Eight Realities of Startup Economics
- by David Capece
While there is hope in the startup world (the second quarter of 2010 featured the highest venture-backed IPO volume and amount raised since 2007), the investment community remains very discerning in their allocation of scarce capital.
So if you’ve caught the startup bug or are just bored of your day job, take this crash course in startup economics to prepare for the hurdles ahead.
1. The Venture Capital community has shrunk during the recent downturn. Jennifer Rossa, Managing Editor of Dow Jones Private Equity Analyst says: “Venture fund-raising was driven by substantial closes by industry stalwarts and renewed interest in smaller venture funds. Many limited partners investing in venture believe the industry has finally found a size that can work for it and that proven managers who cap their fund-raising are worth backing.”
2. Venture Capitalists want significant returns. Jim Flanagan of Valuelytics says: “The typical time horizon is 5-7 years until exit and the general rule of thumb is 5 to 10 times return on the money invested. With that you can calculate the IRR and range of values. It’s got to be at 30 percent-plus or it doesn’t work for a VC.” A little math can help you get a sense of potential valuations. For example, if you can grow your business to $20 million in 5 to 7 years and sell it at 1.5x sales, that would imply a $30 million sale. If the investor wants 10x returns, you’re looking at a $3 million valuation today. Chances are that at a $3 million valuation, you’re raising somewhere around the $1 million range. At that amount, you’ll need to turn to Angels, Seed Funds, Friends and Family, or look your wallet in the mirror. To raise your valuation, launch your product, get paying customers and build a clear path to profitability.
3. Investors need to actualize returns. In the era of split-second trading, buy-and-hold is out of favor. For VCs that are investing millions in your startup, they need to actualize returns. Since your venture is unlikely to return significant cash flows in the early years and the IPO market is relatively quiet despite its recent uptick, the default for an exit is sale via M&A. Beyond the promise of a sale, there might be other options such as interest and other payments. Of course, if you’re planning to make interest and other payments, you’re going to need to get to cash flow positive rather quickly.
4. Ninety percent of zero is zero. If your reaction to No. 2 was, “My business is worth more,” then read on. Too often entrepreneurs have an inflated sense of valuation or are unwilling to give up significant parts of their company. There are many startups that need investment, so if you aim too high, you may struggle to raise money for a cash-starved business with stalling momentum. Just remember that you can own 90 percent of an idea, but if you are unable to achieve revenue and profitability, your idea and business might be worth nothing. Of course entrepreneurs should seek the best terms possible, and ideally hold onto control through the early phases of growth. However, you must realize it’s usually better to have 49 percent of a $10 million business than controlling stake of a $0 million dream.
5. As you can see, there is an intense focus today on driving revenues and cash flows. You might have grand plans of creating an empire—a comprehensive solution to market problems. Today’s environment demands that you make tangible progress one step at a time. Can you break up the market problem into smaller sets of addressable opportunities? Condense the time to market and become comfortable with a Beta approach of continual product upgrades. Recently, a startup wanted to raise $20 million for a series of related projects that provided great synergy. After 60 days of investor conversations, that same startup is raising $2 million for the most promising and near-term achievable of the projects.
6. This leads me to my next point: Fundraising can take a lot of time. I’ve seen too many entrepreneurs with unrealistic fundraising goals (trying to raise too much at a high valuation without demonstrated market progress). What happens? Six months of unsuccessful fundraising later, they’re back to the drawing board. Save yourself the six months and get realistic from the start. Better to focus six months of your time making progress on the business than talking to investors who say no.
7. Where to spend that time? Talk to customers and partners. The only way to make money is to bring in revenue. Since you’re going to get your revenue from customers … spend your time networking with, researching and selling to customers. If you’re lucky, you might be able to get early customers by offering discounts and the opportunity to help shape the product. Even if you don’t land a customer, you’ll likely gain a lot of market intelligence that will make the ultimate product better.
8. Many startups will seek to break the $1 million revenue threshold within 2 years. That’s not an easy task. I recently met with a startup that spent one year just in conceiving their product idea. They went through five iterations that were ultimately scrapped before confidently greenlighting product development. That product then took nine months to develop. That’s 21 months from beginning to actual product launch. Fortunately, the entrepreneurs had other jobs and projects that provided the cash flow. They redirected their earnings to this initiative along with $100,000 from friends and family. They still have some money to market launch the product. Get a head start on your venture by starting at night and weekends and redirecting earnings to make progress while gainfully employed. If you think you’re ready to quit, try working your day job another 3 to 6 months. The longer you make progress at night, the better your lift-off will be. Line up self-funding, friends and family and angel funding to take you as close to the $1 million revenue milestone as possible.
Yes, startup economics have changed dramatically over the past 10 years. But don’t be discouraged. There are still major success stories out there, including Groupon, which announced a $1.35 billion valuation in its April 2010 round of fundraising.
Build your network and call in favors as you strive for ambitious goals in a difficult startup economy.