Track Record

Early-stage investment is a dark art.

Very few investors are forthcoming about their results, and so there is a lot of misunderstanding about what is “normal”.

The common belief seems to be that you just need to invest in ten companies and one of them will be a winner. I actually don’t think those sort of results are typical. My observation is that most investors have a selection bias which skews their returns significantly in one direction or another.

Either way, I thought it might be helpful to others to consider my own experience to date.

My first early-stage investment post Trade Me was Xero, in March 2007. It was a relatively easy decision, as I was also joining the team ahead of the IPO later that year. With the benefit of hindsight, I probably should have stopped after that, and I could now claim a 100% hit rate!

Instead, in the seven years since then I’ve made fifteen further direct investments. I’ve also made follow-on investments in six of these.

In total I have invested just over $4m so far.

This is the list in chronological order 1:

Sonar6 is the only real exit to date, after they were acquired by Cornerstone On Demand in April 2012. As an investor in their later rounds, that represented a ~2x return for me.

Four are sold or confirmed dead (in a couple of those cases there were very small amounts returned to investors, but only cents on the dollar so more of a gesture than something that should be considered a return) and one other is missing presumed dead, so 31% by count or circa 16% by value invested have resulted in a loss of the money I invested. That compares favourably with the 40% figure that Fred Wilson has written about although, as he says, that’s maybe just a signal that I’m not taking enough risks.

Thankfully, I’ve invested larger amounts in the companies which have been successful thus far. This is partly good luck and partly, I think, a function of the approach I take – typically investing a small amount at a reasonable valuation initially and then more later, once the company has proven they can execute and start to scale and as a result have significantly reduced the risk.

Xero is clearly the biggest success on that list at this point. The small portion I’ve sold has repaid my initial investment several times over, and the majority that I retain is worth more than all of the others combined, even after the recent share price correction. I remain very long and patient.

I’m also very optimistic about Vend and Timely, which take a large chunk of my time today. I am chairman at Vend and a director at Timely.

Atomic, Revert and Respondly are three recent investments, so far too soon to tell, but I’m very excited to be working with all of them too.

And, the jury is out on a few of the others – I’m hopeful there may be a couple more winners in that list too.

Overall, the portfolio doesn’t owe me anything at this point.

On top of that I’ve also gained some useful scars from the early failures. This is what I mean when I say get started and be prepared to suck for a bit. I suspect that is actually the only option, if this is something you’d like to be good at.

Some of the biggest lessons, so far:

I’ve learned it’s better to invest in the best companies, not the most companies. As the list gets longer I feel less and less inclined to do more and more.

I’ve learned that investing passively from the sidelines doesn’t provide much personal satisfaction, even if it goes well for the company, so my recent investments have been in ventures where there is an opportunity to get involved in some capacity in addition to investing cash 2. The downside with this approach is that time is finite. At the moment I have my hands full to overflowing with the things I’m already invested in and working on, so I’m focussed on those rather than looking to add anything new into the mix (and, as I have to constantly remind myself, focus means saying no or, aspirationally, having an assistant to say no on your behalf).

I’ve learned that you can achieve a lot more if you’re not worried all the time about who gets the credit, but if you take that approach you have to assume that you won’t get the credit and be comfortable with that.

I’ve learned that as a potential investor aimless networking, coffee meetings and events are a black hole, and you can spend all your time there, but it doesn’t really help you to find the best investments or contribute much of value to the companies you’re already working with.

Time will tell how this goes.

It will be interesting to look back at this list in another seven years and see whether the companies that I think are the possible winners now actually worked out that way, or if there were any surprises. And, who knows if there will be more names to add to the list which at the moment are nothing more than an idea.

I continue to make it up as I go. No doubt there are many more lessons to come.

Perhaps this post will prompt other local early-stage investors to talk more openly about their own results and experiences too. If so, please add a link in the comments below.


 

Notes:

  1. There are a few things excluded from this list, where my investment was a token amount. I have excluded the projects I’ve worked on with the team at Southgate Labs, such as Triage. They are not material to the calculation because my investment there has been predominantly time rather than cash. I’m also a small investor in the latest Movac fund, however it would be generous to count any of their investments as mine in this context so they are also excluded.
  2. In practical terms this means spending a day or so each month working with the founders on whatever they need help with, and being available in between those times via video or email to answer questions or be a sounding board – usually for things like strategy, planning, finance, legal and recruitment (or the opposite!) Ironically, these days, less and less of my time is spent on product or software development, even though being good at that was what earned me the right to be in this position in the first place, although I’ve typically invested in ventures where those skills are well represented in the team already.

Fine Words

All That Glitters


Tweet storms are fun, but I do miss blog posts. :-)

The Dark Net

NZVIF have released their latest Young Company Finance report. The report includes a list of all of the companies that raised new capital so far in 2014. It is an appallingly incomplete list. These are the companies that I know of they have missed:

I’m sure there are many others. Please add a comment to this post if you can give me more names. If you add up the amount raised by just those I’ve listed it comes to more than the $23m that is reported, meaning they miscalculate the amount of investment by at least half. No wonder officials are convinced there is a shortage of capital. They are overlooking all of the best companies who typically don’t need to resort to angel networks to raise money. This was the report on Stuff this morning: Angels give tech start-ups a good shot.

Investment in young companies by Dragons’ Den style investors topped $50 million in the year to June, according to a report by the New Zealand Venture Investment Fund (NZVIF) and the Angel Association.

Angels and Dragons, y’all. Apparently when it comes to young companies calling yourself simply an investor isn’t sexy enough. Just a thought, but maybe we should make it more about the companies and less about the investors.

UPDATED: added a few more companies and some links to media stories about these capital raises – in most cases this information is already in the public domain.

Investor Motives

When founders think about raising capital my observation is they nearly always start with the question of ‘how much?’, when they would often be better served to first ask ‘who?’

It’s useful, although rare, to try and understand the various things that might motivate different investors to be tempted by your venture at the stage you’re at, because it makes a big difference to how you might present the opportunity to them.

1. Story

Some investors are attracted by the apparent glamour of early-stage ventures. They like to be able to tell their friends and colleagues that they are investors in something that seems more exciting than their day jobs.

You need to offer these investors a role where they will get some recognition for their involvement.

2. Contribution

Some investors are looking for something to spend their time on, and prefer to be able to leverage that investment with a financial stake.

You need to offer these investors a role where they can feel they are involved and making a difference.

3. ROI

Some investors are simply looking for a return on investment – that is, at some point in the future they want you to give them back more than they gave you, plus some extra for the risk they took and the period of time that you had the benefits of their money – that could be on-going dividends or cash on exit.

You need to understand what sort of return they are expecting (this will likely depend on their personal circumstances and how early they are investing), and you need a spreadsheet which shows them the numbers to give them confidence that if things go well this is possible in your case.

4. Carry

Some investors who invest a fund on behalf of others are compensated based on the size of the fund and the overall capital gain they produce for their funders – e.g. a VC will typically receive 2% + 20%, meaning they are paid 2% of the total value of the fund they manage every year (this is used to cover the fixed costs of running the fund) and 20% of the gains. See: http://avc.com/2008/08/venture-fund-1/

You need to convince these investors that you have a chance of knocking it out of the park – because they are investing in a portfolio of companies alongside yours, there is not much difference for them between a complete failure and a mild success, so they will expect you to be swinging for the fences.

5. Uplift

Some investors who invest a fund on behalf of others are compensated based on the current value of those investments – e.g. a hedge fund will typically pay managers a bonus every year based on the increase over that time. This effectively means they buy the shares again every year.

You need to show these investors that you can steadily increase the value of your business over time and avoid any nasty shocks which could cause the value to drop from one year to the next.

So what?

Think about what sort of investor is appropriate for you, given the stage you’re at and your own ambitions for the future. It’s surprising how often there is a complete mis-match between the motivations of founders and investors as a venture grows.

If you’re just getting started and need a small amount to cover your costs while you explore the opportunity, then you’ll probably struggle to get larger investors excited, given they generally prefer to invest bigger amounts once there is an obvious way that this money can be used to remove constraints. More than this, it can actually be toxic to get a high profile investor on-board in your first round – in your next round other investors will take the lead from them, and if they choose not to continue investing, for any reason, then you’ll likely struggle.

Likewise, once you’ve proven the venture and are ready larger amounts of capital to help you accelerate, then you’re probably wasting your time if you’re still pitching investors who are mostly interested in the story or contributing their time, but who normally don’t write big cheques.

And, if you just want to create a great business that will pay a good salary for you and maybe a few friends, then you’re creating a future headache for yourself if you raise money from more institutional investors.

I’d encourage you to have the conversation explicitly in advance with potential investors. If it’s not clear which type of investor you’re talking to then take some time to understand what is attracting them to your venture.

What are the other types of investors and motivations that you’ve seen?

Valuation

faster_new

How do you value an early stage company?

It might sound overly simplistic, but I tend to think that this is something that the market decides – the valuation is whatever an investor will offer and whatever a founder will stomach, and hopefully there is some overlap!

For what it’s worth, these are my rules of thumb for founders, when I’m asked about valuation (hopefully publishing these doesn’t come back to bite):

  • Expect to dilute between 20-30% per round (there are lots of recent data points which support this: all of the rounds we’ve done at Vend, and all but the most recent Xero round have been in that range, for e.g.)
  • Plan to raise enough to cover 12-18 months worth of expenses (and there should be a good plan which estimates what these are likely to be!)

Solving the equation given those two constraints gives a valuation range to start a conversation with.

Then the softer, but ultimately much more important questions:

  • Choose the larger investors you want to work with, and work with them to agree terms that you’re both happy with, then fill in whatever is left with smaller investors (nearly everybody does this in the reverse order, which is a mistake)
  • Make sure that the bigger investors are putting enough cash in, and getting enough of a percentage in return, such that they care about the venture and will invest their time and energy and networks into making a success in the future

It gets more complicated if you already have customers and revenue and a growth trajectory, since that gives some basis to start to be valued on fundamentals (e.g. 15-20x annualised revenue are numbers which get thrown around for SaaS businesses), but at an early-stage when the numbers are small that often ends up being in the range I mentioned above anyway. Be aware that numbers can easily mess up a good story!

The other thing which can influence all of this is FOMO, if you’re growing really fast and/or there are external factors motivating the investor to do the deal, you possibly get away with a much smaller dilution (e.g. the most recent Xero round in 2013 was ~8%). The risk with this is you get an investor who needs you to continue to grow very fast to justify their price, which can create some pressures which are not useful.

Finally, try not to get bogged down in this, whether you’re an investor or a founder. At the end of the day neither side wins because they eked the last percentage point of dilution out of a funding round negotiation, they win by working together to build a fast-growing ass-kicking name-taking business. In the not too distant future whatever valuation you agree now is likely to look way too high (because the company is dead and therefor worthless) or way too low (because it became a big success).

So, don’t pretend too hard to be something you’re not and don’t die in the ditch.

Say Something!

Dilbert - Honesty 3

The best sign I have that a company I’ve invested in is dead, or near death, is the silence.

This is why I encourage all of the founders I work with to send regular and detailed updates to all of their investors at least once per quarter, ideally once per month.

Even if you don’t have investors yet, the process of taking a step back and asking yourself what’s going well, what’s not going well, and what you could do differently is hugely valuable.

It doesn’t have to be complex.

In the simplest case just start by sending out basic financial details: how many new customers you have, how much cash you earned in the last month and how much cash you spent in the last month and how much cash you have left in the bank.

Then, later, as you grow, include some commentary about your current constraints – i.e. why aren’t you growing faster?, an update on your team – new hires?, open roles?, how you’re feeling about the culture?, and maybe point to some of your key numbers – how much are you spending to acquire each new customer? how much does it cost to support each customer each month? how many customers cancel (or “churn”) each month?

For bonus points, ask other people in the team to contribute a short paragraph about their area – e.g. the product/engineering teams might want to list the things they’ve recently released and the things they are working on next; the customer support team might like to highlight their Net Promotor Score; the sales and marketing team might want to talk about recent promotions they’ve run and the effects of those.

It shouldn’t take long as these are all details you should have at your fingertips anyway (and if not, then you have bigger problems than not keeping shareholders informed!)

Make sure you talk about both the good stuff and the bad stuff. Investors are smart enough to realise that startups are not a smooth curve up and to the right, and will appreciate the honesty. More than likely they will want to try and help you solve the problems, when you’re up-front about them, rather than stressing about the fact that there are problems.

The real payback on doing this will come when the time comes to raise more investment in the future. There is nothing worse for an investor than an email from out of the blue asking for more money. If you’ve taken the time to keep everybody informed of the progress then you’ll spend much less time telling them where you’ve been, so you can focus on where you want to go next, and you’ll likely find them much more enthusiastic about continuing to be part of it.

So, even when you think you have nothing interesting to say, say something.

It could make all the difference.

Quick Tap

It’s 75 minutes into the match. The score is 15-all. The team hasn’t been playing that well, truth be told.

Awarded a kickable penalty, Aaron Cruden (25 – currently starting first-five, but really second choice behind Dan Carter who is currently on sabbatical) along with Beauden Barrett (23 – up-and-coming, but on the night a replacement fullback) and Victor Vito (27, another reserve, back for his first game after last year being told he wasn’t up to the standard expected of an All Black) together spot an opportunity and decide, without even consulting Richie McCaw (33 – the captain on the field), to instead take the quick tap and go. It leads, a few minutes later, to the match winning try.

This is what Richie had to say afterwards:

“You’ve got to back the guys to have a crack. If they’re always looking to me they’ll never take an opportunity. I was ready to point at the posts but he thought better of it, and it paid off.”

And, the coach, Steve Hansen (55, for consistency):

“It was one of those games where someone had to take it by the scruff of the neck.”

We can only speculate about what might have been said all around if that decision hadn’t lead to a try and the match had ended a draw, or a loss. As it was the headline was “All Blacks lucky against inspired England” (really, that was luck?)

There is a massive organisation that exists to support the All Blacks – the NZRU board, CEO and high performance staff, the All Blacks selectors, coaching and management teams, including specialist coaches, media liaison, medical support staff etc, not to mention the many stakeholders (including all of us as fans).

But, I’m fascinated by how accountability and responsibility is delegated down to the youngest and least experienced, and the culture that is created within the team as a result. We would consider it remarkable for a 25 year old team member or 33 year old executive to be making big decisions in a large company, where the leaders tend to be much older and tenured. But, in the All Blacks, by the time you’re over 30 you’re as experienced as they get, and certainly considered old enough to handle the pressure of making decisions in the moment on the field.

How about In the organisation where you work? Do your junior staff have the freedom to respond to opportunities when they spot them? Or, do they do as they are told until they’ve done their time?