back in 1997 / 1998. I haven't been back since. I was hoping the situation had improved since then. Sounds like it hasn't.
The prevailing attitude then was that "profit" was evil. Essentially "profit" by a foriegn company was considered stealing money from the Chinese people. Even if you could structure some kind of deal that resulted in a profit...good luck trying to take that profit back to the USA. Money made in China stayed in China. There was no reasonable way to "repatriate" profits back to the USA. Has that changed?
Back then most business deals were structured as partnerships with China based "companies". I use the term company loosely because they were all ultimately owned by a China government agency. Sometimes the company names would make you believe they were a real for profit company, but if you dug deeper you would find out they were really owned by some government agency.
The "partnerships" always boiled down to the same theme...the USA company provides the dollars and technology, while China provides the cheap labor, land, and facilities. Any resulting profit stayed in China.
Selling software in China was difficult then. There were no intellectual property laws, no copyrights, no trademarks. And even if such laws did exist...they were never enforced. Just take a look at any store in China loaded with "Gucci" watches, "Nike" shoes, or "Microsoft" software. It was all cheap knock-offs where the brand, logo, and intellectual property was stolen. Has that changed in 10 years?
It is hard enough to launch a successful startup in the USA with all the laws and protections we have here. Imagine trying to start a company in China with all the additional risks you have mentioned. It is enormously difficult and risky. And if you are extremely lucky and succeed...will you be able to keep your profits and convert them to US dollars?
I hope a lot has changed since I tried to do business in China 10 years ago. Based on your observations it sunds like they still have a long way to go.
--------------------
David,
Having both started and invested in a number of businesses myself, I am not surprised by the anecdotes you heard and can see why you were turned off by them. You certainly went one step beyond the simple fascination with China of "fly-in" Western investors.
On the other hand, the "Wild Wests" and jungles (I would say the defining characteristic of this jungle is not the lack of cages but rather than the lack of rules, compared to the zoo) is where money has been and will be made. In the U.S., many industries emerged out of chaos characterized by the same excess and sometimes fraud, and the same lack of rules and clarity. The Internet bubble of the late 1990s is one of them.
No doubt many investors will lose their shirts in China. Many mistakes have been made due to inexperience (mainly on the part of the local investors) and lack of local knowledge and networks (the foreign investors), or both (a surprising large number).
The lack of good entrepreneurs and managers is a real challenge. It is however relative: the investee's competitor has the same issue. A personal network for recruiting and vetting is important in China, as it is in the U.S. Due to a number of reasons, inexperienced entrepreneurs among them, my view is that in China the good VCs can add far more value than they can in the U.S. Unfortunately very few VCs in China have the experience and inclination to add value, particularly when the prevailing wind is "get rich quick".
The real challenge for me is finding entrepreneurs whom I can trust and who is scalable (can be trusted by his/her employees, among other things), but who can be "flexible" when dealing with the external environment. It invariably involves some compromise.
From the perspective of Western VC firms, success will come from the quality of the local China investing team and whether the local team is empowered. Fortunately it is much easier to empower the local team via the VC partnership structure than, say, via subsidiary structures of publicly listed NASDAQ companies, whose performance in China has been abysmal indeed.
Bo Shao
Startup Valuation - The VC Method
by Ryan Junee
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becoming another ‘bubble’ - and everyone, including myself, seems to be cautious about valuing new startups using ‘bubble era’ metrics.
So how should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price.
This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the ‘VC method’). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006.
In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing.
Terminal Value The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneur’s Enthusiasm Error
Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.
Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).
This means in year 5 the VC’s investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That's just (1 + IRR)years x Investment]
So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.
Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.
The Discount RateAbove we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:
The risk-free rate
Premium for market risk
Premium for illiquidity
Premium for value added by VC (compensation)
Premium for “fudge factor” (past experience)
Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:
Seed stage: 80%+
Startup: 50-70%
First-Stage: 40-60%
Second-Stage: 30-50%
Bridge/Mezzanine: 20-35%
Public Expectations: 15-25%
Multi-Stage Financing The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations.
In essence, we calculate the ’share of the pie’ each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %).
To make this conversion, use the formula:current ownership % = (final ownership %)/(retention %)
Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.
Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and you’ll have to model the scenario using a spreadsheet.
After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.
Well - I think this blog post is now long enough :) I hope this has given any interested readers an insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at the beginning contains 54 pages of details, for those interested in reading further.
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becoming another ‘bubble’ - and everyone, including myself, seems to be cautious about valuing new startups using ‘bubble era’ metrics.
So how should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price.
This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the ‘VC method’). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006.
In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing.
Terminal Value The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneur’s Enthusiasm Error
Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.
Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).
This means in year 5 the VC’s investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That's just (1 + IRR)years x Investment]
So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.
Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.
The Discount RateAbove we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:
The risk-free rate
Premium for market risk
Premium for illiquidity
Premium for value added by VC (compensation)
Premium for “fudge factor” (past experience)
Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:
Seed stage: 80%+
Startup: 50-70%
First-Stage: 40-60%
Second-Stage: 30-50%
Bridge/Mezzanine: 20-35%
Public Expectations: 15-25%
Multi-Stage Financing The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations.
In essence, we calculate the ’share of the pie’ each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %).
To make this conversion, use the formula:current ownership % = (final ownership %)/(retention %)
Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.
Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and you’ll have to model the scenario using a spreadsheet.
After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.
Well - I think this blog post is now long enough :) I hope this has given any interested readers an insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at the beginning contains 54 pages of details, for those interested in reading further.
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