Category: Investing

Urvaksh broke the news about Valor Ventures last week with his article New Atlanta VC Fund Will Invest in Women’s Companies. I’m an investor in the fund and excited about helping female founders build large companies. Thinking about a $20 million venture fund, here’s a common investment strategy:

• Allocate 40% of the fund ($8 million) for new investments and reserve 60% for follow-on investments
• Invest an average of $1 million per company with a target ownership of 20% (results in an average post-money valuation of $5 million) and eight total investments
• After dilution in subsequent rounds, and participating pro rata in the “winners”, own an average of 10% across the eight investments
• To achieve a 17% IRR (needed to be top quartile), the fund needs to return 3x cash on cash, which is ~$70 million of cash (inclusive of management fees)
• Owning an average of 10% of eight companies means the portfolio of investments needs to have an aggregate exit value of $700 million

The venture model is predicated on finding startups that have the opportunity to become large, meaningful companies. Picking great entrepreneurs in great markets is the key to any successful fund.

What else? What are some other thoughts on the common investment strategy for a $20 million fund?

Recently I heard about a new investor strategy that I hadn’t seen before: as part of the term sheet, they asked for more pro rata rights than their ownership percentage. Pro rata rights mean that whatever percentage ownership initially purchased — say 10% — can be maintained when the startup raises more money in the future, assuming additional capital is invested to reflect the new percentage.

Here’s how it might work:

• An angel investor offers to put in $200,000 at a $4 million post-money valuation, to own 5% of the company but requires pro rata rights for 10% of the business
• Startup later raises $2 million at a $10 million post-money valuation, and the original angel that put in $200,000 now has the option, but not the requirement, to put in up to $600,000 (original 5% diluted to 4% by the new round but then 6% of the new business is purchased for $600,000) more money in the business and have 10% of the business, even though they had 5% after the previous round
• Startup now has a $10 million valuation and the original angel has put in a total of $800,000 for 10% of the business

The benefit for the angel investor is that they essentially get an option to increase their stake at a later time in the event the startup is doing well and decides to raise more money. In terms of downsides, the only challenge is that the entrepreneur now potentially has to sell more of their business in the second round of financing as many venture investors require a minimum ownership percentage for their initial investment (e.g. 15-25%) such that the entrepreneur might end up selling 35% or more of the business between the seed round and Series A (which isn’t uncommon). It’ll be interesting to see if this catches on for lead angel investors to ask for more pro rata rights than the original ownership percentage.

What else? What are some additional thoughts on more pro rata rights than ownership percentage?

Recently, I was reading the limited partner quarterly updates for a fund where I’m an investor. In the update, the author highlighted that the fund had reviewed 1,000 potential deals last year and invested in four companies. At a ratio of 250:1, it’s clear that there are many more startups trying to raise a Series A than there are Series A investments (see the Series A crunch talked about four years ago).

Here’s how the investment process might work at a venture fund:

• 250 deals reviewed
• 25 one-on-one pitches (where the entrepreneur pitches a single partner)
• 5 full partner pitches (where all the partners hear the pitch)
• 2 term sheets
• 1 investment

Raising money is much harder than most entrepreneurs expect. With funds seeing so many opportunities, but only being able to invest in 1-2 companies per year per investor, it’s clear that most entrepreneurs will feel rejected when out raising money.

What else? What are some more thoughts on the ratio of deals reviewed to investments made?

Venture debt, just like it sounds, is a loan for venture-backed startups. Banks like Silicon Valley Bank and Square 1 Bank have great programs where they loan money at low rates based on how much money has been raised as well as the amount of recurring revenue (see Credit Lines for SaaS Startups). Only, these lines of credit are often maxed out at ~20% of recurring revenue (e.g. have $10 million in annual recurring revenue and get a line of credit for $2 million). There’s an opportunity in the market for subordinated debt that is junior to the debt from the banks.

Here’s how it might work:

• A new venture debt fund that provides lines of credit at half the size of the banks (e.g. 10% of recurring revenue, so an extra $1 million for a $10 million run-rate startup)
• Whereas normal venture debt is often prime plus a couple percent (e.g. 6% in today’s market), this would be much higher interest rates (e.g. 12-15%) and warrants for between 0.5% and 1% of the company
• $1 million in debt at an interest rate of 15% per year would compound as follows (assuming interest only and no principal payments):
  • Year 1 – $1,150,000
  • Year 2 – $1,322,500
  • Year 3 – $1,520,875
  • Year 4 – $1,749,006
  • Year 5 – $2,011,357

This would be attractive to startups that haven’t raised money and want to grow faster as well as venture-backed startups that are trying to put off raising their next venture round until they reach a bigger milestone. For entrepreneurs averse to dilution and venture-backed startups that aren’t able to raise money at a great multiple, more aggressive venture debt could be an option to accelerate growth.

What else? What are some more thoughts on more aggressive venture debt as a market opportunity?

Continuing with yesterday’s post on Startup Stages by Revenue, one stage that can can use better naming delineation is the Seed Stage. The Seed Stage, while still early, represents a huge range, especially when considering the difference between a startup with $50,000 in annual recurring revenue (ARR) and one with $500,000 in annual recurring revenue. At $50,000 ARR, the startup might only have 10 customers paying $5,000/year whereas the $500,000 ARR startup might have 100 customers paying $5,000/year. 100 customers implies product/market fit, many elements of a repeatable customer acquisition process, and close to a sustainable level of success. So, what’s a better name for these Seed Stage startups that are much farther along, but still tiny? And what’s a good revenue cut-off? $100,000? $250,000? $500,000?

Here are a few naming ideas for Seed Stage startups that have at least $250,000 in revenue (a big startup milestone):

• Six Figure Seed Stage
• Late Seed Stage
• Product/Market Fit Seed Stage
• Sustainable Seed Stage

Seed Stage startups with hundreds of thousands of dollars of revenue are very different from Seed Stage startups with a working product and a couple customers. In startup communities, especially emerging communities outside the major startup centers, better naming delineation for Seed Stage startups will help identify high potential companies, engage more investors, and result in more success stories.

What else? What’s a better naming convention to differentiate between Seed Stage startups?

In any given week I’ll receive 1-2 emails from venture capitalists asking for an intro to an Atlanta Ventures startup. Naturally, I ask what stage startup they target, especially if it isn’t explicitly stated on their website (this assumes it isn’t the proverbial associate call). Most of the time, the investor is looking for the startup to be at a later stage, and so the intro isn’t a good fit (most venture firms have moved up market and look for businesses that are further along).

Here are some common startup stages by revenue (investors will also expect to see growth rates above 30% as well):

• Idea Stage – No revenue or product, but lots of energy and enthusiasm.
• Seed Stage – Under $1 million in revenue (often under $100,000), working product, and paying customers with some early metrics (seeking product/market fit).
• Early Stage – Between $1 million and $5 million in revenue with solid metrics and a repeatable customer acquisition process.
• Growth Stage – $5 million or more in revenue, strong team, and working on scaling all aspects of the business.

The next time an investor reaches out, one of the easiest qualifying questions is to ask what stage company they look for, and to have them give a revenue range as part of the answer.

What else? What are some more thoughts on startup stages by revenue?

One of the on-going debates is whether a particular company is a cash flow business or a venture backable startup. Often, investors will pass on a startup because they feel the market is not big enough. Just this past week, Airbnb released seven rejection letters they received from investors when they were trying to raise $150,000 at a $1,500,000 valuation (today, that same 10% would be worth $2 billion). Here are a few thoughts on venture backable startups as different from cash flow businesses:

• Small, fast growing markets can be the best when it’s clear that there’s a big opportunity ahead
• Large, established markets work well if the product is truly 10x better, faster, and cheaper (if it’s only 2x better, the friction to switching is often too high to get much traction)
• VCs want to believe that their portion of a potential exit is big enough to return at least 10% of their fund (so, the market opportunity must be 10x larger when taking investment from a $50M fund vs a $500M fund assuming the same round of financing)
• Almost all new companies are not venture backable as the market size and dynamics aren’t conducive to the scale and value creation needed

The next time you hear an entrepreneur say they want to raise venture capital, ask if the business truly warrants it based on the market opportunity and current traction. Most companies are cash flow businesses, and those are often some of the best out there.

What else? What are some more thoughts on separating cash flow businesses from venture backable startups?

After yesterday’s post Investing in 100 Startups, several people asked me about the lessons learned from the 26 startup investments I’ve already made. Generally, startup investing is much harder and less glamorous than it sounds, but I really enjoy it — entrepreneurs have such great energy and enthusiasm.

Here are 26 lessons learned from investing in 26 startups:

1. Entrepreneurs are always overly optimistic
2. If anything seems fishy or out of the ordinary, immediately pass
3. Any signs that the entrepreneur isn’t self-starting and resourceful, immediately pass
4. Everything takes twice as long and costs twice as much
5. Look for a pattern where the entrepreneur had already started a prior business, failed, and is at it again
6. Lean startups are better than heavy startups
7. Expect regular investor updates
8. More traction reduces risk
9. Lack of liquidity is one the biggest challenges
10. Exits are few and far between
11. Plan for 7-10 years before seeing a return on investment
12. Exit value is more important than entry value (e.g. a small piece of a big pie is usually better than a big piece of a small pie)
13. Reserve twice as much as the original investment for follow-on investments (e.g. exercising the pro-rata rights)
14. Personality fit is more important than entrepreneurs realize
15. $300k is the ideal amount for a seed round
16. Build a portfolio for diversification
17. Investor jargon is more prevalent than expected
18. Know that winning a pitch competition isn’t the same thing as a successful startup
19. Fewer seed-funded startups as a percentage raise a Series A round
20. Developing rapport well in advance of investing is important
21. Evaluate the Investment Readiness Level
22. Seed capital is different from venture capital
23. Bet on the horse, course, or jockey
24. Understand the difference between friendly customers and unaffiliated customers
25. Milestones met pre-investment help improve confidence
26. Investing is an incredibly hard way to make money

Even after investing in 26 startups I still feel I have a ton more to learn. Every investment is different and every entrepreneur is different. When I eventually make investment number 100, I’m sure I’ll feel the same way.

What else? What are some more lessons learned from investing in startups?