David Cummings on Startups

Category: Investing

  • A Series A VC Roughly Owns 1% Individually

    Recently an entrepreneur asked me if VCs get individual compensation beyond the fees and profits from their partnership for serving on the board of a startup. Normally, there’s no individual compensation (this changes if the company goes public and the VC stays on the board), but with some basic math you can come up with a rough approximation of their individual ownership position.

    Let’s work through a simple example:

    • Assume the typical venture firm targets a 20% ownership position as the lead investor in the Series A
    • Assume the typical partnership has four general partners (varies based on size and stage of firm)
    • Assume the venture firm has the standard compensation of 2% management fees and 20% carry (profits)
    • Take the 20% ownership position and multiple by the 20% of profits resulting in an effective partnership ownership position of 4% of the company (assumes a big exit where the initial investment is returned many times over)
    • With four partners and the firm owning 4% of the exit, each general partner effectively owns roughly 1% of the startup individually (this doesn’t take into account junior partners, venture partners, advisors, etc. that have different stakes in the partnership)

    So, while VCs don’t get compensated directly on an individual basis in a successful investment, they often have economic interests equivalent to roughly 1% of the startup’s value.

    What else? What are some other thoughts that a Series A VC roughly owns 1% individually?

  • 3 Reasons Local Investors Don’t Collaborate More

    Last week an angel investor asked me why local investors don’t collaborate more. We chatted about it for a few minutes and I didn’t have a good answer for him. After thinking about it for a week, I realized there are three reasons why local investors do their own thing:

    1. Unique Focus – With so few investors, there isn’t much overlap between interests. Focus areas like sales and marketing technologies, cybersecurity, media, and fin tech don’t usually intersect.
    2. Investing as Hobby – Most of the local investors are investing their own money as a hobby, and don’t treat it as a profession. Also, since it’s a hobby, the pace of activity ebbs and flows depending on other life activities.
    3. Lack of Collective Goals – Without common goals, like growing the entrepreneurial community, there’s little impetus to collaborate.

    Local investors don’t collaborate much, yet there’s a desire to build a stronger startup community, and a belief that more collaboration will help. Hopefully, with time, we’ll see more collaboration.

    What else? What are some more reasons local investors don’t collaborate more?

  • The Institutional Investor Challenge for Local Venture Funds

    Continuing with last week’s post on The Conundrum for Regional Venture Investors, there’s another element of the message that needs further clarification. First, there’s the concept of More Venture Capital vs More Local Venture Capital where many business leaders express the desire for more venture capital in the region and they’re really saying that they want more locally-based venture firms in the region. Second, and the topic for today’s post, is that to have large local venture funds, institutional investors like pension funds, university endowments, and foundations are required. Unfortunately, tapping into local high net worth individuals will only support small-to-medium-sized funds.

    Here’s the ideal lifecycle to raise a large venture fund:

    • Raise a $15M fund from local high net worth individuals and family offices
    • Deploy the capital over 3-4 years and show great paper returns (30%+ IRR)
    • Raise a $75M fund from local investors and some institutional investors and repeat the deployment timeframe and success
    • Raise a $150M fund from local investors and a number of institutional investors and repeat the deployment timeframe and success
    • Raise a $300M fund from mostly institutional investors and build an enduring top-tier partnership

    Starting from scratch, and executing perfectly, this is a 9-12 year journey to have the necessary success to then raise a large venture fund from institutional investors. Without a substantial track record, most institutional investors aren’t interested. Communities that want larger, local pools of venture capital have to understand how institutional investors play a major role. 

    What else? What are some more thoughts on the institutional investor challenge for venture funds?

  • The Conundrum for Regional Venture Investors

    Yesterday I was talking with a local angel investor that had a nice exit this year. One of the comments that came out of the discussion is that the vast majority of capital raised by the successful startup came from the usual money centers (CA, NYC, and Boston). I then pressed why the startup went out of the region to raise capital and the expected response came back: the valuation and terms were much better than local options. VCs outside the Valley play a different game.

    Here’s the conundrum for regional venture investors:

    • By focusing on deals where they “can’t lose money” and requiring terms like participating preferred, the only entrepreneurs that are going to sign on are the ones that can’t raise money on better terms from the money centers
    • Entrepreneurs that can’t raise money from the money centers aren’t as likely to have big exits (see Build a $300 Million Pie So Everyone Can Get a Big Helping) and so the regional funds aren’t going to have outsized returns
    • Without outsized returns, regional venture investors will only be able to raise modestly larger funds (assuming still top quartile returns but not top decile), and if they have a fund that does poorly, it’ll either kill the partnership or significantly reduce the size of the next fund

    Regional venture investors often follow a playbook that’s geared towards ensuring a return, which limits potentially outsized returns. Only with outsized returns will a regional venture partnership be able to achieve the scale and size found in California and the Northeast.

    What else? What are some more thoughts on the conundrum for regional venture investors?

  • Startup Review: Gimme Vending

    Last week, Atlanta Ventures lead an investment in the seed round for Gimme Vending. Gimme was founded by two talented Georgia Tech entrepreneurs: Cory and Evan. So, what does the startup do? Here’s the pitch:

    • Market
      • 4.5 million traditional vending machines
    • Problem
      • Data from each machine is downloaded manually into a Palm Pilot-like device
      • After an eight hour shift by the delivery drivers, data from the machines is downloaded manually at the warehouse into the vending management system
    • Solution
      • Gimme Bluetooth LE device plugged into each vending machine sends the data to an iPad with LTE held by the delivery driver which then immediately sends the data to the Gimme servers in the cloud and loads it into the vending management system
      • Vending machine owners get data up to eight hours sooner to better run the business, prepare the stocking earlier for the next day, and order new products faster
    • Pricing
      • $25 one-time and $50 per year, per machine

    If you know anyone in the vending machine business, please share Gimme Vending with them. I can’t wait to see the entrepreneurs build a great company.

  • Revenue-Based Financing for Startups

    After last week’s post on Early SaaS Loans Before Bank Credit Lines, a couple people mentioned Lighter Capital as an alternative lender that does revenue-based financing. The idea is that instead of the normal venture debt model, which is interest plus warrants in the business, revenue-based financing takes a percentage of revenue over a certain period of time, typically five years.

    With a starting point of $1 million in revenue, an annual growth rate of 30% per year, and a fee of 10% of revenue for a $500,000 loan, here’s how it might look:

    • Year 1 – $1,300,000 in revenue, fee of $150,000
    • Year 2 – $1,690,000 in revenue, fee of $169,000
    • Year 3 – $2,197,000 in revenue, fee of $219,700
    • Year 4 – $2,856,000 in revenue, fee of $285,600
    • Year 5 – $3,713,000 in revenue, fee of $371,300
    • Total fees (which includes repayment): $1,195,600

    Simply doubling the initial money over five years results in a 15% internal rate of return, so borrowing $500k and repaying $1.2 million is just a bit higher when thinking of interest rates for a normal loan. I don’t know if this is exactly how Lighter Capital works, but I believe it’s directionally correct.

    The next time an entrepreneur asks about alternative lending options, mention revenue-based financing as an option.

    What else? What are some more thoughts on revenue-based financing for startups?

  • Early SaaS Loans Before Bank Credit Lines

    Over this past year I’ve talked to several Software-as-a-Service (SaaS) startups that have over $1M in annual recurring revenue (ARR), raised an angel round, but aren’t convinced they want to go the venture capital route. On the financing side, once SaaS startups have about $3M in ARR, banks like Silicon Valley Bank and Square 1 Bank have great credit lines based on recurring revenue (e.g. 3x monthly recurring revenue times (MRR) annual renewal rate), but there are few options for companies in the $1M – $3M ARR range.

    There exists a gap in the market for high interest loans to SaaS companies to help them grow faster without raising outside capital. Here’s how it might work:

    • $750,000 fixed-rate two-year interest-only loan at 20% annual interest rate for a total of $1.08M payable at the end of two years
    • $1M+ ARR startup hits $4M ARR at the end of year two, thereby qualifying for a $1M bank line of credit (assume 3x MRR), and then pays back the high interest loan
    • High interest loan provider makes a good return, the tech-focused bank gets a new customer, and the entrepreneurs create more wealth without giving up more equity

    With this model, that startup has the opportunity to grow faster than it would otherwise and avoids more dilution. The high interest loan provider would need to be very comfortable with the SaaS model and a plan would need to be in place in the event the loan couldn’t be paid back after 24 months.

    Look for more models like this to emerge that provide funding for SaaS startups that have the start of a great business but don’t have the scale to qualify for a bank line of credit.

    What else? What are some more thoughts on early SaaS loans before bank credit lines?

  • Video of the Week: Marc Andreessen on Big Breakthrough Ideas and Courageous Entrepreneurs

    Marc Andreessen, besides having one of the best Twitter streams @pmarca, and an incredible blog, has a stellar track record as both an entrepreneur and investor. In this video of the week from the Stanford Graduate School of Business, Marc covers a number of excellent topics and provides a genuinely optimistic view of the continued disruption by technology.

    From YouTube: Marc Andreessen, Co-Founder & Partner at Andreessen Horowitz, discusses his philosophy on investing in technical founders and the role of technology in today’s startups. Andreessen also addresses the kind of entrepreneurs and ideas his venture capital firm look for: “Big breakthrough ideas often seem nuts the first time you see them.”

  • A Viewpoint Against Angel Investing

    Tucker Max has a new piece up titled Why I Stopped Angel Investing (And You Should Never Start) outlining some of his theories and lessons learned as a successful angel investor. With so much excitement and exuberance in the tech startup world, especially for angel investing, it’s important to understand some of the counter points.

    Here are a few notes from the article against angel investing:

    • 2 reasons he stopped angel investing:
      • There aren’t enough good people to invest in (and too much money is already chasing bad deals)
        • Poor education on going from tested idea to scalable company
        • Young and inexperienced founders thinking they know everything
      • Angel investing is a poor use of time
        • Majority of time should be spent on the best and highest use of skills, with everything else delegated or outsourced
    • The biggest thrill in angel investing is that people flatter you and beg for your resources, and that makes you feel powerful and respected
    • The entrepreneur is doing the important work, not the investor
    • 2 reasons no one should be an angel investor:
      • The economics of angel investing work against all but a select few
      • The structure of angel investing works against all but a select few
    • If you have to be an angel investor, do it as a syndicate on AngelList

    I agree that most people should approach angel investing as a way to help entrepreneurs and to stay engaged or learn something new. As a way to make money, most people are better off staying away from direct angel investments and instead syndicating through a successful investor.

    What else? What are some other reasons against being an angel investor?

  • Second Investment Strategy for a $20 Million Fund

    After yesterday’s post Investment Strategy for a $20 Million Fund, several people reached out and said it was crazy to limit the fund to only eight total investments. After pointing out that if the desired ownership percentage is 20%, and the expected post-money valuation is in the $5 million range, mathematically there’s only room for eight investments. The general consensus was that the fund needs to invest in many more companies to get better diversification and an increased chance of finding a few winners where the capital reserves can be used to participate in future rounds. So, either the target ownership percentage or target post-money valuation needs to go down to increase the number of investments.

    Here’s a potential second investment strategy for a $20 million fund:

    • Allocate 40% of the fund ($8 million) for new investments and reserve 60% for follow-on investments ($12 million in reserves)
    • Invest an average of $500,000 per company with a target ownership percentage of 10% for a total of 16 investments with an average post-money valuation of $5 million
    • Of the 16 investments, take the top four companies and participate heavily in the follow-on rounds using the reserves
    • To achieve $70 million of exit value, the majority of the returns come from the top four investments (e.g. ~$60 million in returns at an average of ownership stake of 10% for a total aggregate exit value of $600 million) and the remaining investments deliver more modest returns (e.g. ~$10 million in returns at an average ownership stake of 5% for a total aggregate exit value of $200 million)

    This approach casts a much wider net and then goes deeper with a handful of portfolio companies. It still requires substantial exits but has more opportunities to find winners.

    What else? What are some more thoughts on this second investment strategy for a $20 million fund?