David Cummings on Startups

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  • Annual Run Rate and Size of Funding Round

    While it’s rare that Yik Yak was able to raise a large Series A round just seven months after launching (see WSJ article), there is a strong correlation between the startup’s revenue run rate and raising money. Too often startups, especially B2B Software-as-a-Service (SaaS) startups, go out looking to raise a large sum of money and don’t have the requisite revenue run rate, or other metrics, to warrant the target amount of capital and corresponding valuation (entrepreneurs typically sell 20-35% of the company during each round of financing, so to raise a $10 million round, the company must have a huge valuation).

    Here’s a ballpark for revenue run rate and size of funding round:

    • Annual run rate less than $20,000, raise a friends and family round of less than $250,000
    • Annual run rate between $20,000 and $100,000, raise a seed round between $250,000 and $750,000
    • Annual run rate between $100,000 and $1,000,000, raise a large seed round between $750,000 and $2,000,000
    • Annual run rate between $1,000,000 and $3,000,000, raise a Series A round between $2,000,000 and $7,000,000

    Now, the goal is to set expectations, based on recurring revenue, of what a normal-sized round might be for a competitive deal. Of course, investors can offer as much, or as little (none!), as they want. It doesn’t hurt to seek a larger round than what the annual run rate and corresponding valuation might dictate, but it’s important to be in the reasonable range to show you’ve done your homework and understand how the process works.

    What else? What are some more thoughts on annual run rate and size of funding round?

  • Growth Metrics Matter and Capital is Mobile – Yik Yak and BitPay

    Earlier today Yik Yak, based in Atlanta, announced a $10 million Series A lead by DCM (see the WSJ article). Last month BitPay, based in Atlanta, announced a $30 million Series A lead by Index Ventures (see the Entrepreneur article). Both the founders of Yik Yak and BitPay moved to Atlanta last year from outside of Georgia. Both raised huge amounts of money in a short period of time from investors thousands of miles away.

    What gives? Why were they able to do it from whatever city they chose to build their company? Why didn’t they have to be in Silicon Valley?

    Growth metrics matter and capital is mobile.

    According to Distimo, Yik Yak has more iOS downloads than Whisper and Secret combined. According to Fortune, Bitpay processes more than $1 million per day of Bitcoin. Investors want to see strong traction in a large market — growth metrics matter.

    DCM is based in Silicon Valley. Index Ventures is based in London. Each is a serious plane ride and many timezones from Atlanta. Investors want to generate the best returns for their limited partners regardless of where the startup is based — capital is mobile.

    When entrepreneurs complain about a lack of funding, point them to Yik Yak and BitPay and show them that capital is mobile with the right growth metrics.

    What else? What are some other thoughts on growth metrics and capital being mobile?

  • Multiple Entrepreneurship Centers in a Major City

    One of the most popular questions I get when people see the Atlanta Tech Village is “when are you going to do the next one?” Quickly, I respond that it’s a one-and-done but that I think within 24 months we’ll see an entrepreneurship center in each of Atlanta’s major sub-markets, and that’s a good thing. Just in the past few weeks we’ve seen announcements for Switchyards in Downtown and Industrious in Midtown. I know of at least three others that are in the planning phase right now and expect more to come.

    Here are a few reasons why having multiple entrepreneurship centers makes sense in a major city:

    • Areas of town already cater to different types of people, so it makes sense to play to a sub-market’s strengths with a corresponding entrepreneurship center
    • Founders and funders of the entrepreneurship centers have their own unique strengths and expertise, which is often a theme for the startups in the facility (e.g. B2B software is strong at the Village)
    • Traffic and commuting is a serious challenge for major cities, thus having multiple centers makes them more accessible to a larger number of entrepreneurs (commute time is a big driver for where entrepreneurs choose to work)
    • Entrepreneurial density helps increase the likelihood of success for all entrepreneurs in an area, so if more entrepreneurship centers create more pockets of density, the city is going to benefit from more job creation

    Multiple entrepreneurship centers make sense for major cities and I’m looking forward to many more forming in Atlanta.

    What else? What are your thoughts on multiple entrepreneurship centers in a major city?

  • Time Off After Selling a Company

    One of the more popular questions I get is “how much time did you take off after selling Pardot?” My situation was unusual in that I wasn’t personally part of the deal post-sale, so I didn’t have an employment agreement or earn-out. After selling the company I promptly started looking for a building to buy for the Atlanta Tech Village and I started Kevy (a cloud integration startup). Personally, I enjoy working on new ideas, so I just went right to the next item on my list (see Keep a Google Spreadsheet of Business Ideas).

    Over the past 18+ months I’ve talked with a number of other entrepreneurs and asked them a similar question about amount of time off. The most common response is that they thought they’d take 1-2 years off only to find that after nine months they got bored and started looking for the next gig. After helping run a successful company, working with a number of great people, and building something special, life post-sale can be less exciting. Sure, having financial freedom is great, and pursuing personal projects is fun, but the thrill of a fast-growing company is truly special.

    Another response I’ve heard talking to successful entrepreneurs is that they took time off and got so engrossed in the life of their kids and community that they won’t ever start another company. One entrepreneur even described it to me that his entrepreneurial muscle had withered and he can’t see himself running another company — the entrepreneurial drive was no more.

    Based on my informal poll, I’d recommend entrepreneurs plan for nine months off after selling their company. Of course it’s an individual decision, but this was the most common timeframe to enjoy things and refresh before finding the next thing.

    What else? What are some other thoughts on time off after selling a company?

  • VC Deal Flow and Investing Volume

    Every few months here in Atlanta someone brings up the idea that we need more venture money in town. People throw around the idea of another $100 million fund (we have about a half dozen currently) and the resulting capital that will get invested in the region. As a response, I like to point out that capital is more mobile than ever before and that entrepreneurs with traction can easily raise money. In addition to capital being readily available for proven startups, it’s always important to educate people on normal investing volume for VCs, as it is much lower than expected.

    Here’s what a typical VC’s deal flow and investing volume looks like per year:

    • Meet with 200 entrepreneurs
    • Invite 20 to pitch
    • Offer term sheets to six
    • Invest in two

    So, a typical VC only invests in two deals per year. While more local funds are good for a region, the actual number of companies funded will still be limited just by the nature of the business model. The best way to grow a local tech startup community is to produce more modestly-successful companies in a capital-efficient manner that can then go raise institutional money if they so choose.

    What else? What are some other thoughts on VC deal flow and investing volume?

  • Founder Equity Shouldn’t be Common Shares

    Back in 2006 and 2007 there were a number of articles talking about a new type of founder stock called “FF class”, named after Founders Fund. These class of shares were designed for founders that might want to take money off the table at some point before selling the company (see this VentureBeat article on Series FF). As a founder, the most common type of equity is that of common shares which don’t have any special privileges. Where common shares break down is in valuation relative to recent financing and corresponding tax treatment if you want to sell some stock.

    Investors typically buy preferred shares in the company that come with special rights (e.g. investors get their money back before other shareholders get any money), and as such command a higher valuation. When it comes to valuations, these preferred shares are often worth 3-7x more than the common shares. 409A valuations are done by third-parties to establish a value for things like employee stock options so that the valuation would hold up in an IRS audit. Any money that a founder sells shares for above the price of the common would be taxed as ordinary income instead of long-term capital gains.

    Let’s look at an example. A founder starts a company and buys common shares (founders buy into their own company for next to nothing). The startup does well and investors want to put in $1 million to buy preferred shares at a $4 million pre-money valuation (making the post-money valuation $5 million). As part of the financing, the investors are comfortable having the entrepreneur sell $100,000 worth of shares (e.g. redeem some stock for cash). Now, this is where things get difficult since the founder has common shares and not FF shares. Since the common shares are worth a fraction of the preferred shares (e.g. say 1/5th of the value for a valuation of $1 million), the founder either has to sell 5x more shares to get the $100,000 with long-term capital gains treatment or sell shares at the price of the preferred, but then pay ordinary income taxes on 80% of the proceeds and long-term capital gains on 20% of the proceeds (the delta between the value of a common share and a preferred share).

    As a founder, the solution is have a second class of shares at time of formation that are similar to common shares but have the option to convert to preferred shares in the event of redemption (taking money off the table), thus being able to be pegged at a higher valuation and being able to receive long-term capital gains for the proceeds. Founder equity shouldn’t be common stock so that founders have the option to sell shares with long-term capital gains treatment at a future time.

    What else? What are your thoughts on founder equity being a special Series FF class so that founders can receive long-term capital gains at the valuation of the most recent round?

    Note: Talk to a lawyer when considering this and make sure the lawyer has experience in it as many aren’t specialists in startups.

  • Thinking About Physical Spaces in an Entrepreneurship Center

    Over the past 18 months I’ve been approached by dozens of people that wanted information or to partner on tech entrepreneurship space. Last week I talked about 5 Tips for Building an Entrepreneurship Center. Early on at the Atlanta Tech Village we received great input from startups by opening up our building pre-renovation and using that feedback to influence our master plan.

    Here are some ideas regarding physical spaces in an entrepreneurship center:

    • Co-working – A small amount is ideal. At first we thought we’d have a significant amount of co-working space only to quickly find that once startups got past a couple people they wanted to have their own sense of identity and dedicated space. 5-10% of the total space for co-working has worked for us.
    • 4-person offices – Maximize the number of 4-person offices. This size space has the most demand and is flexible in that a two-person company can rent a private room (e.g. pay for all four desks) or an 8-person company can rent two rooms.
    • 2-6 room suites – Suites are great for companies that have 8-25+ people but most startup communities don’t need too many as the eco-systems are still fairly immature. As a company grows past 20 or 30 people there are a number of traditional commercial real estate options. At the Village, we converted several of our two-room suites into individual four and six person offices due to the demand for smaller space.
    • Phone rooms – Places for private conversations and conference calls are in high demand for companies that employ sales people and more phone-oriented team members. We have one for every 30-40 people.
    • Conference rooms – Shared meeting space is heavily used and we’ve found that one meeting room for every 30-40 people works well.
    • Event center – A large meeting space is critical for bringing the community together, both within the facility and the greater area. Our event center has proved to be even more successful than expected.

    The ideal mix of physical space at an entrepreneurship center is a function of the needs of the community. Co-working generally draws more 1-2 person startups whereas 4-person offices generally draws 3-8 person startups. An entrepreneurship center should have a number of different resources in the facility and look to foster serendipitous interactions.

    What else? What are some more thoughts on physical spaces in an entrepreneurship center?

  • Example Pro-Rata Participation for an Angel Investor

    The post from two days ago Only Doing Seed Investments Without Follow-On Funding received a number of comments and questions. One aspect of being an angel investor that isn’t well understood is pro-rata participation in future rounds. As an investor you almost always get the right to maintain your percentage ownership if you invest more money each time the company raises money (this assumes an up round where the valuation is higher than the previous round). If you don’t invest more money with each subsequent round, then your percentage ownership of the company will decrease.

    Let’s look at an example scenario for an angel investor over multiple rounds of financing:

    • Angel investor puts in $25,000 for a company that raises a $1 million seed round on a $1.5 million pre-money valuation, making the company valued at $2.5 million, thus the angel investor owns 1% of the business
    • Company makes great progress and raises a $3 million Series A at a $7 million pre-money, making the post-money valuation $10 million, and the angel investor has to write a check for $30,000 to maintain the 1% ownership (the $30,000 is part of the $3 million raise)
    • Company continues to do well and raises a $10 million Series B at a $15 million pre-money, making the post-money valuation $25 million, and the angel investor has to write a check for $100,000 to maintain the 1% ownership
    • Company is in super growth stage mode now and raises a $25 million Series C at a $75 million pre-money, making the post-money valuation $100 million, and the angel investor has to write a check for $250,000 to maintain the 1%
    • Company goes public or is sold for $250 million making the angel investor’s 1% worth $2.5 million

    Of course, this is an unusual and highly successful scenario (most cities are lucky if they have one success story of this size per year). In the end, the angel investor put in $405,000 ($25k + $30k + $100k + $250k) and earned $2.5 million (again, hypothetical). The key piece is that an angel investor who put $25,000 into a startup really had to put in a total of $405,000 to maintain that position as that’s the way to make the most money (by putting more money into the startups that are doing well). People that have $25k to put into a startup generally don’t have an additional $380k to allocate towards a single, illiquid startup investment. A general rule of thumb is to reserve 2-3x of all money invested in startups for follow-on funding. Pro-rata participation and potential dilution are important considerations for angel investors.

    What else? What are some other thoughts on pro-rata participation for angel investors?

  • Passion, Optimism, and Hard Work

    Last week I had the opportunity to attend a YPO Southern 7 conference in Cape Cod. Two of my recent posts came from the event including Three Strong Bones to be Successful and Runner, Jogger, Walker, and Sitter. Some of the speakers included Ron Clark (founder of the Ron Clark Academy), Dr. Bob Rotella (famous sports psychologist), David Marquet (author of Turn the Ship Around!), and Bruce Pearl (Auburn basketball coach). After the event I reflected a bit on the speakers and content, coming away with a renewed enthusiasm about the human spirit.

    Overwhelmingly, the speakers had the same message centered around three areas:

    • Passion – Love what you do or learn to love what you do
    • Optimism – Believe in greatness and the ability to triumph
    • Hard Work – Serious effort is required and the top performers put in the most hours

    It’s always great to hear from engaging speakers with a strong message. I was surprised to hear the same recurring theme throughout the talks, but in reflecting on them it makes complete sense. Love what you do. Believe in the possibilities. Put in the time required to be successful.

    What else? What are your thoughts on passion, optimism, and hard work being the keys to success?

  • Only Doing Seed Investments Without Follow-On Funding

    After doing half a dozen investments in the last 12 months I’ve had the chance to better formulate an investment strategy going forward. My favorite spot is seed investments as I have an opportunity to help entrepreneurs get a new idea off the ground and start the search for product/market fit (see The Four Stages of a B2B Startup). Seed investments also happen to be the area that markets like Atlanta have the most need. Once a startup has some modest traction and good metrics it’s easy to raise money. Only, there’s almost no money to help an entrepreneur get an idea off the ground.

    Now that I’ve done a number of seed investments, I’ve also been in the game long enough to see a few investments need to raise another round of financing. While I’ve participated in some of these, I’ve come to realize that I’m not interested in doing follow-on funding — I’d rather use my capital to help entrepreneurs get started and then let that initial investment ride. Like Dharmesh Shah outlines in his strategy on angel investing, I’m avoiding follow-on investments.

    I realize that participating pro-rata and doubling down on the winners is how many institutional investors generate most of their returns. Right now, I’m willing to forgo putting more money into the ones doing well in order to cast a wider net and get involved with more details. It might not make the most money but I believe it’ll have the most impact in the community.

    What else? What are your thoughts on only doing seed investments without follow-on funding?