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The 8 Things Everyone Should Know About Startup Funding

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Startup funding is not intuitive: you invest large amounts of money in companies that have proven very little, with a really high rate of failure. 

At first glance, it is even total nonsense financially speaking: you put money in companies that have no profit AND don’t plan to pay dividends before *long* (hello Amazon) while not being liquid either (you can’t sell the stocks easily since they are not publicly listed).

So it is very normal that this topic raises questions. Our goal here is to share the underlying lessons and assumptions of VC when they look at a startup.

Publicada em: Tecnologia
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The 8 Things Everyone Should Know About Startup Funding

  1. 1. The 8 Things Everyone Should
 Know About Startup Funding daphni
  2. 2. click here to read the article! #1Growth is the only way
  3. 3. Growth could be the only metric Why is growth that important? Two words: talent and money.
  4. 4. Because if you don’t grow fast, someone else will (big market = high level of competition). Growth and big market are tightly linked Big market is a requirement for growth Growth is a requirement in big market.
  5. 5. Since the risk of success is very low, you need to have a very high target value in case of success Growth is the only way in a high-risk environment E(X) = probability of success * value in case of success
  6. 6. Growth is a race toward an uncertain solution to a certain problem Starting a startup is linked to 3 principles: 
 (1) uncertainty, (2) full commitment, (3) winner-takes-all (1) startups are built around searching: the problem/solution fit, the product/market fit, a scalable model (2) growth is neither short term race (burnouts are not rare enough in the ecosystem) nor a lifetime walk
 (3) digital startups are built on network effects, leading to a race where the winner takes most of the pie
  7. 7. Continuous high growth leads to 
 exponential growth Growth matters all along because growth is cumulative There is a very well documented bias in psychology and behavioural economy which is called the misperception of exponential growth: we tend to grossly underestimated exponential growth.
  8. 8. Bottom line Startups are designed to solve certain problem with uncertain solutions in big markets with a high risk of failure but an exponential growth if well done. So growth could be the only compass. Startups = growth. click here to read the full article!
  9. 9. click here to read the article! #2Growth Before Profits, Sorry, No choice!
  10. 10. If you build a marketplace or a SaaS product, having 40 clients or 39 clients is almost the same: a new user brings no additional cost or very few (the costs of storage and bandwidth are getting incredibly low). startups don’t care about profits* * for quite a long time Tech startups are operating with very specific cost structure: (a) their marginal cost are very low, (b) their returns to scale are very high
  11. 11. Growth OR Profits Why do startups turn a blind eye to profits? Because otherwise it would slow growth. If your activity makes some earnings, you reinvest everything into growth. No dividend tolerated in a race to size.
  12. 12. Look at Amazon’s financial data:
  13. 13. Bottom line if you want to grow as fast as possible, you minimize friction (eg: your product is free) as long as possible and raise funds so you can be the biggest kid in town (and eventually monetize with your huge user base). This is why startups have often negative results and focus at maximizing gross value before they start to maximize profits. click here to read the full article!
  14. 14. Gross profits scale well once startups found 
 their product/market fit, profits come later:
  15. 15. click here to read the article! #3If Growth Forecasting Were Easy, There Would Be Only One VC fund: Nostradamus Partners
  16. 16. [Declarations] of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true. — Thinking Fast and Slow, Daniel Kahneman
  17. 17. Sadly, it’s not possible to know whether the beginning of a strong growth will last and if it is a linear growth or an exponential growth. Traction, which should be defined as quantitative evidence of market demand, is very often related to the actual usage of the product. Is Traction The Ultimate Heuristics?
  18. 18. Because indicators influence one’s activities, you should guard against overreacting. Always pair non-correlated indicators, so that together both effect and counter-effect are measured. Beware of Key Performance Indicators (KPIs)
  19. 19. For a SaaS product, new users is not enough, you need to pair new users with churn. Embrace Complexity But Keep It Simple In fact, it would be even better to distinguish a bit more and to measure on a MoM basis: (a) new users, (b) churned users and (c) resurrected users, to be MECE (mutually exclusive and collectively exhaustive). click here to read the article!
  20. 20. In your dashboard, it is more useful to monitor retention rate than its contrary, churned rate (1- churn rate= retention rate). For the curious minds: [users last period + new + resurrected – churn] = [users new period] <=> churn = [user last period + new + resurrected] – [users new period] Retained users = [users last period] – [churn new period] <=> retained users = [users new period] – new – resurrected Churn rate & Retention rate
  21. 21. Bottom line We’ve seen that growth is key, yet growth forecasting is very hard. We’ve seen the importance of choosing the right KPIs for growth, even if it does not make it more predictable. Yet, investing is not a sheer game of luck. Everything is about assessing one’s potential and hoping for exogenous forces to evolve in your favour (trends are a good indicator too). interested in this? read the full explanation in our article to become a black belt
  22. 22. click here to read the article! #4You Need to Lose Money, But A Negative Gross Margin Is A Really Bad Idea
  23. 23. It’s easy to grow fast: just get a negative gross margin. If you’re selling a $10 note for $1 you will have a ton of growth. But nobody would do such a stupid thing, don’t you think? Well, in fact Paypal did something very close to that. At their early days, they gave $10 to every new user and an additional $10 everytime they referred a friend. That gave them hundreds of thousands of new customers and an exponential growth rate. Of course, this customer acquisition strategy was unsustainable on its own — when you pay people to be your customers, exponential growth means an exponentially growing cost structure. — Peter Thiel
  24. 24. Startups Still Have Negative Gross Margin* Today Negative gross margin might be voluntary: either you believe the margin structure will evolve for your benefit (as explained by Fred Wilson), or you believe the switch costs are high enough and you want to lock as many users as possible. * gross margin= revenue - cost of goods sold (COGS)
  25. 25. Negative Gross Margin Is Not a Good Idea Fernando Suarez & Gianvito Lanzolla showed, in their amazing piece The Half Truth of the First Mover Advantage, it is very difficult to really lock users in rough waters, where technology and market structure are evolving at very fast paces.
  26. 26. Gross Margin => Growth Growth margin represents the percentage of money a business can invest into growth.
  27. 27. Bottom line Some people argue that profit is just an opinion in the short term: you can try to have a positive net income asap (like most of traditional business) or just focus on growth, but cash (revenue over all and gross margin especially) is a fact. interested in this? read the full explanation in our article to become a black belt
  28. 28. click here to read the article! #5How To Have Growth AND Profits? Part 1
  29. 29. In transactional business models, user growth is correlated with revenue growth* As a rule of thumb, here is a good objective MAU quick ratio** > 1.5 (good is > 2, great >4) *all things being equal
 ** (new MAU + resurrected MAU)/churned MAU
  30. 30. Even better: grow your user AND the average price paid per user As a rule of thumb, here is a good objective Revenue Quick ratio* > 4 * (new + expansion + resurrected) / (cancelled + contraction)
  31. 31. Growth and Profits: some formulas & benchmark Life Time Value > 3x CAC (and a payback period < 12 months) (growth rate + profits rate) >= 40% Looking for other formulas & benchmark? Read our article
  32. 32. How To Have Growth AND Profits? Part 2 click here to read the article! #6
  33. 33. In non-transactional business models, user growth is not correlated with revenue growth… … so you need to find the right proxies* for growth and profits click here to read the article! *proxies are indicators that are not in themselves directly relevant, but they are useful in place of an unobservable or immeasurable variable
  34. 34. Make your quick ratio* by replacing the money by your proxy For example, if you measure link sharing: *quick ratio = (new + expansion + resurrected) / (cancelled + contraction)) new = you check new people sharing link expansion = people sharing more links on average resurrected = people sharing links that stopped sharing the previous month cancelled = people that stopped sharing link contraction = people sharing less links
  35. 35. Always favour engagement proxies and go in depth To study engagement distribution the best way is to use Cumulative Distribution Function
  36. 36. Bottom line In the end, it is always a question of fundamental user needs and the way startups tackle them. The moto should be: “build the value, monetization will come eventually” interested in this? read the full explanation in our article to become a black belt
  37. 37. click here to read the article! #7What About Valuation 
 For Late Stage Startups?
  38. 38. Different investors, different approaches Early stage investors are focusing a lot on the team, the product and the total addressable market. The more you move into the funding stages, the closer investors look at traction and eventually at revenue. The more predictable a business model can be, the more investors will focus on future cash flows (and risks), like any traditional company.
  39. 39. Late stage startups valuation The value of late stage startups should be approached very similarly than other companies. 
 The methods are very well described in this guidelines from the IPEV (Price of Recent Investment, Multiples, Benchmarks, Discounted Cash Flows, Net Assets, etc.). Let’s explain the 3 main approaches (and the correction method):
  40. 40. 1. Recent Transactions The easiest way to give a fair price is when the last investment were very fresh (either a primary investment, such as a new round table, or a secondary investment, such as when some of the shareholders sell some shares). If neither the market nor the company have tremendously changed, the last transaction price is a good indicator of the valuation of the company.
  41. 41. 2. Probability-Weighted Expected Return Model The idea of this approach is to compute the expected returns using different exit scenarios (exit type, growth of revenue, valuation, liquidation preferences) for the company. One of the scenario for late stage startup valuation can also be liquidation value: the valuation is then highly discounted, often as low as the price of assets in the company such as their Intellectual Property.
  42. 42. 3. Market Comparables : benchmark & multiples Mutual funds are also using more traditional approaches for late stage startup valuation. They use valuation multiples. In theory, several kind of multiples could be applied: sales, gross profit, EBIDTA, revenue. The idea is to look at the company’s sales/gross profit/EBIDTA/revenue and apply the valuation multiple of similar public companies, taking into account the growth of the metric considered.
  43. 43. Bottom line Late stage startups valuation is based on different approaches, taking into account growth AND revenue. They most often use computing Probability-Weighted Expected Return Model or market comparables, moderating them with premium and discount. interested in this? read the full explanation in our article to become a black belt
  44. 44. click here to read the article! #8Fail Often, Fail Fast? Investors Do Half of That.
  45. 45. The return of a typical VC portfolio 8 will returns no money or very little, 13 will returns only the money invested or much more, 3 will return a multiple > 3x, 1 will return a multiple > 10x. which makes 21 fails over 25 investments (84%)…(returning only the money invested 10 years before is not what we should call a success.)
  46. 46. So after screening 2500+ startups, a professional teams of investment still fail 84% of the time. Let’s call that a false positive (if you consider the investment as a diagnostic of a future financial success (positive)). 1. Failing due to False Positive
  47. 47. This trend will certainly be reinforced by the massive entry of new players, who are less price-disciplined. These new actors step in especially in early stage and late stage. False Positive & New Players
  48. 48. In Early Stage Source: 2015CF - The Crowdfunding Industry Report by Massolution - upfront ventures - daphni Global equity crowdfunding amount (in $B) 1.1 0.4 2.6 2014 2015E2013
  49. 49. In Late Stage Source: - CBInsights 1/1/09-4/20/15, VC backed US startups ex life sciences - upfront ventures - daphni Medium size for mid- & late startup rounds by investor type round sizes have exploded and are highly correlated with lack of price discipline 60 48 35 20 35 71 103 30 60 90 120 0 2012 2013 2014 Family office Hedge fund Mutual fund PE VCAsset mgmt
  50. 50. Unicorns hunting = bigger failures This hunt for unicorns leading to many failures, since roughly 40% of these unicorn IPOs are now flat or trading below their private market valuations. source
  51. 51. VCs suffer also from lots of false negative: company that they thought weren’t likely to become huge successes when they eventually did. Legendary investors, such as Bessemer, missed a lot of great opportunities. They even built what they called an “anti-portfolio”: the biggest company that they meet in their early time and they chose not to invest in (or even to avoid meeting with the founders!). 2. Failing due to False Negative
  52. 52. Bottom line There is a continual pendulum swing between high liquidity and prices, and low liquidity and prices in the VC market, shifting from too much confidence to too little. What is sure is that funding black swans will have trouble becoming a science. interested in this? read the full explanation in our article to become a black belt
  53. 53. about daphini & the author @willybraun, co-founder of daphni special thanks to my parter @mathieudaix, for his feedbacks & inputs follow us! (twitter, facebook, newsletter)