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Will Tech Layoffs Lead to Wider Distribution of VC Investors?

The rise of remote work led to many people and companies leaving high-cost coastal cities. This redistribution of talent has changed how early-stage venture capital is deployed. Before, investors would invest only in entrepreneurs whom they could meet in person. Many investors preferred to not travel, so founders migrated to cities with a high concentration of venture capital investors. But the pandemic and the redistribution of talented entrepreneurs changed this. Investors now regularly invest in founders whom they’ve met only over Zoom.

I’ve been thinking about the tech layoffs by large companies like Amazon and Google and what they’ll do to the distribution of talent. I suspect that a material number of people laid off by these companies will rethink living in their high-cost cities, especially if their job was the main thing keeping them there.

I could be wrong, but if this does play out, I’m curious about how venture capital will adjust. If a lot of talented founders no longer want to reside in the Bay Area, for example, how will these firms adjust? Will they continue to stay heavily concentrated in places like the Bay Area and do even more investing over Zoom? Or will they rethink where their firms or their firms’ investors live?

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Know Your Competition

“Start-ups die of suicide, not murder.” It’s a common saying. It means that most start-ups fail because of self-inflicted wounds like bad decisions, not competition. This is true, but even so, it’s critical for early-stage founders to know the competition when pitching investors.

Investors backing founders at the spearhead of company formation want to back someone who understands a problem and the market for it better than anyone else. They expect the founder to have identified something others don’t see that will allow them to succeed. Part of this process should include understanding existing solutions and why they don’t adequately serve the market. That doesn’t mean you aim to mirror what your competitors have done. It does mean you know how your solution will create more value than competitors’.

If you’re an early-stage founder and you don’t know your competition or can’t speak to how your solution is superior, you’ve diminished your chances of getting capital from investors.  

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Vista Takes Duck Private . . . More Deals to Come?

Today it was announced that Vista Equity Partners will take Duck Creek Technologies private. The transaction values Duck at about $2.6 billion. Duck is a publicly traded company that IPO’d in August 2022. Its market capitalization (i.e., valuation) peaked around $7 billion in 2021. The company’s valuation was below $2 billion last week before this deal with Vista was announced.

This made me think about Vista buying Salesloft for $2.3 billion in December 2021. Salesloft was a private company doing somewhere in the neighborhood of $100 million in annual recurring revenue.

We can’t do an apples-to-apples comparison of the two companies. For example, Duck reported $80 million in revenue last quarter, of which $27 million was professional services revenue and likely not recurring. Salesloft is private, so we don’t know the details of its $100 million in annual recurring revenue. But the Duck transaction shows that Vista is buying a public company for around the same valuation they paid for a private company a year ago.

Last year, I thought that low valuations of great public companies would make them attractive acquisition targets. I didn’t see this play out last year, but I suspect we’ll see it this year if valuations stay depressed. Vista’s deal for Duck could get things going. If this happens, great public tech companies trading below a $2 billion market cap could see increased interest.

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An Old Valuation Killed a New Investment

I caught up with a venture investor and talked about a deal that’s frustrating him. He loves the founder, team, and solution. He’s been working to structure an investment that works for his fund and the company. The company raised over $10 million in venture capital eighteen months ago. That fundraising round was large by historical norms, as was the valuation, considering the early stage of the company. But that was the market at the time, and the founders took the deal. They’ve executed but haven’t made enough traction to warrant an increase in their valuation. Given the current market, this investor believes they’re likely worth the same as, or even less than, they were eighteen months ago.

This investor is walking away from the deal. Why? Given the company’s traction and the fund’s target portfolio construction, the investment would need to happen at a valuation that’s materially below the valuation at the last fundraising round. The founder isn’t open to doing a down round.

High valuations feel great to founders when the deal is done, but founders should be aware that they can come back to bite you. If you received investment at a high valuation, executing flawlessly and realizing material traction is likely your best bet to avoid a down round.

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High Valuations Can Come Back to Bite You

Some founders optimize for minimal dilution in the current round when they raise capital from venture capital firms. They do this by setting high valuations. For example, a company raising $1 million that wants only 5% dilution will have a $20 million post-money valuation. If they accepted 15% dilution on that same $1 million, they’d have a $6.66 million post-money valuation. The difference is large. In isolation, the 5% dilution at $20 million post-money makes the most sense to the founder.

If a founder considers the next financing round, things look different. Investors in the next round might be willing to value the company at or above the $20 million assigned in the first round only if there is a significant amount of traction. Otherwise, the founder could face many bad options (assuming they haven’t reached breakeven). They could run out of cash and close the business. They could raise at a valuation lower than $20 million. I won’t get into all the math, but depending on the terms of the first round, investors from the first round could receive additional ownership when the second round of financing is complete. Depending on how little leverage and runway the founder has, the dilution could be massive.

To avoid all this, founders raising capital should agree to reasonable valuations that won’t give investors in later rounds heartburn or force the dreaded down round.

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Setting Your Valuation Could Work Against You

Founders who decide to raise venture capital sometimes do things unwittingly that could cause a venture fund to opt out prematurely. The most common is setting the valuation before chatting with VCs. Founders decide the amount of capital they want to raise, pick a valuation, and put all that info in their pitch deck. This can be OK in raising from angels, friends, or family, but it’s not advisable when you’re seeking to raise a round of capital from venture funds.

Founders usually don’t have as good a grasp of valuations in venture markets as venture funds do. Funds usually see a constant flow of deals, which helps them keep a finger on the pulse of market valuation for companies at a particular stage. Founders are usually relying on conversations with other founders or data they find online. While helpful, these sources of information may not reflect current market conditions or may not give founders enough data points to really understand market conditions. A fund could be interested but decline to meet the company because the valuation is unrealistic.

Another variable founders should be aware of is a venture fund’s portfolio construction. I won’t get into the details of it, but when a fund is raised, the general partner(s) communicate to limited partners how many companies the fund will invest in, the average check size of each investment, and how much of each company the fund plans to own. These and other factors help create the hypothetical portfolio of companies the fund will own and the hypothetical portfolio return (i.e., how the fund will return a profit to limited partners). If a venture fund receives a pitch deck with a valuation that’s too far high, they’ll be more inclined to pass on the company. A high valuation can mean a lower share of ownership in a company, which can throw off the portfolio construction. If general partners deviate too much from the portfolio construction they communicated to limited partners, they have to explain why. These kinds of conversations can cause some limited partners to decline to invest in future funds. Of course, founders usually don’t know a fund’s portfolio construction, so they’re at an information disadvantage when they set a valuation.

So, what can founders do when they’re raising a round of venture capital? Simple: leave the valuation out of your deck. Include the amount of capital you’re raising and figure out the valuation as you chat with venture funds. These questions can help you figure out the right valuation and evaluate funds:

  • Ask VCs what the current market valuation is for companies at your stage. If you talk to enough funds, you’ll have your finger on the pulse of the market.
  • Ask VCs what their average initial check size is and if they have an ownership target. If a fund says they write $1 million initial checks and aim for 10% ownership, you know they’re likely in the $10 million post-valuation range.

Figuring out valuation for an early-stage company is part art, part science, and part negotiation. I hope this will help founders go into their fund raises better prepared.

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Using Payment Terms to Raise Growth Capital

Today I chatted with founders of a growing software company who are trying to land a big multiyear customer contract and raise capital from investors. They’re considering raising a $2 million round of venture capital.

They proposed a $2.8 million two-year deal to their potential customer. The customer pushed back, saying $1M per year would be easier to get board approval on. The founders have internally agreed that $1 million per year would be a great deal, but they haven’t communicated that to the customer. I saw an opportunity to kill two birds with one stone.  

I pointed out to the founders that this deal has the potential to provide them with the capital they would raise from venture investors. It will be important to negotiate favorable payment terms.

Here’s what I suggested: Write up the contract as a $2.8 million deal over two years paid in equal monthly installments. Offer a discount of about 29%—$800K—if the customer pays the entire two-year contract—$2M—up front. This deal gives the client a strong incentive to pay up front. If they do, the founders will have the $2 million in capital they’re seeking to grow the business without giving up any equity in the company. If the client doesn’t want to pay up front (or can’t), the founders get a premium for taking monthly payments. I’d imagine there would be some negotiation. If they negotiate a $2 million deal paid in two annual $1 million payments, that’s still a win for the founders. They’d get $1 million Jan 2023 and another $1 million Jan 2024 to fund growth for each of those years.

Customer revenue is always the best way to finance growth. Founders should be mindful of this when negotiating and consider offering major customers terms they won’t want to turn down—if they pay up front.

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Apple Savings Accounts Launch: One Step Closer to iBank?

I’ve been watching Apple push into financial services for some time (see here, here, and here). And I believe Apple will become the go-to consumer and small business bank. My thesis is that distribution in banking is going digital, and iPhones are the perfect distribution method for digital banking. Banking is one of the few markets large enough to move the needle for a company the size of Apple that also has high user engagement (people checking bank accounts, transferring money, etc.).

Today, Apple announced a new high-yield savings account in conjunction with Goldman Sachs. To open one of these accounts, one must have an Apple Card.

Banking is an antiquated business that’s overdue for disruption—and Apple is perfectly positioned to disrupt it. I believe the steps it’s taking will eventually lead to iBank or Apple Bank. It’s interesting to see execution of such a massive plan play out before our very eyes. I don’t think most realize what’s happening, but I do. I can’t wait to see the improvements Apple makes in the banking world over the next few years or a decade.

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Network Distance Affects Efficiency of Matching

I had a great chat about matching with a founder friend today. We agreed that great companies are built when founders are matched with capital, knowledge, and resources. The matching is the important part—and the most difficult part at the early stages. The more inefficient matching is, the less likely it is that resources will reach founders who will use them best.

Matching is network driven. The closer founders’ networks are to the networks of people who have capital and expertise, the more likely effective matching is to occur. The farther away they are, the less likely it is to occur. Said differently, network distance affects how efficient matching of high-potential founders and the resources they need is.

If we want to match capital and resources with high-potential founders, we have to reduce network distance to make the matching process more efficient.

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Focus on Value Creation, Not Revenue

I regularly have the conversation with founders about what metrics they need to achieve to raise capital. Most commonly, they’re focused on revenue or some derivative of revenue. I remind early-stage founders that revenue isn’t always the best metric to demonstrate the potential of your solution.

Instead of asking about metrics, I like to reframe the question. How can a founder demonstrate the value they’re creating for users or customers? I like this better because revenue is a by-product (or should be) of value creation. If your solution is adding value to others’ lives, they’re likely to pay for that value (now or in the future). Thinking about value creation keeps you aligned with customers and doesn’t force you to turn on monetization prematurely. If value creation can be quantified in other ways (engagement, sign-ups, repeat transactions, etc.), smart investors will give you credit for the absent revenue.

If people have a problem (realized or not) and you solve it, you’re creating value for them. Healthy revenue is the result of value creation. Focus on creating value for people by solving a problem well, and things like fundraising become a lot easier.

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