The Venture Path
How can you put, keep, and lead your company on the venture capital growth path? Should you (more on this later)?
There are lots of questions around early-stage venture capital. Here are some thoughts of Tilman and me on how very early stage valuation works.
Some preconditions for this to work:
Your company can be a venture capital case.
What makes a startup a venture case? Good question — people have written entire books on this. In a nutshell, here is how we at APX look at it: market, timing, (un-)fair advantage, scalability. Let’s go in order.
First and foremost, do you have a market, and is it big enough? There are several dimensions when evaluating your market. The most obvious one is size. Based on data, you need to be able to claim that the possibility even exists for a venture case to be built. How would you be able to generate $100M in revenues in a market of only $60M in size? You won’t. Aside from size, it would be best if you looked at the growth pattern (typically calculated as a cumulated annual growth rate — CAGR), market fragmentation versus consolidation, market maturity, and entry barriers. This leads directly into the second category.
Especially in the early stages, timing is critical. When you are too early, no one will get excited, and it will be tough to develop any traction with users/ customers and investors. When you are too late, you might not be able to catch up with your competitors or — even if you have the better product — a lot of investors will have invested in the space, and you cannot build traction with investors when you need it.
An unfair significant advantage can arise from multiple sources, but the chances are that you’ll need to make use of at least one to become a venture case. True to the motto veni, vidi, vici, your startup must be in the position to climb to the top and stay there. Ways to do it? Establishing market entry barriers, as mentioned in the previous paragraph, can be a good start. A first-mover advantage should never be underestimated. However, it also carries the risk of wrong timing (see above). The ability to build moats will protect you from arising competitors. Superior technology gives you an edge over incumbents. And to add one more, although far-fetched, becoming a natural monopoly is the ultimate way to shape markets.
The last dimension doesn’t need much explanation — scalability. Whether hardware or software, whether product or service, almost all venture cases depend on the ability to perform well under increased size or scope. One of the most common characteristics are diminishing costs for unit economics.
You are willing to build a venture capital financed company.
Taking venture capital has some consequences. And it is essential, to begin with the end in mind: You will (have to) grow fast. And there will be an exit for your investors. In a perfect case, this will be a later stage IPO or sale of your company for a high valuation. If you look at the number of IPOs in Europe in the past years, you immediately see: It is more likely that you will sell your company than for you to take it public. The classic German Mittelstand scenario: growing and being profitable is not too interesting for typical venture capital investors. There are many discussions and options for the early-stage financing of young startups, but we will focus on what is most interesting for us at APX: Venture capital paths.
Let’s start with the sweet secret first: if you can show that you can sustainably and riskless turn €1 invested into €1.01, you will get all the venture capital (and most other available capital on this planet). The challenge is: although you might be convinced that you will be able to do it, you cannot prove it. So since there is no certainty, you and your investors will need to agree on a joint view on chances and risks. This usually also means you will have to give away some of your company’s shares to investors. Banks will happily lend you the money. Which, to be honest, is so much easier and cheaper than taking up venture capital. The problem usually is that borrowing the money from banks is not available to startups. Or it comes with terms and conditions that are not acceptable/ fulfillable by founders.
You need to agree on a set of assumptions that you and your investors believe will turn into reality. So what you are doing is negotiating the price of your future company “risk-discounted” for today.
Your investors will invest in you and your company because they believe in your idea, model, and ability to execute and then in the opportunity to sell their shares of your company at a ridiculous multiple.
But what about profitability?
As venture capitalists, we are interested in fast-growing companies that can invest all the capital they generate and get in their growth to drive their valuation. This usually means that if they have a business model that can create revenues (in the long run, you have to have this), the perfect state they can be in is the “state of managed profitability.” This means that they could turn profitable in a relatively short period but instead choose to focus on growth with the opportunities at hand.
Don’t get us wrong, though. Profitability is a beautiful thing.
When to raise funds?
Simple answer: when you can.
More in-depth answer: When you can find the right balance between capital and your company's percentage that you have to sell.
Again, we are assuming you want to pursue a venture path. Based on the previous paragraphs, your company will need more money to grow (faster) and have a limited runway (time until your account hits zero). Additionally, as absurd as it sounds, investors will want to see that you have to raise again to make sure that later funding rounds, i.e., jumps in valuation and exit opportunities, happen.
Fundraising takes time, and we typically say that it will eat up 70% of at least one person’s time while you’re actively at it. It’s never too early to start building a network to potential investors but consider that if you’re spending too much time fundraising without proving that you’ve progressed, it might be time wasted. Instead, make sure you have time to execute your strategy and build traction, justifying a higher valuation, but also to allow for a certain buffer before you run out of cash. Depending on the round size, funding rounds typically take between 3–6 months. This process needs to be finalized before your cash account hits zero. You can do the math.
*Slightly unrelated yet important: make sure to raise enough capital to be able to work operationally. Otherwise, you’ll have to start fundraising again right as you closed your previous round.
How to determine the valuation of a company?
This is also pretty simple: You need to find the balance between chance and risk for both the founders and investors. When we invest in a company, we do this because we think the team can turn the idea into a successful business in the current market. We also believe in the ability of the team to raise future funds with other investors. Mainly we choose to invest in the founders because we want to see them execute. And they want to build their company. They know that they will have to raise funds, but their main motivation is building, not raising.
Now we only need to find the balance: If they think their company might be worth 1 billion Euros, we might agree that this is possible. Also, most likely, they will not know how much capital they need to build the company. And we don’t know for sure that they will be able to create the company they and we are envisioning. Hence we are not willing to give them all the capital they need to build the billion Euro company.
On the other end, we have to give the company a valuation to determine how the company's shares are distributed between the founders and the investors.
This often leads to seed rounds at the early stages, resulting in 12%-20% in equity for the investors. Usually, benchmarking and capital requirements to get to the next round are the variables of choice to design early-stage financing rounds. Some market dynamics work in favor of founders: When they can show traction and thereby prove that their plans are working, it is a lot easier to negotiate valuations. If this is the third time the founders are starting a company, and the first two were major successes, it also makes things easier. Psychological effects like FOMO (the fear of missing out) sometimes work within investors.
No matter how the round is designed, both founders and investors need to make sure that the capital structure works over the future financing rounds that will most likely happen. Investors can negotiate for too much equity in a round so that the founders “over dilute” in future rounds and will not be motivated anymore. Any equity round is an opportunity to “fix” the cap-table: what about inactive shareholders (founders/ angels, etc.), or what about key employees you want to turn into “real” shareholders? Consider taxation consequences but use the opportunity to design the optimal shareholder structure for the startup.
It is not always necessary to agree on a valuation: sometimes, it might be the right decision to defer the valuation negotiation to a later point in time and raise financing using convertible instruments: the startup gets the money immediately, and the conversion into equity happens later at a discounted valuation. There are many opportunities in this, and we will most likely address the opportunities of venture debt, convertible notes, etc. in a future post.
The next step then is the negotiation and closing phase. But that’s for another post. :-)
If you are interested in learning more about us, check out our website, meet us at our online events, and meet us at in-person events (this is harder now due to Corona/ COVID19). You can also listen to some of our portfolio founders and us in our podcast series: The Early Stages (this will take you to a Medium post with direct links to all the episodes). If you are interested in working with us as your investor: send us your pitch deck here, and our investment team will be in touch shortly.