Archives for category: vc

A question that came up during my session with Andree last weekend at BarCamp Munich, was how effective accelerators like SeedCamp or Y Combinator are in helping startups receive funding.

Before digging into the numbers, I would first like to point out that receiving funding is not necessarily a good indicator for a startup’s success. And while the above mentioned programs are very different (in both nature and geographical focus) a blunt comparison might not give each the credit they deserve.

I am still convinced that both are doing a terrific job creating great startups and I highly recommend applying there to get real mentorship, exposure to great, passionate people, and accelerate your startup.

For the following analysisI used publicly available data from TechCrunch’s CrunchBase.

It should be noted that there is a minor presence of error as some companies of Y Combinator weren’t showing up on CrunchBase and others did go through funding rounds but did not disclose the amounts raised.

SeedCamp
Having been established in London about 3 years ago, SeedCamp is primarily focused on the UK and Europe. Its primary event, SeedWeek, is happening once a year in London. Due to its roots and its geographical focus, it is also not surprising that the companies coming out of this program are primarily from the UK. But the program’s outreach into other areas has created a pretty diverse roster with startups from 11 different countries.

Y Combinator
Y Combinator has been around for 5 years. Unlike SeedCamp, Y-Combinator doesn’t have fixed deadlines for application. However, Y Combinator hosts its 3-month-mentoring event twice a year. The first data points available for my analysis are from the June 2005 intake. Y Combinator is known for being an American program and hence the startups applying here are primarily from the US (with some minor exceptions like the UK).

Due to the afore mentioned differences, it should be of no surprise that the programs created a very different output in terms of startups going through their programs.

Hence, the fact that the total amount raised by Seedcamp companies was at around € 9.6M whereas this number is at about $ 135.4M for Y Combinator. To determine the spread of these rounds, I looked into the averages and the standard deviations:

What might matter more is the question about how these two programs differ in their performance. While Y Combinator is around for a longer time, the hypothesis can be made that these large amounts are due to sheer numbers. So let’s have a look at averages by plotting how many of each class were funded grouped by the classes they were in.

As is pretty evident by this chart, Seedcamp started out way more successful along this metric. But even Y Combinator shows some swings. The most recent classes should not be considered in both cases as they are both pretty young (Seedcamp’s class usually starts in September and Y Combinator’s in June).

As we will soon see, these numbers are also quite inconclusive as the spread is too big to jump to any conclusions. Going through the individual rounds and plotting these in a bubble chart provides a more visual approach, providing more helpful insights in answering the question above.

The X-axis is the program these startups went through whereas the Y-axis denotes the days between the start of the program and the first funding. I did not consider the amount these startups were receiving from the respective programs to go through the mentoring months. However, should there have been a rather large amount provided by e.g. Y Combinator, I considered this a first funding round.

Conclusion
Again, as these graphs show, both programs are doing a great job bringing out some fine companies. And Y Combinator’s quick flips (e.g. Reddit, Zenter, GraffitiGeo, Omnisio all got acquired within 6 months after going through Y Combinator) show that Y Combinator is doing a great job, accelerating companies for an acquisition.

As you might have heard before, fund investors are putting money in a VC fund because they are expecting above-average returns. The very best VCs have returns of their funds well above 20x. However, the larger the fund, the more do fund managers need to be focusing on really high growth startups. Hence, it becomes more difficult for fund managers to make the right decisions while only a very small number of startups actually qualifies.

Josh Kopelman has a nice post on his blog that pretty much summarizes my hypothesis. But what does that mean for you as a startup? Basically, it means that you should be more selective in who you are going to pitch to.

The VC Selection Criteria
Let’s run the numbers on this for the purpose of illustration. Let’s assume a fund has a size of $100 million and runs for 10 years. Should the fund managers expect to return 10% annually, they need to return 100 x (1,10)^10 = 259 = 2.59x. Hence, after 10 years the manager would need to return a total of at least $259 million at the end of the fund’s lifetime.
During its lifetime, the managers think of making 25 investments which means that the average size of investment is $4 million. Since the failure rate for early stage startups is pretty high, let’s assume that only 3 startups will actually become stars, meaning they will greatly outperform. So, actually these three must generate all of the funds returns or on average $ 86.3 million.
In an early-stage fund VCs tend to take something between 20% and 40%–let’s assume that the managers take 30% for the three investments above. In order to return the $86.3 million, each one of the startups need to generate a value of $288 million.

However, should only 2 investments materialize, each one needs to return $129.5 million–for a 30% stake, this means that each needs to create a value of $431 million.

History Shows
So, we have two categories: exit values of $288 million  and $431 million. Let’s have a look at the real world again: during the past 6 years, the number of exits in both categories has shrunk as the following table shows:

What this means for VCs
All of this is what tips the resentment that the VC landscape will change since larger funds will have more trouble making their investments as they need to be hunting for bigger and bigger deals, competing over the big buyers (who are the only one able to spend that much for a startup) for the largest returns and ultimately realizing their promises to their investors. Smaller funds, however, are much more likely to generate their returns as it will be far easier for them to make a sound investment and sell it off to someone for a reasonable price.

The Startup Perspective
So, instead of just sending your business plan to email-overloaded VCs and running the risk of becoming the latest rumor, it is probably wise getting some basic info on the firm you are sending your information to. And make sure you are raising the right amount of money. I am pretty convinced that the times for higher burn-rates and greater sizes in rounds are long gone. So, run your numbers and analyze how much you really need.
But, in general, it is going to be far more important to determine the true value of a VC: integrity, network, knowledge. Ultimately, the question will always be: do I want to have this guy on my board? And if he is, what value is he going to bring to the table? Nevertheless, some metrics will prevail (e.g. when will the fund need to exit).

After all, there are many more reasons, why smaller funds are more likely to be the future of venture capital. Larry Cheng has a (slightly provocative) post, summarizing those aspects. From my perspective this is neither good nor bad for the industry but might indicate where we are heading to: some really huge funds while the vast majority will remain small and focused.

In general, I agree with cdixon that a startup should raise as much money as possible. However, due to the difference in mentality and capital available, we Europeans might have a different take on the reasons for that.

If you are looking for a first round investment (i.e. not angel money), raising an amount that takes you beyond deploying your product to market and achieve first revenue is likely going to be pretty hard in Europe (or at least harder than in the US). The reasons lie mainly in the size and number of funds in Europe: there are only a few VCs actually pursuing the real seed stage and if they do, their funds are way smaller than in the US (reasons can be found here). Hence, structuring the investment amount is considered equal to minimizing the amount of risk at hand while increasing the ability to pursue more investments over the same period of time. This is opposite to the behavior of American VCs that like to deploy as much cash as necessary to get you to exit.

The following graph illustrates this mentality [Disclosure: this is an example; any similarities to real funds are unintentional and coincidental]:

While the blue arrows denote capital injections due to achieved milestones, the green one might not have been possible without the failure of Venture 2 and/or Venture 4 (the red arrows indicate milestones that were not hit and hence, not additional capital injection was necessary).

How is the European perspective different from the American: generating first revenue and using that cash to grow?

First, earning $100 is not going to get you through the month. But I proves that customers are willing to pay for your product. No matter how much you want to raise, this fact alone will increase your valuation and the likelihood for raising an additional round–maybe with someone else.

Second, let’s assume you will generate those first pennies in 6 months. That is a long time for a startup. So, it is not uncommon for startups to switch their business models upside down a couple of times before they finally find the right monetization strategy. Hence, you better have more cash than what you got from your first sales.

Europeans like to structure their investments and tie those cash inceptions to milestones. So, every time you are hitting one of those milestones, you are supposed to receive another tranche of cash.

Therefore, unless you have already sold your business, you are constantly seeking investors. I refer to this as a dance that never stops unless you don’t feel like you know what business you are pursuing or have successfully exited your venture.

A lot of the negativity VCs are feeling from entrepreneurs roots in the misunderstanding of why VCs keep telling entrepreneurs to grow really big and hence seem to be pushing for more and more, making them appear like slave drivers.

VCs also serve someone else
Even though there are many VCs who might make you feel that it’s their personal money they put into your startup (which, in all honesty, is usually partly true), it’s usually coming from a fund. Funds are composed of smaller sums of money contributed by wealthy individuals and/or institutions. These people/organizations usually get to know in which companies their money went but they care only about the return their money in the fund makes. In order to make the investor happy, a VC needs to generate quite an excessive amount of money over the lifetime of the fund (usually something between 5 to 7 years). And since the failure rate of each individual startup is very high, a VC pushes for everyone to make the most and compensate for the failure of the others.

It’s unsustainable to remain small
Many people think that it’s ok to have a business that is generating enough money to provide a living for oneself and maybe a family. While this model might still work in some areas, it is usually not true in today’s hyper-competitive internet market. With radical shifts happening every couple of years, a business can easily be leapfrogged and killed by competition every second. Hence, it is hard to make a point that you can provide a sustainable living for yourself for long with a small business in a niche.

The solution: grow!
So, the answer to this problem is growth. There’s always four ways to grow according to Ansoff:

As you may understand immediately, defending  a competitive edge is something very hard to achieve for a small startup with a small customer base in the long run. Diversification can increase complexity and might create other problems (organizational, economies of scale, burn rate) at smaller companies as well. So, there is basically only one of two ways: straight up or straight right, penetrating more markets with your product or expanding in your current market with new products. And this is exactly what large enterprises are seeing: small competitors that are in a niche they have not conquered before and which are cheaper to acquire than to running the risk of failing themselves pursuing the same users.

No matter which path you choose, it will always feel like an uphill battle no matter the size or age of your company. The chances of losing connection to your target market are increasing the larger you grow because of the complexity you add with more products or more people to manage. But this is exactly why startups will always have a chance in today’s market. And this is exactly why there is still a huge supply of capital from venture capitalists to this industry.

I attended the announcement of the winners of futureSAX business plan competition where I was a juror yesterday. And I brought back some memories of how this was like when I was once competing in other such competitions before. Although I am not a big fan of business plan competitions, I think they do have their pros and cons and it is vital to understand what you are getting yourself into before you submit your papers.

How business plan competitions are structured

Most business plan competitions work the same way: you register online and submit your papers. Most of these competitions are divided into stages (they usually have glorious names such as ideas, growth, and excellence) and industries (such as bio, cleantech, IT). Once papers are submitted, jurors are being handed a sample of the stack together with forms to grade them. Jurors usually have about two to three weeks to go through the pile of papers and submit their grades.

After that, it’s getting a bit different. While some competitions allow for a live presentation by the selected few, others solely focus on the papers. The grading sheets are usually confidential and only reverted to the teams until after the competition.

The winners usually get announced at pretty lofty events where all jurors and all teams will be present.

Standardized checklists

However, this is one of the facts most discussed among jurors. While it is true that teams should have an open approach to submit their plans, the grading sheets certainly try to capture the essence of what should be covered. I am not too excited about checklists as I remain sceptical that a standardized grading pattern will capture those really disruptive opportunities. This is especially true the earlier you are into the game.

So why checklists after all? As you can imagine with a couple of hundred business plans submitted, it is a bit too much for just a handful of jurors to go through these aside from their work and provide useful feedback. Therefore a lot of people get invited. Usually sponsors get juror seats. So, keep this in mind when you write about market trends and your technology.

The right industry

As mentioned, most competitions allow you to submit your plans for certain industries. Make sure you understand those industries. As was the case yesterday, there was a web startup in service. Most of them, however, were in IT. It could be a wise approach to shoot for service as an industry to be considered as IT is usually more competitive. But you should also understand that jurors are being handed your plan according to their preference. Hence you should tailor your writing to a less verse audience if you want to compete in an industry further away from your original space.

The networking party

As mentioned before, winners usually get announced at large events where all jurors, participants, and also the press will be present. Don’t get me wrong: I can’t think of another way of making this happen and the winners should deserve attention and recognition for their ideas and efforts. But be aware that the atmosphere at such events is usually mixed. There are a few winners and many, many disappointed people.

Final thoughts

Business plan competitions are good if you know what you are getting yourself into. It is great if you want to gain some recognition. There are a couple of studies that some of the greatest companies never won business plan competitions (even though they tried hard). Thinking that you will automatically receive funding is most likely not right. Sometimes it might be even better to lose a competition as most winners were not the most successful companies.

I attended Telekom’s Innovation Day a couple of weeks ago and joined a discussion on European Entrepreneurship. The other people joining this discussion were from different backgrounds: Finance, product management, startups, entrepreneurs. After a short while the discussion centered around two questions: what is the reason Europe seems to be creating less successful startups and how do you successfully start a company internationally?

How do you start a startup to become big internationally?
I think a great comment came from Sebastian Wallroth who pointed out the difference between the business and the developer perspective. Developing something to be internationalized and building something for international use might be seen differently by these two parties. I personally believe that it is important to start your company close to your initial users/customers. It is crucial to get as much feedback as possible–especially in the beginning. Facebook’s Net Jacobsson also repeated this theme at the very same event, stating that he attributes much of Facebook’s growth in applications to Facebook’s developer garage events which were held locally to strengthen the community and gain insights into what developers wanted.

Having been a software developer for several years, I know how tempting it can be to build the best, most robust and extensible application right from the start. And while I certainly agree that web applications should be built with internationalization in mind, I can also see the threats of over-engineering and getting tied up in details. Starting a company in a European country (aside from the UK most probably) almost demands rolling it out in the local language first. However, if your application has global applicability, it might be worth considering a first beta version in English.

As Julie Meyer from Ariadne Capital put it in a panel discussion earlier at that event: there are many startups which think small but then need to grow big quickly.

What about Europe?
As there are more than enough examples of highly successful European entrepreneurs in the US, the logical inference was that it might be Europe which is limiting the growth in new companies. While many agreed that the lack of sufficient seed and early stage capital might be a factor, I doubt that the underlying problems can be solved by just providing more cash for young entrepreneurs. On the other hand, I do not neglect that Germany should provide a better soil for more VCs. However, an entrepreneur who wants to work at a startup just for the salary is probably not all aware of the difficulties ahead.

I certainly believe that the attitude towards taking risks is different in Europe. Having spent two years in the heart of Silicon Valley, I am pretty sure that rewarding risk is almost unique to the most vibrant startup scene on this planet. Risk-taking is a vital part in startup life. Europe lacks this sort of entrepreneurial thinking. This thinking also includes the idea that people who have been out of the large corporate setting for some time are still able to adapt and thus capable of switching to a different working environment. Unfortunately, this is just not (yet) part of our thinking.

Selling too early?

Another, very interesting point came up shortly before the discussion ended: what about the statement that a lot of companies in Europe are not able to develop fully before being sold? The hypothesis was that a lot of investors in Europe are also still not willing to take larger risks and hence hinder greater exits. Thus, the lightning rods like the ones in Silicon Valley with high valuations are lacking and in turn not creating enough interest for people to pursue an entrepreneurial career. I found this to be a really compelling statement. Too bad it is most probably going to remain a hypothesis for the lack of actual data.

I figured that there is a great deal of confusion about valuations out there. Hence, I decided to shed some light on this from the other side of the table. I am going to concentrate on early stage businesses here. There is a great deal of books for mature companies (I personally recommend McKinsey’s book on Valuations on this topic).

Misconception #1: it’s all about other valuations
Nothing can be further from the truth. Although this might sound counter-intuitive at first, other valuations are just one piece of the puzzle. Only because a competitor might receive a high valuation does not imply the same for your business. There is a great deal of factors that make up a valuation, even more so in the early stages of a business. The reason why so many VCs state that the team is a great factor, comes from the fact that it is common knowledge that you might switch your business model around three times before you hit the right market.

Misconception #2: the higher the valuation the better
This is something that you might not realize when you’re just thinking about your first round. However, it might get back to you in the following rounds. Down-rounds, i.e. rounds in which the current stock price is considered lower than in previous rounds, may have many implications. For one, your previous investors might receive more shares due to anti-dilution clauses. But even worse: it signals that you might not have hit the target set out by your previous investors, maybe decreasing your chances of raising another round.

Misconception #3: there is a fixed formula
If there were, we would not have those nice negotiations, right? There are many tools that you can use to calculate the pre-/post-money value, the share founders get if the option pool is considered, etc. But the real valuation, determined by the amount of the investment for the share of the company, is always a plug-in number. Therefore, a tool like the Valuation Calculator should not be taken too seriously. There are some indicators (stock market prices, general market development) but they may have different value for different people.

Misconception #4: first revenue means higher valuations
The more data you have on the actual money value of your business, the more likely it is that the valuations from different people might be closer. More data points usually help assessing a business better, hence the valuation can be done more accurately. But it doesn’t necessarily mean that your valuation will rise. If you are greatly underselling your product, this might also indicate that the customer does not value the product as high as you might have expected or your ability to sell is just weak. And having missed certain milestones or not being able to expand the business is at least equally bad for a valuation.

Misconception #5: valuations are a primary business concern
It is reasonable to think that you should only pursue the fields driving most revenue and thus creating most company value. And higher revenues usually drive valuations up. Nevertheless, constant business does not increase valuation. There were a couple of companies which were once valued less than the money they had in the bank. Don’t forget: valuation alone does not help you grow your business–business does.

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