In a previous posts, I talked about one of the two principle purposes of a company is to create corporate value and to do so with capital efficiency. As one might imagine, the institutional investment community would create common frameworks and models that integrate the corporate development stages with investment milestones in a manner that is consistent with their particular investment model. There are a very great many investment models covering a wide span of focus, expertise, hold period, corporate development stages, and investment levels. It’s useful to break them apart into Venture Capital (VC) and Private Equity (PE) and to identify the types of investment models common to each. It is also useful to understand how Angel Investors work in the early stages of the Venture model. Within these broad categories, there is tremendous variation which makes these models useful references that must be tailored and adapted to each investment firm and investment. In this and subsequent blog posts, I will explain the general way each of these broad classes of investment firm work and the investment model frameworks they use; in the third model, I will discuss Angel Investors and their special role and the ways they work. This blog will focus on VC and its focus on early risk retirement as a key element in driving capital efficiency.
Figure 1 General Investment Entity Structure
It’s worth understanding how Venture Capital (VC) firms work. There’s a lot of information out there on this subject and many different approaches to portfolio strategy. What most people see as the VC is the General Partner (GP) and their associated staff. They run the fund, make the investment decisions, and participate in the governance of the portfolio companies. However, the real source of the funds are the Limited Partners (LP); which can be a great many different types of entities including mutual funds, endowments, pension funds, corporations, banks, or other investment companies. Federal securities law governs who may invest and how many among other things. LPs generally have little knowledge of and no involvement with the portfolio companies. Venture Funds start by raising a fund, the GP defines the funds focus and investment guidelines and forecasts a financial return profile and seeks LP’s to invest in the fund. A VC firm may have more than one fund operating simultaneously given the hold times and each is likely to have a different set of LPs; these and many other rules are agreed to in the Limited Partnership Agreement. The funds invested into the fund are subject to a management fee around 2% ±; these fees pay for the staff, offices, and other expenses of running the VC entity.
Every VC fund operates on the basis of progressively larger investments in accordance with corporate maturity; this is based on the principle of scaling investments up as the portfolio company demonstrates success in reducing the risk of failure. It is from this principle that the practice of Series A, B, C etc. was formed. Within each Series commitment, funds are typically additionally metered in tranches to address both corporate development risk as well as cash concentration risk (fraud, embezzlement).
The following is an idealized example of a $100M early-stage fund. The Limited Partner Agreement allows for 2% annual management fees, a 20% carried interest, and a 10 year hold. The fund’s portfolio strategy is to invest 80% of the fund in writing $2M series-A checks and taking a 33% stake with non-dilution rights. 40 investments are made in a little more than 3 years. Of these original 40 investments, 65% will eventually fail and return nothing or some fraction of the original investment, contributing only 4% of the fund return cash. In this example, the fund participates on a non-dilutive basis in all rounds after the initial round; meaning at each round the fund invests additional funds to retain a 33% stake in the resultant portfolio company equity pool, funds available. Some of the later stage investments are limited by the fund’s investment recycle cap. Of the remaining 14 portfolio companies, all will continue to raise capital and exit at various stages with roughly 10 returning 1-5x investment return, 3 returning 5-10x, and only 1 returning more than 10x original investment. Nearly the entire portfolio return rests on these few companies that survive past the first round. These data are from a study published by Correlation Ventures of 21,640 fundings from 2004 to 2013 using data from VentureSource (Dow Jones) and a variety of other sources. Note that fund commitments from Limited Partners into the fund are generally metered based on cash demand of the actual investment profile; in this example the commitments and the cash flow are shown at the same time. Actual fund returns will benefit from delayed cash infusion and suffer from delayed exits of portfolio companies.
Figure 2: Idealized Example of $100M Early Stage Fund Financials
After investments and exit proceeds as well as management fees, the fund has been grown to $342M. On liquidation, the Limited Partners receive 100% of the original capital first, with the balance divided according to the carried interest terms. The $242M gain earns the General Partners a 20% carried interest of $48M, with the other 80% or $194M going to the Limited Partners. This results in a cash:cash return of 2.9 over a 10 year hold for an IRR of 12.7%. This return is appropriate to the risk profile of the investment.
Looking deeper at the portfolio in this example in Figure 3, it can be seen that the 1/3 of companies that survive into second financing rounds deliver 93.2% of fund results, and the single company that continues to a 10x return accounts for 39% of fund performance.
Figure 3: Dissecting Portfolio Returns
Using these results, it should be obvious that successful VC’s must be very efficient at identifying, investing, and governing portfolio companies to maximize the likelihood of success including identifying which companies in which to stop investing. Nearly all VC’s have a great deal of information on their web site about deal criteria driven by the terms of their LPA and their portfolio strategy which will cover industries or themes, development stage, financial ideals and limits, governance participation, and many other potential terms. They publish this information so you won’t contact them unless you have a deal that fits their investment criteria. An additional result of this need for efficiency is an entire set of frameworks that have been developed and broadly accepted for guiding a startup in its quest for a repeatable business model, mature that business model through proof stages, scale that model, and then expand and scale that model into a thriving enterprise suitable for a strategic or financial acquirer. These frameworks include milestones of corporate development suitable for determining next stages of investment. Like all models, they are guides based on reasoned theory and experience to which a group of people agree because it provides a framework for discussing and executing improvements on the business. Without an agreed framework, it can be more difficult to identify the next step and to agree that what has been done is progress. It is extremely useful for CEOs and their potential investors to use these models as a basis for discussion for the particular evolution path to be used for a given company; there are variations in team and investor experience, the specific market and company, past actions, and current market conditions that may necessitate tailoring and adaptations.
A common top-level model for a startup is shown in Figure 4. This particular model has a high level of funding granularity. In a previous post, I noted that capital efficiency mattered and a fundamental lesson was that the same improvements to capital efficiency performed earlier yielded very large downstream value benefits when compared to the same improvements performed later in the corporate life cycle. In this model, early risk retirement and structured corporate development are built-in capital efficiency levers. Another way to look at this is to understand that if you’re an investor you don’t want to fund anything more than the minimalist activity required to retire risk until the viability of the enterprise is reasonably assured.
Figure 4: Early Stage to Exit Startup Funding Model
In this model, the stages are broken into four clearly defined stages of development:
Product / Market Validation
Business / Economic Model Validation
Scale / Value Development
I won’t cover each of these phases in extreme depth here; my purpose at this stage is to explain the overall structure of the model to frame a deeper explanation later. Further, there is a great deal of material out there on these models and they are broadly known, accepted, and tailored.
Customer Development begins with the milestone of Founding and ends with the milestone of Product / Market Defined. The initial founding team must come together and organize, raise funding to the extent necessary, agree on a focus, and start the task of seeking a market problem and solution around which they believe they can discover / build a business model. Many at this stage are served well by using the Business Model Canvas and the ideas developed and elaborated by an entire community (including Steve Blank) as explained by Steve Blank. The objective is to start with a market and a problem, then populate the business model canvas through a variety of exploration techniques. Within the business model canvas, the founding team explores potential value propositions and the groups for whom they might be valuable, then the supporting elements of turning that into a business including how to reach the market, activities and resources, partners, cost structure, and potential revenue. The model is then evaluated and the team pivots to correct minor issues or to entirely new models to correct major issues. The byproduct of this process is a product concept to be validated with the target market, using a product called a Minimum Viable Product (MVP). The validation that matters is revenue. Each pivot can result in a return to the start or back into the middle of the process. A great deal of time can be spent in this phase until the company has discovered a product / market match that generates some revenue and the future elements of the business required to develop, sell, deliver, and support that product are defined and explored. The challenge of this phase is quickly finding a valid model. A sufficient benchmarking to identify the core metrics of Life-Time Value (LTV), Customer Acquisition Cost (CAC), Gross Margin (GM), and R&D costs can provide an early insight into the maturity of the business model as well as the key opportunities for improvement. The Product / Market Defined milestone is defined as having a paying customer(s), major product development and market acceptance risks identified and the most significant addressed, and the core team having been identified and potentially on boarded (in many cases, companies at this stage identify tentative key players who will not come on until further funding). The management team at this stage will remain very lean with many personnel wearing multiple hats.
If the founding team has developed a business model that is institutional investor (VC) appropriate, the next step is to prepare for and raise either an Angel or Series A Venture round. VC appropriate companies are a small subset of growing entrepreneurial companies. They have a very large and growing market (often $1B+), a credible potential for a $100M+ valuation exit and will need more than $5M in capital, a market disrupting advantage, and have an experienced team that is prepared to share control of the company. The pursuit of institutional investment at this stage can be a many-months (or years) long pursuit that can devour the attention of the management team. It is at this stage that a candid review of the company’s prospects and degree of success in preparing appropriately can accelerate the process and reduce the costs significantly. It should be clear that the activities of this phase are entirely focused on the corporate development milestones required to satisfy Angel Investors and rationally proceed to the next step or minimally pivot to cash-flow positive to self-fund. There are many Angel groups, capital associations, accelerators, and others that can assist in this process; we can help as well.
Product / Market Validation:
This next phase begins with completion of the prior phase and the raising of an Angel round (if appropriate and successful) and ends with Product / Market Fit. The focus of this phase is proving that the company has a product that is being accepted and retained by a market. While the previous phase proved that the product can produce some revenue, it hasn’t proved that the product’s success is not simply the exuberant adoption of early adopters who bought because it’s a first product to address their pain-point despite its shortcomings, but who will abandon the product if it doesn’t show steady improvement and adoption. Key issues addressed in this phase relate to product features and capabilities, proof of performance, churn / retention, pricing, and standing up a broader but still simplistic operating model.
During this phase, the company builds or completes its first version operating systems. This necessarily includes operating elements of technical product delivery platforms, CRM, pricing, service delivery models, contracts, HR policies, cyber security approach (which should be designed in from the beginning), and must include basic operating metrics including customer count and lifecycle, churn, price sensitivity, marketing and sales costs, integrated customer acquisition cost, customer and key stakeholder Net Promoter Score, platform and delivery costs, support models and costs, and product development costs. If the company has been operating without a budget prior to the Angel round, it should be creating and operating against budgets prior to raising a Series A. The Product / Market Fit milestone requires that the company has revenue bearing customers producing repeat revenue with initial pricing studies performed and refined and appropriate proof of performance developed. Reference customers will have been obtained and delivery studies will have been performed. The company will have made further progress on elaborating and mitigating key risks and the management team will have been further filled out.
As with the Angel round, the raising of the next round of capital will be a significant effort that should be planned well in advance of consuming the Angel capital raised; planning this as a coherent activity that begins immediately after closing the previous round and culminating in closing the next round is typically the correct approach. The activities of this phase are focused on meeting the risk reduction requirements of a typical VC at this stage of maturity in order to be prepared for the pitch, strategic due diligence, and functional due diligence of the Series A raise.
Business / Economic Model Validation:
Business / Economic Model Validation begins at Product / Market Fit and ends at Economic Model Fit; typically a Series-A will fund this phase and this phase will culminate with raising a Series B. During this phase, the focus is on refining the operating model for sufficient efficiency to prove that it can be refined with customers retained and to transition the company to being ready to scale. Prior to this phase, significant investment in making the marketing and sales process more efficient, to refine operating costs to raise Gross Margin, and to fill out a still-lean but more complete overhead team were not risk-appropriate. The Business / Economic Validation phase is the time to address these issues. Key issues in this phase to address include cost of goods sold, product features and capabilities, marketing messages and channels, sales process and supporting collateral, product development process, and key management hires.
Consistent with the planning that went into selling the Series-A, this phase will focus on investments in processes and systems. First generation systems involved in order fulfillment and client relations need to be addressed to streamline cost-inducing and most importantly customer frustration inducing delays and inflexibility. The product should be refined to the point where the value proposition becomes compelling to the enthusiasts that follow the earliest adopters; these customers love the product concept as much as the product, but will buy and keep buying based on rational value which has to be present even if it isn’t overwhelming. Marketing systems need to evolve during this phase to stand up marketing automation, CRM integration, integrated social media, lead lists / market segmentation, and all the other elements required to push a regular marketing message cadence out to an appropriate target audience. In sales, the final pre-scaling hurdle is to work to a deep understanding of market segmentation and ideal customer, customer identification criteria, channels, and performance benchmarking to drive sales scaling. A natural part of this process is that the company is likely to shed non-performing customers; early adopters brought on as customers because of relationships or irrational exuberance who aren’t happy because of fit issues that weren’t known when the sale was originally performed. These are challenging losses that should not be allowed to occur without some attempts to tailor the product or customer situation; but it will be important to recognize this is a natural occurrence in this phase and it will be important to identify and understand the nature of this particular churn. In some cases, it will make sense to make significant accommodation to retain these customers because of critical cash flow, but this is a delicate balance as it both funds the company and also spends critical resources; this choice should be made with a good understanding of the strategic cost.
The exit milestone to Business / Economic Validation is Economic Model Fit. The criteria for reaching this milestone will be “Good” customer criteria and credible churn control of “Good” customers (typically below 5% annually, but this can vary with business model), profitable growth opportunity measure of LTV >> CAC, completion of the activities noted above, and key hires for scaling identified and on boarded or ready to onboard. Raising a Series-B to drive scaling would be a common choice at this stage or it may be delayed until the company reaches cash-flow positive; depending upon the planned trajectory of transformation in this stage.
The assessment of Life Time Value (LTV) much greater than Customer Acquisition Cost (CAC) is a way to test if the product, market, and systems associated with the company are ready to reliably produce the Gross Margin to scale the company and drive profitability. I will write another future blog on this metric and its many pitfalls with calculation and usage. When combined with other metrics and analysis, it can tell a great deal about the state of corporate development of the company and trigger deeper dives that can pinpoint important issues.
Scale / Value Development:
This final phase begins with Economic Model Fit and ends with an Exit event. This final phase is the most fluid in its definition and content and its duration may be the longest in the life cycle of a given startup enterprise. The fundamental objective of this scaling phase is to grow the company profitably to a sufficient scale to exit as well as prepare the company in all other ways for that exit event.
The levers of growth include organic growth exploiting the original business model of the company, identification and penetration of peripheral and potentially non-peripheral markets, and identification and usage of a variety of sales channels to grow top line revenue. An additional lever is the introduction of peripheral products and services, partnerships, and integrations across the value ecosystem of the customer in order to create and capture more value per customer. The final lever of growth is in operational and financial improvements to improve Gross Margin and EBITDA as well as competitive positioning to prepare the company for an exit.
The tools of value growth and capture in this phase are product management / portfolio management for price optimization and introduction of greater flexibility, marketing, sales including direct and channel, process improvement across the enterprise, overhead reduction, digital transformation, asset utilization optimization, risk reduction, and quality improvements. These tools can be implemented through organic staff growth and deployment, outside expertise, and Mergers and Acquisitions. Critical to this phase is a deep understanding of the relative impact, the interdependency and implied ordinality, as well as the potential pitfalls of each of the many options.
The company should develop a deep understanding of the strategic options and their relative merit through this phase and develop a regular cadence of option evaluation, strategic planning, and performance evaluation. It is at this point that ROI, IRR, and common-model exit-value impact analysis should be the routine tools of option assessment.
Looking at this model through the lens of a P&L statement and risk retirement, it’s easy to see how the approach addresses the largest risks first. Figure 5 shows the progression through the P&L statement and the primary risks retired with each phase. The risks noted are the fundamental existential risks to a business that must be retired before substantial investment is warranted. Through this evolution, VC investors fund retirement of critical risks and don't risk the most capital until it will clearly be going to scaling a proven marketing and sale engine, a functioning product management / development engine, and the ongoing scaling and efficiency gain of the operation where those funds will clearly drive value growth.
Figure 5: P&L and Risk Retirement
In future blogs I will look at the processes of raising capital, strategic planning, the evolution of various functions across the corporate development map, the specific tools of value growth, and many other topics relevant to this model. If you would like to discuss how your company is evolving, need help with any of the transitions noted above, or just have a question please contact us.