Sometimes Tough Love Is The Best Love

Attended a shareholders’ meeting of a portfolio company recently, during which the founder demonstrated a working product that is starting to generate revenue. The investors present were quick to congratulate the team and the founder, which is understandable. What surprised me is that none of the investors were willing to ask hard questions even though the product is late to launch, as a result of which the startup now needs to fund raise sooner than planned.

I am not a confrontational person, and I dislike playing bad cop as much as the next person. But when things are not going to plan, it is the investors’ responsibility to push founders to do things that may be unpalatable to them in the short term (e.g. cutting founders’ salaries) but will ensure the viability of the company in the long term. It is easy to pat founders on the back, but investors are doing both themselves and the entrepreneur a disservice by not asking the tough questions when there is still time to turn things around.

I’ve always been an advocate of investors maintaining a good relationship with founders during good times and bad. Building a startup is tough, and there will inevitably be bumps along the way. From personal experience I know that having investors who remain supportive when it’s tough going is invaluable. I also know that sometimes tough love is the best love.

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Business Model Innovation

Nick Bilton postulated in a recent article that eager investors are perhaps guilty of overvaluing tech start-ups. Pinterest’s latest $225 million round of financing at a $3.8 billion valuation certainly surprised me, considering the company is not generating any revenue. As Mr Bilton rightly pointed out:

Once a start-up reaches a $1 billion valuation, they limit the number of big companies capable of acquiring them.

Acquisition potential aside, I wonder what the ceiling to digital ad spend is. It’s easy for startups to tell investors that with enough eyeballs, advertisers will come. After all, the business models of Google and Facebook – two of the Big Four in tech – are almost entirely predicated on advertising revenue. As Twitter goes on the road to pitch its stock sale to institutional investors, it is promising to increase profit margins more than fivefold, to up to 40 percent, predominantly by selling more ads. Pinterest, we can safely assume, is betting on ad revenue as the easiest route to monetisation.

How many billion dollar companies can advertisers support? Is there no limit to the amount of digital ad spend? Perhaps it is time for tech startups to look beyond ad revenue? To the entrepreneurs out there building the next great social network, or search engine, or whatever else you are building, perhaps the real innovation is not so much in the product but rather the business model. If you have a good idea, ping me at iam@therealjohntan.com

 

Skin In The Game

The New Yorker:

Venture funds were growing yet most venture capitalists didn’t have skin in the game: only one per cent of the money in a V.C. firm’s kitty might come from its partners. Mulcahy discovered that it was a bad deal for investors.

It is worrying the number of VC funds out there investing other people’s money, with the partners risking little or none of their own money. Couple of problems with this model. One, the partners of the fund are incentivised by the two percent management fee they charge to go out and raise as much money as possible. Wouldn’t the time spent fundraising be put to better use looking for great founders and startups? Two, VC partners may make investments that they wouldn’t have made if they were putting their own money at risk (head I win, tails you lose).

At 8 Capita, we call our setup an investment partnership as opposed to a VC. It’s mostly the partners’ money, so we spend more time listening to startup pitches than pitching investors to put money with us. We think that is the way it should be.

p.s. If you’re curious about what goes on in San Francisco/Silicon Valley, read this fantastic New Yorker article.

BlaBlaCar Founder on Raising Money

Nicholas Brusson, co-founder of BlaBlaCar:

First, do as much as you can to gather evidence that your concept has potential. Even if you are not able to offer the full vision of your product, because you have limited resources, whittle the idea down to its bare bones so you can test it in the market. Get your first customers as soon as possible, find out how much they need what you offer them. This will be proof for investors. It will validate what’s called market need.

 

Second, and especially if this is your first business, try to get as far into this process as you can without raising too much money. Think “capital efficiency” rather than “raising capital”. The more you have been able to prove your concept the higher your chances of raising money from the right people.

 

Of course, you will probably need capital at some point down the line, so, build relationship with angels and VCs early on. Discussions are always easier when you are not (yet) negotiating.

 

Great advice – validate market need, bootstrap, and cultivate relationship with VCs and angels early.

Read the full interview here.

 

 

Valuation vs Ownership

Fred Wilson:

We recommend that entrepreneurs keep the funding amounts small in the early rounds when the valuations are lower and then scale up the amounts in the later rounds when it is a lot more clear how money can create value and when the valuations will be higher. This model has worked out pretty well. David Karp raised $600k, then $4mm, then 5mm, then $25mm, then $80mm (or something like that). And at the time of the sale to Yahoo!, he owned a very nice stake in the business even though he had raised well north of $100mm. He did that by keeping his rounds small in the early days and only scaling them when he had to and the valuations offered were much higher.

I made a similar point at Echelon Ignite in Sydney couple of months back. Entrepreneurs should be realistic about valuation in the earlier rounds. The higher the early round valuation, the greater the expectations, and the harder it is to justify the valuation that is going to be even higher the next round (nobody wants a down round). Here’s an example. A startup I invested in was valued at $3m post-money after raising its seed round. Shortly after the initial raise, they did a bridge round at the same valuation ($3m pre bridge money). Realistically, they need a pre-money valuation of at least $5m to do an A round, which requires significant traction in terms of user and revenue growth to justify the increase in valuation. Not easy, bearing in mind this is in South-East Asia where valuations and exits are much smaller than in the Valley. The entrepreneur took what was on the table, and you can’t fault him for it. On hindsight though, perhaps it would have been better for him to have raised a smaller seed round at say half the valuation (so $1.5m post-money), then do a post-seed/Series A at $2-3m pre-money. A $2-3m valuation is a lot easier to justify than a $5m valuation, so chances of closing the post-seed/Series A at the lower valuation are much higher.

The point of all this is, raising a boatload of money too early at an artificially high valuation puts the entrepreneur under a lot of pressure to up the valuation even higher to raise the next round. Doing small rounds at smaller valuations is not a bad thing, especially since raising less money forces entrepreneurs to become more disciplined about how they spend the money.

A Response To ‘Dear Dumb VC’

Mark Suster:

‘The industry is dying, except for the top 2%’

The industry isn’t dying. It is changing. And reinventing itself. And some firms will go under. And others will emerge. That’s normal. It’s a market, after all.

‘The best VCs don’t try to help entrepreneurs’

Great VCs create the fabric of their success by backing the best entrepreneurs they have access to and then helping them to lean on the scales.

‘VCs Spend Too Much Time Deciding’

Some of the most bizarre sounding deals end up being huge winners. Some of the most obvious companies and talented entrepreneurs end up not working or burning through too much capital.

VCs are wise to go slowly

‘VCs shouldn’t call their entrepreneurs once they invest’

So the VC’s job is to challenge. Cajole. Debate. Offer contrasting views. Play Devil’s Advocate.

And then step back.

‘VCs often don’t use the products of the companies in which they invest’

It’s hard for me to imagine investing in companies in which you don’t use and understand the products and markets.

‘VCs should never be late’

In a perfect world everybody would be on time. In reality, that is seldom the case.

‘You suck if you don’t have 2+ $1 billion exits’

And as John Doerr has noted, “your lemons ripen early” so I like to say that if I had a ton of exits it would be because I haven’t done my job as well as I would have liked.