Startup investment memo

The purpose of this article.

The two-fold purpose of this article is to:

  • Provide an investment memo template for a startup investor, investment fund, or angel group.
  • Enable early stage startups to understand how they will be assessed.

This article is linked to “Due diligence questions for an early stage startup”1

You may download a PDF of this article from: Startup investment memo

There are three phases to an early stage startup.

Startup

  • A startup is a temporary organization designed to search out a repeatable and scalable business model. Lots of learning experiments are carried out. The focus is on getting some delighted cash paying customers.
  • A business model describes how a company creates value for itself while delivering products or services to customers. What are you building and for whom? What urgent problems and needs are you solving?

 Preparing to scale

The startup believes it has a business model which can meet the needs of a large number of cash paying customers. The focus shifts to putting in place cost-efficient and easily scalable technology, processes, and talent.

Scaling

The focus shifts to growing the:

  • geographies
  • marketing, sales, delivery resources and activities.
  • channels and distribution partners.
  • Customer segments.

The purpose of the Investment Memo .

Recommend whether or not the investment is appropriate to proceed to the term sheet stage. The Investment Memo is based on:

  • The answers from the early stage company to the due diligence questions.
  • Additional facts gathered from third party questions.
  • Analysis of the collected facts.
  • Investor judgement, based on a variety of criteria.

In an early stage fund, the investment memo is presented to the partners to explain why the investment should be made, or not made.

The investor will have used simple criteria to quickly filter out early stage companies before devoting time in due diligence E.g.

  • After spending less than 5 minutes reading an emailed application.
  • After a 15-minute phone call or meeting.
  • After listening to a pitch at an event.

A deal-killer recommendation.

Each investment fund will have some deal-killer criteria. If the startup-meets any one of these criteria, there is no deal.  The deal-killer criteria vary by fund.  E.g. market size is too small, founders are not trust-worthy, no potential customer interviews or surveys, etc. Deal-killer criteria could include not answering, or unable to answer, critical due diligence questions.

In this situation, the investment memo only one-page long.

Investment Memo with no deal killers – the process.

 The detailed structure of the Investment Memo follows the structure of the due diligence questions for the startup.

For each question, indicate whether the questions were answered, whether or not there are any issues, and what validation was done.  Validation can include: talking with 3rd party experts, doing independent primary and secondary research, preparing analysis separate from that submited by the startup.  I’ll indicate below some possible approaches to validation in each section of the investment memo.

There is a one-summary, which includes the recommendation.  Each section in the summary has 1-2 lines.

Recommendation: either proceed to a term sheet OR recommend not to proceed with the reasons why.

Each of the six sections in the one-page summary also contains: recommendation: yes or no and why, plus any critical read flags

  • How does the company create value for customers and itself?
  • What are the plans?
  • Investor specific
  • What is being asked of the investor?
  • Legal documents
  • Historical results.

Detailed report

Each section of the detailed report starts with the summary information from the one-page summary.

Each section/subsection of the report contains:

  • Indication of whether or not the due diligence question was answered
  • Indication of whether the answer was a “pass” or “fail”.
  • Any red flags.
  • Any input from third party experts.
  • Any input from the investors primary and secondary research.
  • Any results from the actions noted below.

#1 How does the company create value for customers and itself

Target Customers

  • Interview potential and current customers.
  • Assess market size determination (TAM, SAM, and SOM) and review sources cited.

Value proposition

  • Review some or all interview notes from potential or current customers.
  • Review some or all survey responses from potential or current customers.
  • Review analysis of interview notes and survey responses.
  • Interview potential and current customers

Channels

  • Review some or all interview notes from potential or current customers.
  • Review some or all survey responses from potential or current customers.
  • Review analysis of interview notes and survey responses.
  • Interview potential and current customers regarding their expectations.
  • Review detailed financial information to validate appropriate allocation of costs & revenue to: CAC (Customer Acquisition Costs) and calculation of LTV (Life Time Value)
  • Review calculation of the churn rate.

Key Partners

  • Interview current and potential partners.

Key resources

  • If patents, check with patent offices
  • If trademarks, run a trade mark check
  • If contracts, call third parties to validate
  • Have all required resources been identified?

Key Activities

  • Have all required activities been identified?

Cost structure

  • Assess whether the cost-drivers are in fact cost-drivers.

Charging customers

  • Review some or all interview notes from potential or current customers regarding value and pricing.
  • Review some or all survey responses from potential or current customers regarding value and pricing.
  • Review analysis of interview notes and survey responses regarding value and pricing.
  • Interview potential and current customers regarding their expectations regarding value and pricing.
  • What are competitors or similar companies charging?

Talent

  • Assess team bios for relevant skills and experience
  • Run a background check on the team.
  • Are the founders emotional or irrational under pressure?
  • Do the founders have empathy?
  • Are the founders unable to clearly and easily communicate their pitch.
  • Are the founders arrogant or overconfident?
  • Are the founders transparent and honest?
  • Are the founders fully committed or is this a part time effort?

#2 What are the plans?

  • Does the 24-month Gantt chart reflect the key milestones?
  • Is the 24-month Gantt chart plausible?
  • Review the detailed allocation of costs and revenues to validate the calculation of LTV and CAC.
  • How does the LTV to CAC ratio change in the cash flow forecast? How does it vary by customer segment, channel, and partner?

#3 Investor specific

  • Are the presentation decks (oral and standalone) consistent with the rest of the due diligence material.
  • What are the issues with the current and forecast cap table? Do the founders have enough equity.
  • What are the options for an investor exit?
  • How long has the fundraising round been open, what’s been committed, by whom?
  • Who is the lead investor and what is their reputation?
  • Are previous investors following on? If not, why not?

#4 What is being asked of the investor?

  • What are the issues regarding terms and valuation?

#5 Legal documents

  • Who has the legal right to make what kinds of decisions under what conditions? Review loan agreements, voting trust agreements, shareholder agreements, board of directors and committee mandate, delegation of authority to CEO, etc.

#6 Historical results

By target segment, by channel, by partner, by cohort.

  • Monthly growth rate in number of cash paying customers, and revenue.
  • New customer value achievement leading indicator (e.g. for Slack it was 2,000 team messages sent within 60 days).
  • New customer success metric (e.g. % of new customers achieving new customer value achievement indicator within 60-90 days).
  • NPS (Net Promoter Score)
  • How many similar competitors have failed in the past? Why? How is this startup different?

Next steps

Regardless of what type of investor you are:

  • Prepare your list of deal-killer criteria and deal-killer unanswered questions.
  • Prepare a one-page investment memo.
  • Customize the due diligence questions and due diligence report to reflect the specific nature of investor and the nature of the investment. The due diligence questions, due diligence report, due diligence cost and time invested will be very different for an angle investor contemplating a $25,000 investment in a pre-revenue company vs an investment funding contemplating a $10 million investment in a company that is scaling.

Footnotes:

1 Due diligence questions for an early stage startup: https://koorandassociates.org/selling-a-company-or-raising-capital/due-diligence-questions-for-an-early-stage-startup/

Further Reading

Definition of startup terminology and metrics: https://koorandassociates.org/selling-a-company-or-raising-capital/startup-terminology-and-metrics/

Red flags for any investor to consider:  https://medium.com/swlh/red-flag-list-for-vc-deals-9beea446270d

Due diligence questions for an early stage startup.

The purpose of this article

The two-fold purpose of this article is to:

  • Enable early stage startups, prior to scaling, to understand the due diligence questions they may encounter from an investor.
  • Enable an investor to structure a set of due diligence questions.

You may download a PDF of this article from: Due diligence questions for an early stage startup

There are three phases to an early stage startup

Startup

  • A startup is a temporary organization designed to search out a repeatable and scalable business model. Lots of learning experiments are carried out. The focus is on getting some delighted cash paying customers.
  • A business model describes how a company creates value for itself while delivering products or services to customers. What are you building and for whom? What urgent problems and needs are you solving?

Preparing to scale

The startup believes it has a business model which can meet the needs of a large number of cash paying customers. The focus shifts to putting in place cost-efficient and easily scalable technology, processes, and talent.

Scaling

The focus shifts to growing the:

  • Marketing, sales, delivery resources and activities.
  • hannels and distribution partners.
  • Customer segments.

The early stage due diligence questions are one of the inputs to the Investment Memo

The purpose of the Investment Memo is to recommend whether or not the investment is appropriate to proceed to the term sheet stage. The Investment Memo is based on:

  • The answers from the early stage company to the due diligence questions.
  • Additional facts gathered from third party questions.
  • Analysis of the collected facts.
  • Investor judgement, based on a variety of criteria.

The investor will have used simple criteria to quickly filter out early stage companies before devoting time in due diligence E.g.

  • After spending less than 5 minutes reading an emailed application.
  • After a 15-minute phone call or meeting.
  • After listening to a pitch at an event.

The  investor asks the startup five sets of due diligence questions

#1 How does the company create value for its customers and itself?  What is the company building and for whom?  What urgent customer needs and problems are being solved?

        • Target customers:
    • Who exactly will you be creating value for?
    • Who will pay you? What are the differences between users and customers segments, if any (e.g. Google – user do searches for free.  Companies pay to advertise.
    • How will they recognize themselves?
    • Who will be your most important customers?
    • What is the market size? TAM (Total Addressable Market), SAM (Serviceable Addressable Market), and SOM (Serviceable Obtainable Market)1
    • Who is your initial target segment?
  • Customer Value Proposition: A value proposition is the customers perception of value. This perception can be influenced by: facts, emotions, family & friends, social media, etc. The value proposition = (All the customer achieved benefits) / (All the customer incurred costs) All the customer achieved benefits can include problems solved, gains achieved, financial and non-financial (e.g. time savings, convenience, status, etc.) All the customer incurred costs can include financial (purchase costs, costs to switch to your company, other adoption costs, and ongoing costs) and non-financial (time, inconvenience, loss of status, etc.)
    1. What value will the customers perceive they will achieve? This is very different from your opinion as to what value you will deliver.
    2. What problems do your customers think you will solve?
    3. What customer needs will be fulfilled?
    4. Why does the customer believe the value of your solution is better than the status-quo or the competition?
    5. What does the customer believe will be the impact of your solution? E.g. 10 times improvement in something?
    6. What is your MVP (Minimum Viable Product)? What is the smallest set of urgent problems and needs you can solve for a target customer segment, while delighting the customers, and having them pay you?
    7. What is the path to enhance your MVP until you believe you have a solution that can be scaled to meet the needs of a large customer segment?
  • Customer Relationships: What type of customer relationship do your customers expect to have with you?
    1. How will customers be acquired, kept, and grown?
    2. Why type of relationship does each customer segment expect you to establish and maintain? ? g., if it’s a software product, how often will there be updates with new features?  How easy will it be to install a new version?  Will customer service be a chatbot or a live person?
    3. What types of relationships have you already established?
    4. What is the cost of each type of customer relationship?
    5. What is CAC – customer acquisition cost?
    6. How many customers are you losing – churn rate?
    7. What is LTV – lifetime customer value? In the initial startup stages, LTV will be less than CAC, because of the need to obtain an initial pool of customers by doing inefficient things that don’t scale.  As the startup is getting ready to scale, it will have figured out how to make LTV exceed CAC.
  • Channels: Channels are how to connect the value proposition to the target customer. There are three different types of channels. Communications – used to communicate with potential customers.  There may be many communications channels. Sales – where customers and sellers agree on the transaction. Usually there are fewer sales channels than communications channels. Logistics – how to deliver the solution to the customers.
    1. Through what types of channels do the customers want to be reached? In other words, what channels are most effective? E.g. website, app, social media, face-to-face, marketplaces, etc.
    2. What channels already exist?
    3. Which channels are most cost efficient?
    4. Which channels are integrated with customer processes?
  • Key Partner: A channel may also be a partner, if the answer is “yes” to one of the following questions: Is the partner a leading entity with a brand and market position that adds to your credibility? Does the partner add expertise and resources to your solution in a way that increases the value of the solution for the end customer? Is the partner (and their brand/expertise/resources) required to land a contract with the key target customers?
    1. Who are the key partners?
    2. Who are the key suppliers?
    3. What key activities, supporting your value propositions, to your partners perform?
    4. How effective are your current partners and suppliers?
    5. What types of partners and suppliers do you need?
  • Key Resources: Resources mean any relevant intellectual property (IP), technical expertise, human resources, financial and physical assets, key contracts and relationships. In other words, resources refer to anything within your control that can be leveraged to create and market your value proposition (e.g., a patent pertaining to your value proposition, key contacts within the industry).What resources are necessary to:
    • Enable the customer to achieve their value proposition?
    • Maintain channels and partnerships?
    • Build relationships with customers?
    • Build revenue?
  1. What resources exist today?
  2. How effective are they?
  3. What are the plans to close the gaps?
  • Key Activities: What are the key activities to enable customers to achieve their value proposition, and generate revenue for the startup. What key activities are necessary to:
    1. Enable the customer to achieve their value proposition?
    2. Maintain channels and partnerships?
    3. Build relationships with customers? Marketing? Sales, Customer service?
    4. Build revenue?
    5. R&D?
    6. Billing?
    7. What activities exist today?
    8. How effective are the current activities?
    9. What are the gaps and plans to close the gaps?
  • Cost structure: What is the cost of delivering the value proposition, including the resources needed and key activities involved.
    1. What are the largest costs?
    2. What are the fixed costs and variable costs?
    3. What activities are the costliest?
    4. What resources are the costliest?
    5. What is the burn rate? (i.e. excess of costs minus revenue)?
    6. What is the runway? (i.e. how many months before all the cash is gone)
  • What will you charge your customers and how will you charge your customers?
    1. What is the value the customers are willing to pay for?
    2. How much are they willing to pay?
    3. How much are they paying today?
    4. What is the pricing model? Subscription, one-time, freemium, advertising, etc.
    5. What are the revenue streams? These could include: subscription-based per person per month, free for a basic service, with multiple tiers of extra services with fees, etc.
    6. How are they paying today? Cheque, credit card, etc.
  • Who is the talent and how are they relevant to the startup’s success?
    1. Appropriate biographies of the management and advisors.

 #2 What are the plans?

  • Gantt chart on one page of the next 24 months.
  • Cash flow forecast. There may be multiple cash flow forecasts illustrating multiple scenarios.

#3 Investor specific

  • Oral presentation deck which supports the oral presenter and is not intended to be read on its own.
  • Standalone presentation deck is intended to be read on its own and therefore has much more information than the oral presentation deck.
  • Cap table lists out each type of equity ownership capital, the individual investors, and the share values. A more complex table may also include details on potential new funding sources, mergers and acquisitions, public offerings, or other hypothetical future transactions.

#4 What is being asked of the investor?

  • Type of capital and amount?
  • Being lead investor?
  • Serving on board or advisory board?
  • Access to investor’s network of other investors, customers, employees, etc.?

#5 Legal documents

e.g. Charter documents, corporate organization, etc.2

#5 Historical results

Company history, past milestones, historical growth, etc.

 Your Next steps

  • If you are a startup, immediately begin to organize your data room to be able to address potential investor due diligence. The bulk of the information in your data room will also help your startup succeed.
  • If you are an investor, create your list of documented due diligence questions.

Footnotes

1 This article contains definitions https://koorandassociates.org/selling-a-company-or-raising-capital/startup-terminology-and-metrics/

2 This is a sample legal due diligence checklist  http://www.1000ventures.com/venture_financing/due_diligence_checklist_byvpa.html

Startup terminology and metrics.

Startup terminology and metrics.

 The purpose of this article

This article has a two-fold purpose:

  • Provide definitions of startup terminology and metrics. My various articles will refer to this article, which means that I don’t have to include definitions and metrics in each article.
  • Enable a startup to quickly create its own set of terminology and metrics

You may download a PDF of this article from: Startup terminology and metrics

What is a startup?

A startup is a temporary organization designed to search out a repeatable and scalable business model.

A business model describes how a company creates value for itself while delivering products or services to customers.  What are you building and for whom.  What customer problems are your solving? What customer needs are you addressing?  What benefits and value are you enabling customers to achieve?

A startup evolves

  • The startup phase, which concludes with the determination that you have discovered a business model that can be scaled and that has a large number of potential paying customers. Many startups fail before this phase completes.
  • The getting ready to scale phase concludes with the having the talent, technology, and processes to enabling profitable scaling.
  • The scaling phase, focuses on increasing the number of geographies, distribution channels, partners, and customer segments combined with marketing and sales investments.

MVP (Minimum Viable Product)

A product or service with just enough features to have delighted early cash paying customers by enabling them to solve some urgent problems, and to have obtained customer feedback for future development

 Customer Metrics

New customer value achievement leading indicator (e.g. for Slack it was 2,000 team messages sent within 60 days).

New customer success metric (e.g. % of new customers achieving new customer value achievement indicator within 60-90 days).

 NPS (Net Promoter Score) The single most important question is asking  “Would you recommend our solution to others?”  (Follow on questions could be “If so, why?  If not, why not?”) This metric is known as NPS.  What is your NPS? Above 0 is good. Above 50 is excellent. Above 70 is world class. How do you compare to your industry and competitors? What has been your NPS trend?

The Net Promoter Score concept was initially developed by Bain.  The following is a link to the Bain website homepage for Net Promoter Score, which contains several short articles:

http://www.netpromotersystem.com/about/why-net-promoter.aspx

The following is a quick overview of using Net Promoter Scores:

https://www.forbes.com/sites/shephyken/2016/12/03/how-effective-is-net-promoter-score-nps/#1b1391b423e4

Market Size

Market size = (The number people (or organizations) with an urgent problem or need that they are willing to spend money) times (the amount they are both willing and able to spend).

What is TAM (Total Addressable Market)?

  • What would be the startup’s revenues with their future solution if 100% of the customers demanding a solution to their problem bought startup’s solution. This assumes all potential geographies, distribution channels and partners.
  • Is the startup’s TAM large enough to launch and grow the startup? For example, the global smart phone TAM is huge, but the global TAM for smart phones that have a keyboard is tiny.
  • The best way to calculate TAM is with a bottom up calculation, starting with a clear description of the target customer segments, its needs, and then considering the subset of customers who will actually provide revenue, and the revenue per customer. Recognize not everyone in every country will be able to afford the solution.

What is SAM (Serviceable Addressable Market)?

  • This is the portion of the TAM that is within the reach the startup’s geographies, distribution channels, and partners, and your ability to deliver and support your solution. This still assumes 100% market share of those customers demanding a solution. SAM will change over time, as growth occurs in geography, the number of distribution channels and partners, and the volumes from each distribution channel and partner.

What is SOM (Serviceable Attainable Market or Share of Market)?

  • SOM will be lower than SAM for three reasons: there will be competitors, customers who are demanding a solution may not actually buy a solution, and there will be an adoption rate ranging from early innovators to laggards.

TAM, SAM, and SOM will vary at different points of the 5-year forecast.  TAM, SAM, and SOM will also change as the startup validates assumptions by progressing through: initial assumptions, customers interviews, feedback from prototype in customers hands, feedback from initial revenue producing customers, feedback from MVP, customer feedback as solution capabilities are enhanced to provide value to a greater set of customers, etc.

 

NPS (Net Promoter Score) The single most important question is asking  “Would you recommend our solution to others?”  (Follow on questions could be “If so, why?  If not, why not?”) This metric is known as NPS.  What is your NPS? Above 0 is good. Above 50 is excellent. Above 70 is world class. How do you compare to your industry and competitors? What has been your NPS trend?

The Net Promoter Score concept was initially developed by Bain.  The following is a link to the Bain website homepage for Net Promoter Score, which contains several short articles:

http://www.netpromotersystem.com/about/why-net-promoter.aspx

The following is a quick overview of using Net Promoter Scores:

https://www.forbes.com/sites/shephyken/2016/12/03/how-effective-is-net-promoter-score-nps/#1b1391b423e4

Financial Metrics

Burn Rate and Runway

The monthly burn rate is the amount of cash the startup is losing each month.  Burn rate = revenue – expenses.

Runway is when you run out of cash.  There are multiple runway scenarios e.g. revenue and expenses remain constant; forecast revenue vs forecast expenses.  There may be multiple forecasts.

 CAC (Customer Acquisition Cost) includes all the costs to acquire a new customer:

  • Sales.
  • Marketing.
  • Onboarding.
  • Related compensation of the people.
  • Overhead associated with the people.
  • Technology to support CAC.
  • Legal expenses associated with sales and marketing.

LTV (Life Time customer Value)

What is the lifetime customer profit, after customer acquisition?  This will take into account churn.

A scalable business model is one in which LTV exceeds CAC.

Churn is the % of paying customers who leave each month.  Your target should be at most 2% per month churn.  5% per months means you are in trouble.  You must figure out and fix the churn problem if you hope to grow your company.

COGS (Cost of Goods Sold) What comprises cost of COGS? Everything required to meet the direct needs of current customers.  E.g.

  • Customer support people, and software
  • Technology e.g. software, cloud services, communications costs.
  • Bug fix and minor enhancement to the software – after all you do need to retain current existing customers.

CAC is not part of COGS.

G&A (General and administration) What comprises G&A?

  • Payroll administration.
  • Recruiting administration.
  • Finance
  • IT security.
  • Corporate development e.g. M&A.
  • CEO salary/benefits.
  • Legal expenses (both in house and external), other than those associated with sales contracts.

R&D/Engineering/new Development?

All of the costs associated with discovering major changes to the business model and enhancing the solution.

Gross Profit Margin

(Revenue minus COGS) divided by revenue.

Let’s use QuickBooks to illustrate the concept of the financial metrics.

There is a GL line item for salaries.

Then then there is a class i.e. where does the salary belong?  (i.e. QuickBooks class)

  • CAC?
  • Cost of goods sold?
  • R&D/Engineering/new Development?
  • G&A?

Next steps

Create definitions and metrics for your startup.  This will help everyone (founders, employees, advisors, investors, etc.) have a common understanding about you actually mean when you use certain words.

How does a startup raise capital from investors?

The purpose of this article is to provide a framework for startups to create their specific plan to raise capital from investors.   You may download a PDF of this article from: How does a startup raise capital from investors

This article has a limited scope and does not address all situations.

  • The focus is on startups, not established companies raising billions from an IPO or Private Equity.
  • The assumption is that the startup is not bootstrapping i.e. launching and growing the startup using the founders’ personal savings and borrowing combined with friends and family.
  • The types of investors include: individual investors, angel investor groups, various types of investment funds including venture capital, and family offices.
  • This article does not address government funds (loans, grants, tax credits, etc.), accelerators which invest equity, venture studios1, corporate venture capital2, listing on a stock exchange, crowdfunding, etc.
  • This article does not address the many different types of capital: common stock, preferred stock, convertible notes, venture debt, SAFE, etc.
  • This article refers to fact-based research. This research is from the U.S.  I was not able to find applicable fact-based research for the Toronto ecosystem.

The startup may utilize multiple sources and types of capital.

What can you learn from fact-based research?

200 startups that successfully closed their round.4

  • The average seed stage round takes 12 ½ weeks.
  • 20% of the startup require 20 weeks or longer.
  • 20% of the startups require 6 weeks or less.
  • The longest successful round raise took 40 weeks.
  • Approximately 90% of the startups closed their round by contacting less than 75 investors.
  • Companies that failed to raise a round gave up after an average of 6.7 weeks.
  • Funding led by a seed stage fund is more efficient that one led by angel investors. (average time to fundraise: 9.6 weeks vs 13.5 weeks; average number of investors contacted: 29 vs 68; average number of investor meetings: 27 vs 45; average money raised: USD $2 million vs USD $989,000). However only 3% of seed stage startups are funded by seed stage funds.
  • The average time spent by an investor to read a pitch deck is 3 minutes and 44 seconds, with 12% of investors reading the deck on their phones.

The key implications are:

  • If you have not closed your round after contacting 100 investors, you must do a fundamental rethink about whether or not you have a viable startup or whether your targeting the wrong types of investors.
  • Don’t give up early. 20% of the time it may take 20 weeks or longer.
  • You must research to understand what each seed fund is looking for. Your pitches and material should answer the fund questions before they ask them.  My observation is that many startups don’t do this research and as a result are quickly eliminated by the seed funds.

How much time should you target between fundraising rounds?5

A fund-raising round can take a long time. This research study examined 13,916 financing events.

  • The average time between fundraising rounds was 20.6 months.
  • The time between rounds ranged from 6 months, to 35 months, 68% of the time. e. 16% of the time less than 6 months and 16% of the time longer than 35 months

What are the 3 greatest contributors to startup failure?6

This research study analyzed 101 startup failures and identified the most frequently cited reasons for failure.  Usually there were several reasons for failure.

  • 42% of the time built a solution looking for a problem i.e. no market need.
  • 29% of the time running out of cash.
  • 23% of the time, not the right team.

My personal observation is that I’ve lost track of the number of startups where:

  • The only understanding of the market size is a slide they copied from a consulting firm that said the market size was $10s of billions. Seed stage funds immediately eliminated these startups because there was no understanding of market need or size.
  • There was no monthly cash flow forecast which considered the length of time required to raise capital and the time between fundraising rounds.
  • The founding team was incomplete and could not communicate their relevant experience.

Few pre-revenue companies are funded by third parties

  • Only 3% of angel funded companies are pre-revenue.7
  • There are pre-revenue funds, but they represent a tiny fraction of all funds.

My own observation of angel investments is that the majority go to revenue generating companies.

The framework for raising capital has 13 stages.

The 13 stages overlap and are not all sequential.

Stage #1 24-month cash flow forecast, by month with monthly milestones – this is a minimum time frame

  • The cash flow forecast reflects the time necessary to raise capital and time between financing rounds.
  • Plan to use your own funds, plus friends and family funds, to get your company to the point of have a few delighted cash paying customers.
  • The planned milestones reflect the major accomplishments investor would expect to see. There is a clear relationship between capital used and business accomplishments.

Stage #2 Decide upon the types of capital and capital sources in this round

Define your requirements for an investor e.g.

  • Are they a lead investor?
  • Do they have they same values and interests in growing your business as you do?
  • How soon do they want to exit?
  • What is there reputation?
  • Are they easy to work with? What do other startups say about them?
  • Should they have relevant industry experience?
  • What functional experience should they have?
  • What capability should they have to introduce: other investors, potential customers, potential suppliers and partners, potential employees, etc.
  • Should they have the financial capability to continue to invest in future rounds?
  • What value could they provide on a board of directors or advisory board?

Stage #3 Build your information pyramid8

  • The information pyramid outlines the varying types and quantities of information the startup communicates to potential investors. This includes the various types of oral and written pitches.
  • The top of the pyramid has limited information, with each succeeding layer having more.
  • The pyramid includes your data room for due diligence.
  • A startup has a plan and process for managing this information pyramid with potential investors.
  • The approach varies depending upon the stage of the startup e.g., a founder dealing with friends and family is different from a billion-dollar IPO.

Stage #4 Prepare a list of capital sources

  • All your existing investors are potential capital sources.
  • Based upon your requirements from Stage #2, prepare a target list of capital sources.
  • Try to make this target list global in scope. Angel groups from the U.S. are investing in Toronto startups. Some global funds from the early stage to post Series A are investing in Toronto. Many U.S. funds are investing in Toronto.

Stage #5 Arrange warm introductions and send out cold call emails

  • Only 12% of closed deals result from cold call emails to funds. Warm introductions are critical to fundraising success.9
  • You have to research your own network to find out who knows someone at your target investors.
  • Touch base with those people. Send them an email which they can forward to the target investor they know.
  • Use a CRM to manage the amount of information you’re collecting, and people you’re phoning and emailing.

Stage #6 3 weeks of non-stop meetings

Schedule investor meetings for a 3-week period.  Your CRM will be crucial

You will be totally consumed during this time,

Stage #7 Investor Due diligence

  • Interested investors may conduct due diligence within 3 weeks.

Stage #8  Term sheet negotiation and agreement

  • Negotiating and finalizing a term sheet may take up to 6 weeks.
  • At least one of your advisors needs to assist you as you contemplate business terms.
  • A lawyer with deep experience in startups is valuable.

Stage #9 Get the money in the bank

  • Fundraising is only complete once you have the money in the bank. Some founders have told me that they’ve had investors who failed to actually provide the money.

Stage #10 Implement your revised governance framework

  • Your investors may be involved in decisions. This decision-making involvement must be documented to ensure a common understanding, along with establishing the necessary processes.
  • Your investors may also have stated their ongoing information requirements. You’ll need to put the necessary processes in place.

Stage #11 Send out monthly updates to potential investors8

  • You must stay in touch with the investors who did not invest.
  • Your monthly update demonstrates month by month accomplishments, with the focus on increases in the number of customers and revenue.
  • Consider including advisors and others in this monthly update.
  • Your CRM will manage who you send the updates to and track who actually opens them.

Stage #12 Send put monthly updates to existing investors10

  • You must send out monthly updates to those who have entrusted you with their money.
  • Do this even if its only friends and family.
  • Your CRM will manage who you send the updates to and who actually opens them.

Stage #13 Keep the information pyramid up-to-date, especially the pitch deck

  • You will need to enhance your CRM to meet the additional information reporting requirements of your investors,
  • You never know when an investor that you’ve decided you want, will express major interest.
  • You have to be ready.

Your next steps

  • Prepare your 13-stage fundraising plan to reflect your startup’s specific situation.
  • Implement a project management tool and CRM.

Footnotes

1 A venture studio is an organization that creates startups, typically by identifying a market need, assembling the initial team, strategic direction and providing the capital to launch.

2 Corporate venture capital is where a large firm takes an equity stake in a small but innovative or specialist firm, to which it may also provide management and marketing expertise; the objective is to gain a specific competitive advantage.

3 SAFE stands for Simple Agreement for Future Equity. At the early stage of a startup, it can be difficult to accurately assign a value to the company because there is usually very little data. A SAFE is a form of convertible security that allows you to postpone the valuation part until later on. A SAFE is neither debt nor equity, and there is no interest accruing or maturity date.

4“What we learned from 200 startups who raised $360 million”, Professor Tom Eisenmann, Harvard Business School, and DocSend

5 https://medium.com/journal-of-empirical-entrepreneurship/how-much-runway-should-you-target-between-financing-rounds-478b1616cfb5

6 https://s3-us-west-2.amazonaws.com/cbi-content/research-reports/The-20-Reasons-Startups-Fail.pdf

7 Angel Capital Association and Hockeystick, “2019 ACA Angel Funders report “

8 This outlines the various components of the information pyramid. https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/how-does-a-startup-communicate-with-potential-investors/

9 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, April 2017, Page 41  This survey of VC firms included: 63% of all VC US assets under management, 9 of the top 10 VC firms and 38 of the top 50 VC firms.

10 https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/how-can-portfolio-companies-update-investors/

Valuing a pre-revenue startup

You can download a PDF of this article from: Valuing a pre-revenue startup

The purpose of this article is to:

  • Help investors value pre-revenue startups
  • Help pre-revenue startups understand what makes a fundable pre-revenue startup and what they need to communicate to pre-revenue investors.

There is very limited angel investment in pre-revenue companies.1

  • Only 3% of angel deals were done with pre-revenue companies.
  • 60% of angel deals were done at the seed stage and 25% at the Series A stage.
  • The average pre-revenue valuation was $4 million U.S.

An individual pre-revenue startup must have the potential to provide an angel investor with an average of 33 times their return on invested capital. 

  • Luis Villalobos studied 117 investments made by 4 angel investors, who invested a total of $9,936,534. 101 investments, totaling $8,646,402 returned a total of $5,614,653 – a loss of 35%. Average time to exit was 2.9 years,
  • The remaining 16 investments, totaling $1,290,132 returned $42,926,748 – a cash on investment return of 33.3, with an average time to exit of 8.6 years.
  • The overall investment portfolio return was $51,092,249 on the $9,936,534 investment – a cash on investment return of 5.1X. The IRR is about 22%, given the 8.6 years to make profitable returns. The IRR does not consider the time devoted by the angels to selecting and managing their investments nor any out of pocket costs.
  • Luis’s study is illustrative. The number of angels and investments is not statistically significant.
  • Broader research of U.S. angel groups has shown than when the group does more than 40 hours of due diligence per startup, cash on investment returns for the group is 7.1X2

The pre-revenue startup must have the potential to achieve an exit valuation of 100 to 150 time its pre-revenue valuation.

The angel investor is targeting an average cash on investment return of 33 times.  The dilution efforts of later round investments tend to be a factor of 3-5 therefore the pre-venue startup needs an exit valuation of 100-150 times its pre-revenue valuation in order for the angel investment to grow 33 times.

There are many challenges to valuing a pre-revenue company

  • There are very few facts and no historical trends, due to the fact that there is no revenue. Quantitative analysis it not possible,
  • Financing can be in different forms: common stock, preferred stock, SAFE (Simple Agreement for Future Equity)
  • Liquidation preferences may vary.
  • What is the value of having a board seat?

The Scorecard Valuation Method by Bill Payne (October 2019 revision)3

Bill Payne has developed a method for thinking about the valuation of a pre-revenue startup.  This method depends upon the knowledge and judgement of the investors.

General concepts

  • The method is a process to use the angle investor’s judgement to determine a valuation.
  • The method is not a spreadsheet which analyzes numerical data.
  • A valuation is always determined, unless there is a deal killer resulting in the startup being rejected with no valuation.
  • Each investor may have their own weights, scoring criteria and scores.
  • Each investor may have their own deal killers e.g. one fund only invests when the startup CEO has already been a CEO, another fund only invests if the CEO has a coach.
  • The method does not make an investment recommendation. The investment decision depends upon many factors including due diligence.
  • As noted above, there are many challenges to valuation. The method only considers some of the factors.
  • Valuation is ultimately a judgement call.
  • 70% of the valuation assessment is based on: team, opportunity size, and the solution. 30% of the 70% is for the team.  The team needs to have the ability to learn and change as they may need to focus on a different submarket with a different solution.  25% of the 70% is for the size of the opportunity.  The opportunity must be large in order to have an exit valuation of 100 to 150 times pre-revenue valuation. 15% of the 70% is for the solution.  Funding is only available if there is a great solution with the potential for massive growth.

The Scorecard Valuation Method has 5 steps

Step #1 Calculate the median pre-money valuation for pre-revenue startups

There are many sources for this information: e.g. the historical facts from an angel group, the U.S. “Angel Funders Report” by the Angel Capital Association”.

Then you need to think about adjustments e.g. Should Toronto valuations consider valuations from other cities and countries?  Should adjustments be made for the type of startup – AI vs Fintech vs healthcare?

Step #2 Score the target startup vs the average pre-revenue startup.

Score the target startup in terms of better or worse than the average startup.

A draft set of scoring criteria is in “Appendix Scoring Criteria”.  Those are the criteria used by Bill Bayne.2

Step #3 Multiply the Weighting by the Scoring to obtain the Weighted Score.

Step #4 Sum the individual Weighted Scores to obtain the Total Weighed Score.

Step #5  Multiply the median pre-revenue startup valuation by the Total Weighted Score to obtain the valuation.

The following is an example:

You can view the table if you download the PDF from: Valuing a pre-revenue startup

If the median pre-revenue startup valuation was $4 million, then this target company would have a valuation of $4.6 million.

Investors – your next steps

Customize the method and incorporate into your investment analysis process.

Startup – your next steps

  • Ask your advisors to customize the process and then assess your startup.
  • Enter your startup’s data into Gust.com (a platform which connects startups with angel groups and other funders). Use the free evaluation tool to asses your startup.
  • An educational illustrative valuation tool is available at https://www.caycon.com/valuation

Footnotes

1 Angel Capital Association and Hockeystick, “2019 ACA” Angel Funders “, Pages 4,7 Report”https://www.angelcapitalassociation.org/angel-funders-report/

2 Matthew C. Le Merle, Louis A. Le merle, “Capturing the expected returns of angel investors in groups December 2015 “ https://koorandassociates.files.wordpress.com/2020/03/7340d-fiftherawpfinal-c.pdf

3 Bill Payne https://www.angelcapitalassociation.org/blog/scorecard-valuation-methodology-rev-2019-establishing-the-valuation-of-pre-revenue-start-up-companies/

Appendix Scoring Criteria

You can view the three page table of scoring criteria if you download the PDF from: Valuing a pre-revenue startup

How does a startup communicate with potential investors? V2

The purpose of this article is to outline the various types of messages and information a startup may communicate with potential investors.

You may download a PDF of this article from: How does a startup communicate with potential investors V2

 Communications with potential investors is based on the information pyramid.

The information pyramid outlines the varying types and quantities of information the startup communicates to potential investors.  The top of the pyramid has limited information, with each succeeding layer having more.  A startup has a plan and process for managing this information pyramid with potential investors. The approach varies depending upon the stage of the startup e.g., a founder dealing with friends and family is different from a billion-dollar IPO.

The information pyramid has eight layers:

Layer 1: The one sentence pitch

“My company (company name) Is developing (a defined offering) to help (a target audience) (solve a problem) (with secret sauce).”

The one sentence pitch is further described in this link to the Founder Institute:

https://fi.co/madlibs

Layer 2: The elevator pitch

This 20-30 second summary will enable investors to decide whether to learn more about the CEO and the startup.  The investor decision is based on:

  • The key words include: the CEO’s name, company, solution, target customer, the problem/need being solved, and suggested next steps.
  • How the CEO speaks e.g., does the founder immediately start a one-way broadcast vs first learning about the investor, tone of voice, body language, etc.?

If the investor doesn’t like the founder, chances are there are no next steps.

Layer 3: The pitch deck which supports an oral presentation

This pitch deck is designed to support the oral presentation by CEO to investors. There are lots of graphics and images, with limited detailed information.  This deck is not designed to be read as a standalone document.

Layer 4: The executive summary

The executive summary is a 1-2 page document designed to be read as a standalone document.  This summary contains a broad range of information including: the target customer; customer segments; the customer problem; the solution; business model; sales & marketing strategy; competitors; competitive advantage; financials, etc.

The CEO must clearly, simply, and briefly communicate the most critical points, which will result in an investor wanting to meet and learn more.

MaRS has a document which outlines the creation of an executive summary:

https://learn.marsdd.com/wp-content/uploads/2010/12/The-Business-Plan-Executive-Summary-WorkbookGuide.pdf

The Gust website provides a structure for creating an executive summary.  Gust is an information sharing platform which connects accelerators and angel investor groups with startups. The website also has an automated tool to analyze the executive summary.  .

www.gust.com

Layer 5: The Oral presentation and standalone pitch deck

The oral presentation conveys far more information than the Layer 2 pitch deck. The CEO also has the challenge of building relationships with the investors. During the Layer 4 presentation potential investors are considering: how the founder communicates, their confidence, how questions are answered, etc.  Investors are thinking things such as: Do I want to work with the CEO? Do I trust the CEO?  Does the CEO have a deep understanding of the customers, their problems, and the startup’s solution?

U.S. research shows that investors will spend an average of 3 minutes and 44 seconds reading a pitch deck that has been sent to them.  The deck should be between 10 and 20 pages.  The startup CEO has only a few minutes of reading time to generate interest so that the investor wants to have a meeting to learn more.

Layer 6: The Business model canvas

The business model canvas is the story of who your customer is, why they buy from you, and how you make a profit. The canvas consists of both narrative text and numbers, with assumptions and facts.  On day 1, the canvas may be entirely assumptions – the canvas evolves rapidly as the startup validates or invalidates assumptions.  One page may be enough for the canvas.

The canvas has nine components:

Customer segments; customer value proposition; customer relationships; channels; key partners; key resources; key activities; cost structure; and revenue streams.

Further information on the business model canvas is available at:

https://koorandassociates.org/tools/what-is-a-business-model/

Layer 7: The business plan

The business plan includes details on how the company will be built. A critical part, from day 1, is the monthly 24-month cash flow forecast, with key milestones.  The value of the forecast is ensuring that the startup does not run out of cash.  Many startups underestimate both when revenues appear, and when investors provide capital.

The business plan outlines how the business model canvas will be created, and where the limited resources will be deployed.  The CEO must decide which are must-dos vs nice-to-dos, and what is good enough.

MaRS has a template for a business plan:

https://learn.marsdd.com/article/are-business-plans-for-raising-money/

Layer 8: The data room

The data room contains the documents required by investors for their due diligence. The National Angel Capital Organization has an example of the contents of an online data room:

https://www.nacocanada.com/cpages/common-docs

A later stage startup will require more information in the data room.

Monthly communications with potential investors

The primary focus of many investors is customers and customer engagement.  The question in the investors’ minds is: are there a large number of potential customers that would need to buy a solution.  If there aren’t customers with a problem they are willing to pay solve, there is no viable startup.

The purpose of monthly communications with potential investors is to generate interest so that the investor wants to meet again.  A startup with an ever-growing set of customers generates this interest.  The monthly communications do not and must not answer every possible investor question.  Investors will be getting many of these communications and have limited time.  They may well be reading the update on their phone.

The monthly update has historical customer engagement growth, the milestone(s) achieved in the past month and the milestone(s) for the next month.  This enables investors to determine if you accomplish what you say you will accomplish.  An investor red flag is a CEO not achieving what the CEO said they would in the next month.

Customer engagement at the pre-revenue stage may include:

  • The number of potential customer interviews (these are not sales calls). An investor red flag is not interviewing customers to validate that they have a problem they are willing to pay to solve, and that there are a large number of these customers.
  • Potential customer survey results.
  • Website metrics such as number of people reading specific content.
  • Number of potential customers following your blog, signed up for your newsletter, etc.
  • Letters-of-intent from potential customers.
  • Numbers of potential customers and users in your pilots.

At the revenue stage with a minimum viable product, the key metrics include:

  • The number of cash paying customers.
  • Customer churn.
  • Customer retention.
  • Net promoter score. An investor red flag is if the current customers would not recommend the company.  One investor said they look for startups where the customers are “foaming at the mouth” in enthusiasm for the startup.

This monthly communications to potential investors contains a small subset of the information going out to existing investors.  Send these emails the same day and time each month.

Potential investors have other ways to learn about your startup

The communications the startup is doing with other startup ecosystem members may also end up with potential investors.  These types of communications include: advisor and advisory board updates, board of directors updates, customer and supplier updates, employee updates, website updates, press releases, presentations at seminars and conferences, updates on social media, etc.

The startup ecosystem members may be doing their own communications.  For example, employees posting comments on Glassdoor.

 Your next steps

  • From day 1, start to organize your information in the pyramid.
  • The information and messages will be in different layers of your pyramid. Determine how you will keep your information and messages in sync.
  • You will be communicating with different members of your ecosystem. Determine how you will keep your information and messages in sync.
  • To minimize work and minimize confusion in your ecosystem, seek to re-use information and messages rather than creating content from scratch.

Further reading

“Finding new investors” https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/finding-new-investors/

Finding new investors

The purpose of this article is to outline how a startup can find new investors.

You can download a PDF of this article from: Finding new investors

Building relationships with potential investors is the foundation for raising funds.

What is the source of VC’s (Venture Capitalists) closed deals?1

  • 12% of closed deals resulted from a startup making an application.
  • 65% came from referrals and the VC’s professional network.
  • 23% are proactively self-generated by the VC.

Warm introductions to VCs are the most likely way to result in a closed deal.  A warm introduction comes from someone the VC knows and whose recommendation the VC trusts.

Building a trusted relationship takes time

Investors give money to those they trust.  It takes time for the startup founders to build that trusted relationship.  The founders need to contact investors before they need money is needed, update the potential investors each month, be honest and transparent, and achieve the short-term milestones they said they would achieve.

You will have to contact and meet a large number of potential investors

The statistics for an average seed round raise in a U.S. study were2:

  • 58 investors contacted
  • 40 meetings with investors
  • $1.3 million raised
  • 5 weeks to close.
  • The average pitch deck was 19.2 pages
  • The average time an investor spent to read the pitch deck was 3 minutes and 44 seconds.

There are six ways to connect with potential investors

#1 Introductions from your lead investor

Your lead investor has the reputation of investing in good startups and also knows a number of other startup investors.  Your lead investor will make the effort to draw in other investors.

#2 Warm introductions from someone the investor knows and whose recommendation the investor trusts

The following email template is what you send to the person doing your warm introduction. The only work they need to do is forward your email

A sentence regarding catching up/meeting/talking with your contact.

 One sentence bio regarding a big achievement in your career relevant to your startup.

 Three sentence paragraph about your startup.  Your one sentence pitch.  Customer traction growth plus a milestone or two.  What you’re seeking e.g. seed stage investor.

 One sentence thanking your contact for their introduction to XYZ.

 A paragraph regarding XYZ showing what you’ve learned about them and why they might be interested in your startup.  Ideally you could provide some value to the investor e.g. knowledge or someone they’d value connecting with. This could take a couple of hours of research.

#3 Presenting at pitch competitions and other events with investors

This can include events such as: demo day at your accelerators, a booth at Collision.  Identify potential investors who are interested in you.  Suggest a follow up call or meeting.  Get their contact information and follow-up within 24 hours.

#4 Attending events where investors attend

You and the investors are all part of the audience.  Events can include: pitch competitions, conferences, etc. For you, this is a non-pitching situation.  Let’s assume there are a large number of investors present and you’d like to meet as many as possible.  Carefully plan out your three-minute meetings.  The objective or each meeting is to create a relationship, not to make a pitch.  The different stages of the three minutes are:

  • Initial introduction: smile, be enthusiastic, and be 100% focused on the investor.
  • Learn about the investor: be curious and ask questions such as; why they are at the event. Do not pitch.  It would be great if you’re able to provide some value to the investor e.g. knowledge or someone you can introduce them to.
  • Wait for them to ask about you. Then share your one sentence pitch followed by one sentence regarding customer traction, major milestone achieved and what you’re seeking e.g. a seed investor.
  • See how they respond. If they are interested and ask more questions about your startup, you have a prospective investor.  If they are not interested, and do not ask questions about your startup, do not pitch your startup.
  • Meeting conclusion: For prospective investors, you’ll need to judge the appropriate request for next step. Your options are: are meeting, a call (Zoom, Skype, or phone) or an email.  Get the prospective investors business card with contact information, or connect on LinkedIn immediately.  You will be doing no follow-up with non-prospective investors.

Within 24 hours of the meeting, follow-up with the prospective investors.

#5 Scheduled meetings with investors at events

Conferences and other events often enable startups to schedule meetings with investors.

#6 Cold call emails.

The goal of a cold call email is to generate sufficient interest to get a reply back and begin an email conversation.  This is the beginning of a trusted relationship. The goals are not to set up a meeting, get a check, etc.  The cold call email do’s and don’t include:

The cold call email must be short enough to be read within 60 seconds.  An email which takes two or more minutes to read will be deleted by the potential investor because she simply does not have time to read the large number of emails coming in.  The potential investor must be able to read the email, think about it and reply within 2 minutes.

The template for the cold call mail is:

  • Write a subject line than generates interest. If your subject line, does not generate interest, your email may be deleted. The investor often will read your email on her phone. The first 30-40 characters of the subject line are key and you only have about 90-100 characters to generate interest. The two most important things in the subject line are: customer traction and your ask e.g., “$1 million ARR, seeking seed VC”.
  • The first paragraph describes the problem being solved.
  • Next a paragraph with bullets of key metrics e.g. customer traction growth, revenue growth, key milestones achieved.
  • Next a paragraph of what the company does.
  • Then a paragraph showing what you’ve learned about the investor and why they might be interested in your startup. Ideally you could provide some value to the investor e.g. knowledge or someone they’d value connecting with. This could take a couple of hours of research.
  • Concluding with an ask for call or meeting.
  • Attached the pdf of your pitch deck. Do not have a link to your pitch deck.

Some do’s and don’t to consider for your email are:

  • Build a list of potential investors and research them. Do not contact investors who would not be interested in your type of startup e.g., the investor only funds U.S. headquarters companies and your headquarters is in Canada. Research the potential investor to understand what they want. What have they said about their investment targets: industries, geographies, technology, stage of company, types of founders, valuation, etc. How much money do they typically invest? Are they a lead investor or do they require a lead investor?
  • The email must state: the problem, the solution, customer traction, if you have revenue paying customers and what the customer growth has been, market size, who the co-founders are, and the unique insight or special sauce the startup has.
  • The email must not contain: The story about how the company came about because the history does not determine whether or not the investor is interested.
  • The email must not contain the CEOs biography.
  • Do not use industry specific jargon or acronyms because the person reading the email may not be an industry
  • The email must come from the company’s email with the person’s name e.g., jane.doe@website.com
  • Don’t send a follow-up within a month. The investor has made the decision on whether or not to reply.  When doing a follow-up, there should be some new information, especially regarding customer growth.
  • Attaching a standalone pitch deck is optional. Your research of the investor can indicate what they want included in a cold call email. Do not have a link to your pitch deck – make it easy for the investor to look at the pitch deck on their phone.
  • Email must contain facts, not vague claims.
  • Use a CRM to send the email so that you can track whether or not the email has been opened. Do not do a mass emailing.  You’ll also need the CRM to manage the large amount of information you’ll be collecting about a pool of potential investors.

Your next steps

  • Define your fundraising plan. You need to start building investor relationships before you need money.  The plan should include time and funds to travel outside of the Toronto area.
  • Implement a CRM to manage your investor relationships and related investor information.
  • Research investors to build a list of potential investors. Resources to find potential investors include: your existing network, LinkedIn, AngelList, Crunchbase, Gust, Hockeystick, Startup HERE Toronto funding database, and VCWiz.

 Footnotes

1 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, April 2017, Page 42  This survey of VC firms included: 63% of all VC US assets under management, 9 of the top 10 VC firms and 38 of the top 50 50 VC firms.

2 “What we learned from 200 startups who raised $360 million”, Professor Tom Eisenmann, Harvard Business School, and DocSend

Further reading

“How does a startup communicate with potential investors?” https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/how-does-a-startup-communicate-with-potential-investors/

How do venture capitalists create value?

You may download a PDF of this article from: How do venture capitalists create value

The purpose of this article is to help startups and investors in venture capital funds understand what VCs (venture capitalists) do to create value.  VCs are focused on creating financial returns for their investors.  VCs often have other objectives, such as helping women founders, or having social impact.  Many startups apply to VCs.  VCs go through a multi-stage process to filter out startups before making an investment decision.

Very few startups succeed. 

Andreessen Horowitz, a U.S. VC fund with over $10 billion of asset under administration, has public shared their experience1.  They receive 3,000 startup applications per year. 200 startups are looked at seriously. 20 startups are funded.  Only 8% succeed i.e. 92% failure rate.

What do VCs actually do to achieve their objectives?

The following facts are from a survey of institutional VC firms (i.e. not private equity, angels investors, etc.) which included: 63% of all VC U.S. assets under management, 9 of the top 10 VC firms and 38 of the top 50 VC firms.  The survey results are averages.  A startup or VC fund investor needs to research what each individual VC does.  I have focused on early stage investments. There are different survey results for late stage VC investments.

#01 What is the source of closed deals?

  1. 12% of closed deals resulted from a startup making an application
  2. 65% came from referrals and the VCs professional network
  3. 23% are proactively self-generated by the VC

Startups need to build relationships with the VCs network, in order to enable valuable warm introductions.

Startups also need to build social presence and a network of relationships to enable VCs to find the startup.

#02 What does the median deal funnel look like for a VC firm?

  • 250 startups are seriously considered
  • 60 result in management meetings
  • 20 are reviewed with partners
  • 13 undergo due diligence
  • 5 are offered a term sheet
  • 4 close

1.6% of the seriously considered startups are funded.

#03 What financial metrics are used by VCs to analyze investments?

The average VC uses close to 2 metrics.  The most common metrics are:

  • 56% cash on cash multiple
  • 26% IRR
  • 17% no financial metrics
  • 12% NPV
  • However, 48% often make gut investment decisions and only 12% quantitively analyze past investments.

Financial metrics are often used, but the investment decision is not driven by financial metrics.  The assessment of the team is the most important factor.

#04 What are the VCs IRR and Cash-on-cash multiple requirements for an individual investment?

  • IRR 33%
  • Cash-on-cash 7.5

The requirements are high because the few investments that do succeed must cover-off the vast majority of investments that fail.  Part of the VCs’ filtering process is eliminating those startups that do not have the potential for a large number of customers leading to a large amount of revenue.

#05 What exit multiple have the VCs achieved according to the survey?

  • The average is 4.2
  • 27% of the time it’s less than 1 i.e. lost money
  • 12% of the time it’s 10X

To make an overall profit, VC must have these 10X home runs.

#06 What is the most important factor when deciding to invest?

  • 53% is the team
  • 13% fit with the fund 12% product
  • 7% market
  • 7% business model

By the time an investment decision is being made, a lot of filtering has already occurred.  Poor products and small markets have already been filtered out. Most VCs focus on the ability of the team to both execute and to make the necessary changes as the team learns more about the market.

#07 What % of VCs believe is the most important factor in the success of their investment?

  • 64% the team
  • 11% timing i.e. being either too early or too late costs money.
  • 7% luck
  • 6% technology
  • 6% industry
  • 4% business model
  • 1% market
  • 1% misc.
  • 0% board of directors. 32% of VCs believe the board of directors is an important factor.

#08 What % of VCs believe is the most important factor in the failure of their investment?

  • 60% the team
  • 10% industry
  • 8% timing
  • 7% business model
  • 6% technology
  • 4% luck
  • 3% market
  • 2% board of directors

#09 What % of VCs believe is among the most important factors for the team?

  • 65% ability
  • 59% passion. Passion is a combination of execution and vision.
  • 58% industry experience
  • 52% teamwork
  • 48% Entrepreneurial experience

#10 What does deal closing look like?

  • 73 days to close the deal
  • 81 hours on due diligence
  • 8 references called

Many VCs use consultants to conduct part of the due diligence. Reference calls may be made to: current and lost customers, former employees, suppliers and other partners, other investors etc.

#11 What are the key items VCs demand in their contracts?

  • Pro-rata rights
  • Liquidation preferences
  • Anti-dilution provisions

#12 What % of VCs say their interaction with portfolio companies is in the first 6 months after investment?

  • 2% every day
  • 28% multiple times a week
  • 33% once a week i.e. 63% of VCs interact at least once a week.
  • 23% 2-3 times a month
  • 13% once month
  • 1% less than monthly

A startup needs to be prepared for frequent interactions with their VCs.

#13 What % of VCs take specific actions in portfolio companies?

  • 86% strategic guidance
  • 81% connect with other investors
  • 69% connect with customers
  • 65% operational guidance
  • 55% hire board members
  • 51% hire employees

#14 What benchmarks do VCs think are the most important to LPs (Limited Partners, the investors in the VC fund)?

  • 59% Cash-on-cash multiple
  • 26% net IRR
  • 9% relative to VC funds
  • 2% relative to S&P 500

#15 What are the performance results reported in the survey?

  • Cash-on-cash 4.0

#16 What do VCs market to their LPs?

  • IRR will be 24%
  • Cash-on-cash will be 3.8
  • 93% of VC say that will they will out-perform the stock market.

Next steps if you are a startup

  • Find your lead investor who will have the network to draw in your other investors.
  • Target VCs who may be interested in your type of startup.
  • Define what your VC requirements are (e.g. ability to introduce to customers) and target those investors
  • Stay in touch with potential VC with a brief monthly update.
  • Understand what the VC needs from an exit and how your startup meets those exit requirements.
  • Do reference checks on your potential VCs.

Next steps if you are an investor in a VC fund

  • Define the role the VC investment class within your overall asset allocation and long-term financial plan.
  • Define your financial and non-financial requirements for your VC investments.
  • Ask your potential VC for the necessary facts. Cash-on-cash results should be from the investor perspective i.e. net of all fees. Understand whether VC IRR results are based on valuations or exist, and if reflect net investor returns.
  • Do reference checks on your potential VC.

Footnotes:

1 https://corporatefinanceinstitute.com/resources/knowledge/other/how-vcs-look-at-startups-and-founders/

2 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, April 2017, Page 42  This survey of VC firms included: 63% of all VC US assets under management, 9 of the top 10 VC firms and 38 of the top 50 50 VC firms.

How do venture capitalists assess teams?

You may download a PDF of this article from: https://koorandassociates.files.wordpress.com/2020/02/how-do-venture-capitalists-assess-teams.pdf

The purpose of this document is to help startups understand how VCs (venture capitalists) assess founding teams.  Everyone has their own point of view.  I will share with you some research.

Research shows that the most important factor early-stage VC (venture capitalists) consider when it’s time to make the investment decision is the team.

  • 53% of VCs believe the team is the most important factor.1
  • 64%% of VCs believe the team was the most important factor in their startups’ success2
  • 60%% of VCs believe the team was the most important factor in their startups’ failure3

An analysis of the personality traits of the founders of 500 startups revealed 4 key traits correlated with success or failure.4

  • Quick and decisive decision makers were the most negatively correlated with success. The most successful founders were calculated, deliberate, and focused.
  • Compassion, consideration, and concern for people were negatively correlated with success. The greatest  degree of negative correlation with success was when the team thought the founders were people focused.   A startup founder needs to make many difficult, unpopular decisions especially those regarding the exit of team members.
  • Self awareness is critical. The most successful companies had a very aligned understanding between the founders and the team members regarding each others traits.  The smaller the discrepancy between the founder’s self-awareness and the team’s perception of the founder, the higher the startups performance.  I read research that for large companies, there are huge differences between the CEO and C-suite perception of themselves vs the employee perception of the C-suite.
  • Women founded companies performed better than companies with only male founders.

Have a calm demeaner when pitching to VCs.5

An analysis of how VCs evaluated pitches revealed that the finalists tended to have a calm demeaner.  Further study showed that VCs equate calmness with leadership strength.

California angel investors’ judgement as to which CEOs should go into due diligence tended to prefer trust over skills.5 Technical skill gaps can be addressed via training, hiring, and advisors. Character is hard to change.  The angels sought CEOs who were honest and trustworthy.

California angel investors’ judgement as to which CEOs should go into due diligence preferred CEOs who were open to new ideas from investors regarding ways to increase value5.  The angels did not want CEOs who refused to consider new ideas or refused input from the angels.

CEOs should view pitches as an improvisational conversation with investors, listening to questions, and even asking the investors what they think.5

 My own observations are:

  • Gaining understanding of the points raised above requires meetings in addition to pitches, most likely in the due diligence process. Investors determine if they can work with the founders for several years.
  • Many investors seek founders who are able to learn knowledge(e.g. about customer, the marketplace, competition, etc.) and skills (e.g. cash flow forecasting, key business metrics, technical skills)
  • Most investors seek founders who demonstrate a deep understanding of the customers’ problems, the benefits, and the competition. I’ve seen too many founders first build a solution and then try to find out if customers actually have the problem and are willing to pay for it.
  • Many investors seek founders who have some unique capabilities.
  • Many investors seek startups with unique technology or a unique solution which cannot be easily copied by competitors.
  • Successful founders tend to be brilliant, able to assimilate and analyze large amounts of information (both quantitative and qualitative) and focus execution on the unique insights they’ve gained.
  • Investors, especially angel investors, vary in terms of the potential size of the market and company they are seeking. I’ve seen angels get excited about a company that has the potential to grow to $10 million in revenue per year.  Other angels seek the potential for $1 billion per year future revenue.

Your next steps

You must research each VC to understand how they assess startups.  All VCs are not the same.

 

Footnotes:

1 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, April 2017, Page 42  This survey of VC firms included: 63% of all VC US assets under management, 9 f the top 10 VC firms and 38 of the top 50 50 VC firms.

2  “How do venture capitalists make decisions”, Page 53

3  “How do venture capitalists make decisions”, Page 54

4 Brittney Riley ,”How should investors evaluate founding teams”, Medium posting, April 24, 2017 This is an analysis of the relationship between company performance and personality traits of 500 startups.

5 Lakshmi Balachandra, “How venture capitalists really assess a pitch”,  “Harvard Business Review”, May-June 2017

What is the value and role of a lead investor?

You may download a PDF of this article from: What is the value and role of a lead investor

How do you read this article?

  • This article is written for startup founders.
  • There are two examples of a lead investor.
  • Then there is a generic description of a lead investor. The lead investor in your specific situation will likely be different.

Two examples of a lead investor:

The lead investor in an angel investor organization

  • Produces the due diligence report. Consultants and other angels may have provided input to the report and carried out specific due diligence task.
  • Negotiates with the founders on behalf of all the angels.
  • Manages angels’ lawyers.
  • Manages the angel close including getting the money into escrow.

The lead investor of a syndicate:

  • Has prepared a due diligence report, completed a term sheet after negotiations with the founders.
  • Then begins to actively recruit more investors to the deal.

What is the value of a lead investor?

  • Without a lead investor, you may fail to raise capital.
  • The reputation and network of the lead investor will attract other investors.
  • Many VCs, angels, and angel groups will not invest until there is a lead investor.
  • Including the name of the lead investor and terms in your pitch deck greatly improves your chance of success.
  • Having a lead investor reduces the overall time and effort to raise capital.
  • The lead investor will make a major investment, at least 15% of the round and sometime up to 50% of the round.

What may the lead investor do?

  • Prepare a due diligence report. Subsequent investors may still decide to conduce their own due diligence.
  • Negotiate the term sheet.
  • Hire a law firm to handle the investors paperwork. Sometimes the startup will pay for some or all of the lead investors out-of-pocket costs.
  • Sit on your advisory board.
  • Sit on your board of directors.
  • Make introductions to potential investors, customers, partners, suppliers, employees, and others.
  • Help manage the other investors.
  • Help structure future fund raising rounds.
  • Participate in future fundraising rounds.

What are the characteristics of a lead investor?

  • They passionately believe in you and your startup. They are not going to try to force you out and take control.
  • You’ll be able to work with them for the long term. Divorce from a spouse is often easier than divorce from a lead investor.  Do you actually like the lead investor?
  • Consider the investor’s values, morals, and ethics.
  • They are respected in your industry and/or in the startup financing world.
  • It’s helpful if the lead has been a lead before.
  • They have invested before and those investments have done well.
  • They have lots of funds for follow on investments and investments in other startups.
  • They are not in any kind of financial distress.
  • The investors have diverse portfolios so that market problems in one sector will not result in pressure on your startup to perform.

Look for the lead investor before you look for the follow-on investors.

  • This can take a long time.
  • You may make hundreds of phone calls and emails, meet with over a hundred people, and spend over 20 hours a week for three to nine months to find a lead investor.
  • You need to build relationships with investors over time. You’ll need a plan, and a CRM, to stay in touch with them.

How do you find a lead investor?

Your next steps

  • Define what you are looking for in a lead investor.
  • Set out you plan to find a lead investor and to stay in contact with the investors you have met.