Category: Investing

Recently I was talking to an investor about my personal angel investing strategy and I mentioned that I don’t follow on most of the time. Why? Because I’m interested in getting a 10x or greater return, and as the valuations go up, the chance of getting a 10x+ return goes down. Of 1,000 startups that have raised venture capital, between .2 and 2% ever sell for $100 million or more. Now, that’s for ones that have raised venture money and the odds are even lower for the ones that haven’t.

Here are few thoughts on a potential investor’s desired returns:

• Some investors are playing for the 100x homerun return and double down on their winners, regardless of stage (most VCs outside the Valley play a different game)
• Larger venture partnerships often manage multiple funds with different return expectations (e.g. a venture fund for earlier stage deals and a growth fund for later stage deals)
• Generally, as the size of investment goes up, the size of the expected return goes down (e.g. 3x is a common return goal when investing at north of a $150 million valuation)

Entrepreneurs need to know the potential investor’s desired returns and make sure they align with their own goals.

What else? What are some more thoughts on needing to know the potential investor’s desired returns?

One of the common questions I get from other angel investors and VCs is regarding my personal angel investing strategy. Most investors have a strategy about the types of deals they like to do, and then when a deal fits the strategy, they go through their investment criteria (see Ask Investors About Their Investment Criteria).

Here’s my angel investing strategy:

• Look for entrepreneurs that have failed at a previous venture and started again (shows they’re serious about being an entrepreneur and aren’t a hobbyist)
• Find small, fast growing markets that have the opportunity to be much larger
• Demonstrate modest traction with at least 10 arms-length customers (once an entrepreneur has 10 customers, I can help on the journey to 100 customers)
• Prove basic unit economics (strong gross margin potential) and primarily recurring revenue

My angel investing strategy has evolved over the past few years and continues to do so. This strategy focuses on serious seed stage entrepreneurs with early, modest results and a recurring revenue business model.

What else? What are some more personal angel investing strategies?

Earlier this week I was meeting with some local entrepreneurs to learn about their business. I had the Simplified One Page Strategic Plan prior to meeting so I knew the vision, goals, and metrics for the startup. We had 30 minutes for the meeting and by the end of the allotted time they still hadn’t asked if their business model and stage fit my investment criteria. It’s like trying to sell a product without doing customer discovery or a sales discovery call first.

Here are a few thoughts on asking investors about their investment criteria:

• Don’t start the conversation asking about their investment criteria
• Work to make the pitch a dialogue and not a one-way conversation
• Summarize the pitch and company progress towards the end of the meeting and then ask if it fits their investment criteria
• Be patient, listen, and take notes as the investment criteria is explained
• Know that just because things aren’t a good fit right now doesn’t mean they won’t be a good fit later (often, investors will need to see more traction before investing)

Entrepreneurs would do well to understand investors’ investment criteria as part of the pitch process and use that to gauge interest and potential alignment.

What else? What are some more thoughts on asking investors about their investment criteria?

Reading about Expa Labs in the NY Times I couldn’t help but think about what the economics might look like for a $100 million incubator. From the article, there are five partners (I’ve met one of them through a mutual friend), eight startups per class, two classes per year, and $500,000 invested in each startup.

Let’s look at some hypothetical math:

• Five years of new startup investing/incubating and 10 year total fund life (the incubator is essentially a fund with an investing period and a harvesting period)
• 40% for new investments ($40 million), 10% for fund expenses ($10 million), and 50% for follow on investments ($50 million)
• 8 startups per class x $500,000 per startup x 2 classes per year = $8 million in investments per year
• $40 million for new investments at $8 million in investments per year makes for five years of new investing (80 total investments)
• Estimated initial target ownership stake of 40% (roughly 20% for the incubator’s value-add and 20% for the $500,000 investment)
• Assume 20% average ownership stake at time of exit based on a combination of dilution and pro-rata participation
• Required 3x cash on cash return to be a top tier fund necessitating $300 million in fund proceeds
• With 20% ownership to achieve $300 million in proceeds, the exits need to have a combined value of $1.5 billion

Put another way, if Expa Labs can make one unicorn and one half of one unicorn out of 80 incubated startups, they’ll be considered a successful incubator based on having top tier returns.

What else? What are some more thoughts on the economics of a $100 million incubator?

In investing circles, there’s an old saying: you set the valuation, I’ll set the terms. Meaning, the valuation can be any price but the terms actually have a greater impact on who makes what money. When investors model potential investments, they attach a value to the different financial terms thereby lowering the effective valuation (e.g. the term sheet says one pre-money valuation but the reality is that the investor actually views it as a lower pre-money valuation).

Here are three common term sheet terms that lower the effective valuation:

• Cumulative Dividends – Much like an interest payment, this amount accrues until the company is sold (e.g. a $1 million investment with a 7% dividend would be a $70,000 increase in ownership in year one, a $74,900 increase in year two, etc. for the investors)
• Participating Preferred – Many term sheets require that the investors get paid back before other shareholders get any money (non-participating preferred) but if the exit is greater than the investment valuation, everyone splits up the proceeds based on ownership. Some go further and require participating preferred where the investors get their money back (or a multiple of their money) and then split the remaining proceeds based on percent ownership, thereby double dipping.
• Option Pool Shuffle – Investors typically require that entrepreneurs create a new option pool representing 10-15% of the company as part of the financing event. If the new option pool is created before the investment, as opposed to after it, and the investor buys in at the agreed-upon pre-money valuation, the company is effectively less valuable to the current shareholders since their ownership stake has been reduced (e.g if the entrepreneurs each own 30% and then add a 10% option pool, their ownership stake is 27% at time of investment when the new investors dilute them further).

These three common term sheet examples aren’t meant to make investors look bad. Rather, the goal is for entrepreneurs to better understand the most common terms that effectively lower the pre-money valuation so that it can be incorporated into the decision making process.

What else? What are some more term sheet terms that lower the effective valuation?

One important consideration for entrepreneurs out raising money is the desired exit size for any given investor. Meaning, all investors want to make great returns, but the size and scale of the desired return varies based on the size and scale of the venture fund. When raising a seed round or small series A from a $25 million fund, if the investor bought in at a $2 million or $3 million valuation and the company sells for $25 million, there’s a good chance everyone will be very happy. Now, if an investor from a $300 million fund bought a small stake in the Series A round and the company sold for $25 million, the investor wouldn’t be happy. Why? Turning $500k into $5 million doesn’t move the needle for a $300 million fund.

Consider the 27x rule for venture fund aggregate investments. It says that for any given fund size, they need an aggregate exit amount equal to 27 times the size of the fund to be top quartile investors — this requires big exits. Similarly, one venture fund I know doesn’t feel it was a quality exit unless they returned at least 10% of the fund back to their LPs (see Ask Prospective Investors About the Ideal Exit). If the average venture fund owns 10% of a portfolio company, and needs to return at least 10% of the fund size to their LPs in the event of an exit, the target for a typical exit needs to be the size of the investor’s fund, or larger.

Entrepreneurs would do well to know that the VC fund size is a good indicator of minimum required exit size for everyone to be happy. The larger the fund, the larger the required exit.

What else? What are some more thoughts on the idea that VC fund size is a good indicator of required exit size?

Earlier today I received the quarterly update from a venture partnership where I’m a limited partner. Limited partners are the investors behind the investors. The LP update includes information about the fund (like number of investments, amount of money deployed, etc.) as well as a page for each portfolio company. Similar to an executive summary, the LP portfolio summary explains the startup in a straightforward way with limited hype. Here are the typical sections in an LP portfolio summary:

• Company name
• Geographic location
• One line company description
• Investment summary table
  • Amount invested
  • Total equity capital invested
  • Ownership percentage
  • Investment date
  • CEO
  • VC board member
• Investment overview
• Company overview
• Market overview
• Management team

For entrepreneurs looking to raise money, writing an LP portfolio summary from the perspective of your potential investor is a good exercise to get in the mindset of the investor and think through the respective details. The key is to present the information in a concise way that is informative without being jargon-filled.

What else? What are some more thoughts on writing an LP portfolio summary from the investor perspective?

Entrepreneurs are an optimistic bunch. Just the nature of building something from nothing lends itself to people that believe they can figure things out (high locus of control). After investing in over a dozen startups, I’ve encountered a phenomenon that makes sense but wasn’t apparent before: entrepreneurs almost always burn the new cash in the bank in 18 months. Whether the entrepreneur raises $300,000 or $3 million, 18 months later the cash is gone.

Here are a few thoughts on entrepreneurs burning new cash in 18 months:

• When looking at cash on hand and monthly burn, it’s critical to identify the necessary metrics that will enable the next round of funding, or get to cash flow breakeven
• It’s important to decide if the number of days of cash on hand is shared internally
• Recognize that if the startup is pre product/market fit, it’s a different equation — everything is about finding 10 unaffiliated customers that love the product, and that often takes longer than expected
• Remember that lean startups are better than heavy startups

Entrepreneurs have big dreams, and after raising money, almost always spend the cash in 18 months. Entrepreneurs would do well to recognize this and plan accordingly.

What else? What are some more thoughts on entrepreneurs almost always burning new cash in 18 months?