Fast Growth and a Big Market to Raise Money

As a follow up to Common Investor Questions at The Atlanta Tech Village, one of the questions I received was why do investors have a hard time finding investment opportunities. There are a number of excellent startups with customers, management teams, and decent growth. Only, they can’t raise any money. What gives?

Just because the startup is making progress, without fast growth and a big market, most investors will pass. Fast growth is an indicator of product/market fit and latent demand for the product. Big markets present an opportunity to build a major business and generate out-sized returns. Investors often require both be present.

Most startups aren’t growing fast (> 100% year-over-year), even though they are a growth-oriented company (see the definition of a startup). They want to grow fast but haven’t achieved their goal. Most markets aren’t big enough to generate venture-like returns. Entrepreneurs pitch that their product serves a big market, but most of the time it’s a much smaller slice of the market.

Investors want fast growth and a big market. Startups that don’t have both rarely raise money.

What else? What are some more thoughts on fast growth and big markets as requirements to raise money?

Common Investor Questions at The Atlanta Tech Village

Several times a month I meet with investors from out of town that are interested in the Atlanta market and startups at the Atlanta Tech Village. With so much capital that needs to be put to work, investors are eager to find startups that have the beginning of a big business and the potential for strong unit economics.

Here are some of the common questions investors ask:

  • What startups should we be paying attention to in the building?
  • Any entrepreneurs we should meet with the next time we’re in town?
  • Do you have any startups doing X, Y, or Z (e.g. specific areas of interest like machine learning, health IT, marketing SaaS, etc.)?
  • Any startups growing fast with X to Y range of revenue (e.g. $1 – $2 million in recurring revenue)?
  • What events or programs should we consider for future visits (e.g. Atlanta Startup Village)?
  • Anything we can help with?

As expected, the questions from investors are fairly consistent as they’re looking for startups that meet their criteria and the opportunity to invest. Surprisingly, investors don’t have enough strong startups to invest in.

What else? What are some more questions investors should be asking?

Encouraging Institutional Investors to Buy 10% of the Angel Investor Equity

In last month’s post Why Not More Startup Success Stories, reader Jeff offered an interesting idea where institutional investors would be encouraged to buy 10% of the equity from the angel investors, assuming they’d be interested in selling. For most startup communities, there are very few exits resulting in long/indefinite delays before angel investors receive a return on their money and thus the rate at which returns are recycled back into the community is limited. If institutional investors more routinely bought a small stake from the angel investors — say 10% — that’d generate angel returns faster and allow institutional investors to buy a larger piece of the startup.

Here’s how it might look:

  • Angel investor buy 10% of the startup for $150,000 resulting in a $1.5 million post-money valuation
  • Startup achieves strong traction and raises a $3 million Series A at a $7 million pre-money ($10 million post-money)
  • Institutional investor that’s buying ~30% of the company (less the pro-rata from any existing investors that want to invest more) is willing to increase their investment up to $3.14 million such that the existing investor that owns 10% before the financing round can sell up to 20% of their stake which represents up to 2% of the company (10% ownership of the $7 million pre-money represents $70,000 for one percent) for $140,000 thus nearly recouping their initial investment while still having 8% of the company remaining (pre Series A investment)
  • Post Series A investment, and after selling 20%, the angel investor now has 5.6% of the company (8% diluted by 30%, not counting a potential increase in option pool)

The institutional investor would want the angel’s equity reclassified as the same type of equity as the Series A otherwise there might be a discount.

By encouraging institutional investors to buy a small piece of the existing equity held by the angel investors, angels are more likely to invest in other startups and capital will be recycled faster in the community. Entrepreneurs should consider asking institutional investors about this when raising capital.

What else? What are some more thoughts on the idea of encouraging institutional investors to buy a small amount of equity from existing angel investors?

Due Diligence for an Angel Investment

When raising money from angel investors, they often require a fair amount of due diligence to ensure the startup is what the entrepreneurs say it is and that it has proper record keeping. If the startup raises money from Institutional investors, like venture capitalists, the amount of due diligence increases substantially. Here are a few commonly requested items as part of due diligence from angel investors:

  • Operating agreement
  • Founder legal agreements like non-compete, non-solicitation, etc.
  • Cap table with any equity grants, stock sales, etc.
  • Customer contracts
  • Employee IP assignments
  • Financial forecasts
  • Financial statements
  • Recent bank statements

Entrepreneurs would do well to keep their legal and financial affairs in order generally, but especially so when close to the term sheet phase of the fundraising process.

What else? What are some more thoughts on due diligence when raising money from angel investors?

Raising Money as Forcing Function to Drive Towards an Exit

Recently I was talking to an entrepreneur that was working on raising money for his startup. After asking the normal questions including “why do you want to raise money”, he volunteered something I don’t hear too often: I want to raise money to bring on a partner that will position the business for an exit in a few years. The idea is that raising money will act as a forcing function to drive towards an exit.

Here are a few questions to think through:

  • Why not sell now? What additional value will be gained raising money?
  • What specifically is desired in a capital partner?
  • What’s the ideal timeline? What milestones need to be hit?
  • Are there any market dynamics at work that might improve or decline over the next few years?
  • How many more rounds of capital, and dilution, will be required to achieve the desired exit?

Planning for an exit in a timeframe is never really doable unless the business is profitable with enough scale to know that there’s an exit based on an EBITDA multiple to a private equity firm or other financial buyer. Most startups want a buyer that pays up based on growth potential, and those are nearly impossible to plan for confidently. Raising money does create more pressure to eventually find an exit, but isn’t a guarantee.

What else? What are some more thoughts on raising money as a forcing function to drive towards an exit?

Anatomy of a Successful Venture Deal – PetSmart’s Acquisition of Chewy.com for $3.35 Billion

Recode published an article earlier today that PetSmart is acquiring Chewy.com for $3.35 billion in the largest e-commerce acquisition ever. This is a case where raising venture capital helped a startup grow significantly faster, resulting in a much larger and more valuable business when compared to growing organically. According to CrunchBase, Chewy.com started in the summer of 2011 and is less than six years old. Last year, Chewy.com did almost $900 million in revenue (source) and presumably will do over $1 billion in revenue this year.

For a venture perspective, this is a homerun. Let’s look at how the economics might play out:

  • Volition Capital invests $15 million in the Series A in 2013 (source) and buys ~25% (a guess) of the company (typical venture rounds are for 20 – 35% of the company)
  • Chewy.com goes on to raise a total of $236 million in equity over multiple rounds (source) resulting in dilution to the Series A investors (depends heavily on pro-rata participation)
  • Assuming the original Series A investment was diluted down to ~10% (a guess), that $15 million investment would be worth $335 million now (depends on earn-outs and other behind-the-scenes factors)
  • Turning $15 million into $335 million is a 22.3x return and likely returned more than the entire Volition fund

Congratulations to Larry at Volition Capital and the whole team at Chewy.com on the acquisition.

What else? What are some more elements of this successful venture deal?

Investor Reference Call Questions for Existing Investors

Several months ago I was talking to an entrepreneur/angel investor that was interested in investing in a startup where I’m an investor. As part of his due diligence on the potential investment, he wanted to talk to existing investors and get their thoughts on the startup. Naturally, I obliged.

Here are some of the reference call questions from a potential investor to an existing investor:

  • What’s your experience been like working with the startup? What’s gone well and what hasn’t gone well?
  • What’s your experience been like working with the CEO? What’s gone well and what hasn’t gone well?
  • What’s your outlook on the business? How has that changed from your original investment?
  • What are the dynamics of the board like? How productive are the board meetings?
  • Are you participating in this next round? Why or why not?
  • What questions should I be asking as a potential investor?

New investors want to hear that existing investors are bullish on the startup and have had a good experience. Of course, existing investors often want the money from new investors to help the company, so there’s an element where potential investors have to make a judgement call as to the quality and truthfulness of the existing investor responses.

Entrepreneurs would do well to keep their existing investors informed and engaged for a number of reasons, one of which is that potential investors in the future will expect to do reference calls with them.

What else? What are some more questions for potential investors to ask existing investors?