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?

Reality Distortion Field

I found this fantastic rant by Dave Grohl, of Nirvana and Foo Fighters, describing his documentary Sound City:

“This movie wasn’t made for cynical middle-aged music critics, it was made for my daughter, or for the teenager down the street who’s trying to figure out how to start a band. When I think about kids watching a TV show like American Idol or The Voice, then they think, ‘Oh, OK, that’s how you become a musician, you stand in line for eight fucking hours with 800 people at a convention center and then you sing your heart out for someone and then they tell you it’s not fucking good enough.’ Can you imagine? It’s destroying the next generation of musicians! Musicians should go to a yard sale and buy an old fucking drum set and get in their garage and just suck. And get their friends to come in and they’ll suck, too. And then they’ll fucking start playing and they’ll have the best time they’ve ever had in their lives and then all of a sudden they’ll become Nirvana. Because that’s exactly what happened with Nirvana. Just a bunch of guys that had some shitty old instruments and they got together and started playing some noisy-ass shit, and they became the biggest band in the world. That can happen again! You don’t need a fucking computer or the Internet or The Voice or American Idol.”
Rock n Roll Jedi, Delta Sky Mag

I wonder if people in other vocations feel the same about how reality television distorts their experience?

Do chefs love MasterChef? Do property developers love The Block or Property Ladder? Do people who work with troubled kids love Super Nanny? Do architects love Grand Designs? Does anybody love The Beauty & The Geek?

I doubt it.

Because if you substitute musicians for start-up founders, what Dave Grohl described is exactly how I feel about Dragons Den and the like.

All of these shows are entertainment, which is fine. No harm, no foul. Very little reality, despite the name. Except that it seems that many people often fail to make that distinction.

Despite all of the evidence to the contrary, people do believe that entering a talent show is the path to a career as a singer, and they keep lining up every time there is a call for auditions. These train wreck shows seemingly have no problem finding folks who think that inviting cameras in to film their wedding planning or their house build or their blind date with a stranger is a normal and constructive thing, without appreciating that the only possible winner from that equation is the person selling advertising around the eventual show when it screens. Even the viewer, as entertained as they might be at the time, is a loser by any reasonable measure of opportunity cost.

It is, to use Dave Grohl’s patter, fucking nuts!

And, it makes me sad and angry to see it happening more and more in my industry.

A contrived start-up experience has as much in common with a real start-up as being a contestant in Survivor has with living unassisted in the Amazon for three weeks.

But, there is a large and growing group of people who think that the only way to a successful start-up is via an accelerator program, where they get locked in a room for twelve weeks, inundated by mentors, pressured into customer discovery and product pivots and whatever else is the buzzword de jour, taught to pitch and then pushed on stage to pimp their pre-pubescent start-up to a room full of investors. And then… who knows what?

This is just Startup Theatre: a scripted experience that has very little in common with the things that successful startups in the wild fill their days with, in my experience. The only thing missing is the film crew, although surely that can’t be far away.

The latest “season” of Lightning Lab had their demo day in Wellington last week.

This is how I saw it promoted on Twitter:

https://twitter.com/seamusfitz/status/471411781840031744

Seriously? Did it rain? Were folk hustled?

The people who are advising founders to approach investors in this way are naive and wrong. Be aware that you’re creating a significant selection bias by doing this, because smart investors do not want to be hustled and won’t be tricked into investing in your dinguses.

Likewise, if you think this is the best way to access people who you would otherwise struggle to connect with, you’re massively underestimating how easy it is to reach smart investors in a small place like New Zealand (or a large place like San Francisco, for that matter) if you have something compelling to pitch them. But you do have to get the train in front of the tender. Otherwise you’re not really a founder.

(I keep talking about smart investors, but I realise I haven’t ever explained what I mean by this. It’s possibly a subject for a future post, but for now I’ll define it simply as those who typically contribute more value than they capture, both in terms of dollars and, more importantly, in terms of advice and support.)

So far the results from these sort of programs locally are pretty skinny. But, we only need to do this a few more times before one of these companies becomes Dropbox or Airbnb. That’s how the maths works, right?

In fact, we believe in accelerators so much that we now have a government grant programme designed to accelerate accelerators. That’s four derivatives, if my calculus is correct!

(The questions I would ask those that approve this sort of funding are: a) how will you measure the impact you have on the companies who benefit from this investment?; and b) what is the control group?)

Please, don’t hold your breath.

You may reasonably ask: if this is so wrong, why is it increasingly common and popular?

I think the explanation is simply that doing a start-up is hard. And more than likely a complete waste of time and effort. So we’re all attracted to this sort of reality television approach because we think it might be an easier route, or increase the likelihood of a successful outcome.

But, I think the short cut we hope to find in this approach is a mirage.

I tried to opt-out of this debate a while back, as I figured there was little chance that I would convince anybody who believed otherwise, and there was no shortage of better things to put my time and energy into. I still believe that. But, I’ve realised I never explained the alternative.

I think Dave Grohl has the answer: You have to enjoy the walk.

If you’re a would-be founder, don’t be impatient. Realise that the person promising you a short cut is probably trying to sell you something. Rather, find some friends to work with, and understand that for quite a while you’re going to suck. But suck in the knowledge that you’ll look back later and realise how much you enjoyed sucking, or more accurately how much you enjoyed sucking slightly less each day. Accept that it’s better to suck in relative obscurity. Don’t be tempted too soon by the glare of the spotlight. Tell your story to everybody who will listen, and if you have something that’s actually compelling word will spread. And know that after taking a few small steps forward each day you’ll look back and be staggered by how far you’ve come.

If you are a would-be investor, don’t be lazy and sit back expecting good ventures to come to you. New early-stage investors often fall into the trap of thinking their job is to pick which companies to invest in, but the smart investors realise that the best companies select their shareholders, rather than taking any money they can get. So, get out there and find the people working on interesting things and roll up your sleeves and help them out in whatever way you can. There is a huge dark net of start-ups, beyond the prominent few that make all the noise. Pick one or two, validate that they are willing to take guidance, and prove that you can contribute more than just cash. And then, when the time comes, there is a better chance they will choose to talk to you.

Of course, doing all of these things still provides no guarantee. Not every group of friends playing grunge in their garage in the 90s became Nirvana. Sorry I don’t have a better bridge to sell you. But, since you’ve read this far, I assume you’ve decided it’s all worth it, despite the odds.