VCs like to give out homework. They won’t call it that, though. But rather they use words like “diligence” and “information requests.” Just like in school, the homework can actually be productive, as in this case it can lead to a new customer or advisor. But just like bad teachers did in grade school, VCs sometimes assign completely useless busywork.
Receiving a homework assignment or two after initial meetings with a venture capitalist is generally a good sign – it signals that the potential opportunity is interesting and exciting enough to engage further. They’re often positioned as simple diligence requests that (actually often genuinely) help an investor get a better sense of the startup and its prospects. Yet as those initial assignments turn into an endless string of assignments, the signals can turn south. At the best it’s an indication of indecisiveness, and at the worst repeated homework can be indicative of bad intentions to show minimal engagement to “hang around the hoop.”
There are a number of reasons why venture capitalists give out homework to entrepreneurs who have pitched them… usually the rationale isn’t one of the following, but rather a combination:
- Answer specific questions. Whether it’s about the market, competition, etc., VCs typically want to “get smarter” about a domain, especially if they’re less familiar.
- Validate thinking. VCs walk out of a pitch with a thesis – it might be about the team or the market opportunity or whatever – but they like to hear from others that that thesis is indeed sound. In other words, they seek supporting points to verify their reasoning.
- Overcome their partner’s objections. If a new non-linear homework assignment comes up mid-evaluation process, it’s typically a direct reaction to a VC’s partner objecting to the investment on specific grounds. The homework assignment can be a way to provide ammunition to overcome those objections politically (especially within larger firms).
- Build trust. Sometimes the content of the assignment is irrelevant, but rather the VC is utilizing the process as a way to build a rapport and see how an entrepreneur interacts beyond an hour pitch-meeting. The process can reflect if an entrepreneur listens well and is open to feedback, meets expectations about output, and generally does what he says he’s going to do.
- Delay. Going through a process of repeated diligence requests can sometimes be intentional stalling tactics to a deal process, allowing VCs to gather more data and preserve optionality for as long as possible.
- Play chess. Assignments can be a part of a larger power-play game with respect to negotiation of an eventual deal.
Given the above motivations, a number of kinds of homework tasks can emerge:
- Produce more internal reports. Often VCs are looking beyond the headline numbers in a pitch deck to validate that the “traction” is truly real or just spun for a presentation, but other times the requests are just to verify what an entrepreneur said is true is.
- Produce financial models. Sometimes these spreadsheets are helpful to run different scenarios about what the drivers are of the business are and/or outputs under different sized capital raise. But more importantly, it’s a way to demonstrate deliberate thoughtfulness about the business. However, there is a risk (and I’ve seen it happen) of VCs sending an entrepreneur on endless modeling exercises which are completely useless – you can’t dictate the impossible into reality, but you sure can model it.
- Assemble (third-party) reports. Additional information about the market sizing, competitive dynamics, potential acquirers, etc. can help educate an investor about a space where s/he is less familiar.
- Allow for customer / partner / advisor / employee conversations. It’s sometimes a sensitive topic to allow potential investors access to key constituents within an emerging organization, especially customers, but they are often the most revealing about the opportunity and can be the final convincing data to push an investor towards conviction.
- Talk with a own domain expert. VCs have their go-to people in their network, sometimes formally affiliated with the firm or sometimes just friendly informal relationships, who they introduce to entrepreneurs to hear their perspective on the opportunity (see #2 and #3 above).
- Talk with new potential customers or partners introduced by the VC. Often if a VC has made other investments in a (related) space, he is able to introduce potential new customers or partners to a company even before making an investment. These kinds of intros (if they’re actually apropos) can be beneficial to the startups, but they also give an investor the ability to first-hand see how a potential new customer reacts. Trouble, however, can arise if that customer isn’t as good a fit or has another idiosyncrasy which generates erroneous feedback back to VCs.
In all of the above, I haven’t shared a value-judgment to either the motivations for these assignments or the types of them. But it’s clear that some can be quite constructive for a startup, while others can be neutral to even unconstructive. My partner Rob Go wrote a post a couple years ago about interpreting diligence requests to figure out whether indeed they’re “bad” or “good.” Because just as a VC uses the diligence process itself to evaluate an entrepreneur as the leader for an investment opportunity, entrepreneurs can similarly use these interactions to decipher if a particular VC is going to be a good partner to the company going forward once an investment has been made.
About a year ago, I wrote a post about how office space is the face of a startup – it communicates both an outward message and provides insight into what’s going on underneath, as the physical environment in which startup employees work inevitably match the company’s story and culture. Recently I’ve been thinking that it’s not just the space of a startup itself which matters, but that perhaps also the location of that office which matters as well. Startups invariably seem to cluster together, and there’s perhaps something meaningful to that phenomenon.
So just as a thought-experiment, I plotted both NextView Ventures’ Boston-based and Manhattan-based companies on a map to see what the picture looked like. I kind of knew the answer beforehand, but not to the extent until I actually went through the exercise. (My partner Rob Go recently took a stroll through the NextView portfolio in a post which only briefly touched upon geography.)
First, take the startups in our portfolio based the greater Boston + Cambridge area. In reality, though, that “area” isn’t too large. In fact, with one exception, the office locations are fairly binary – either they’re located in/outside Kendall Square in Cambridge [green + purple below] or in the Leather District in Boston (which is sometimes but not always counted as part of the Innovation District) [orange]. In fact, what is interesting to note which isn’t on the map below, is that an overwhelming 70%+ of our Boston/Cambridge portfolio started the company either at One Broadway in the Cambridge Innovation Center or within two blocks of it (including at Dogpatch or other VC’s offices) [purple]. But then as headcount grew along with the importance of a dedicated space and the need for better per-sq-foot pricing, our portfolio has fanned out further from the Kendall Square epicenter [green] or hopped the river but stayed on the T redline.
View NextView Ventures Portfolio Companies in a larger map
In Manhattan, the map our portfolio company locations is similarly consistent. Again, with one exception, all of the startups in our portfolio are one east-west block from Broadway, running from 30th street through the Flatiron to just south of Union Square.
View NextView Ventures New York Portfolio Companies in a larger map
So what’s the takeaway here? Do we at NextView Ventures only invest in companies which are located in these shaded areas, using it as a selection criterion for investment decisions? Quite the contrary; rather we see a trendline because it’s a correlated reflection of the choices of the company types which we invest in. Internet startups are the starving artists of the corporate entity set – they optimize around relatively cheap rent, accessibility to transportation, and a certain intangible “vibe.”
On the other hand, venture capitalists are lagging, not leading, indicators for startup locations. There has been much ballyhoo about the migration of venture capital firms from Waltham to Cambridge over the past five years. But to me, it’s a non-story… the startups were already there, so of course VCs had to follow. It’s interesting to note that when we at NextView selected our own office location as the Leather District for us a year a half ago, one Waltham-based VC told us point-blank that it was “terribly stupid decision.” Today we’re now neighbors in our building with Uber, our portfolio company TurningArt, and social media marketing firm Likeable Media, among others… including three other portfolio companies on the above map a stone’s throw away [orange]. But again, as VCs, we’re here because that’s where startups are, not the other way around.
In the end, I think that startup location matters because it’s indeed correlated with success… but of course it doesn’t cause it. Startups gravitate towards each other because they have similar needs and employee profiles, and there is actually something to innovation density breeding additional innovation. So the right way to go about finding a location isn’t to figure out what peer startups are doing and copy, but rather figure out what’s best for the company itself… but you might just end up in good company in the same neighborhood anyway.
Happy New Year and welcome to 2013. According to all of the blogosphere chatter over the past month, seed-funded internet startups are entering this year gearing up for the now-near-infamous Series A Crunch. The CB Insights report specifically which came out just before the holidays put a bright light on the supply-demand imbalance of the seed-stage companies searching for Series A capital. The figures are indeed the facts, and this report is probably the most accurate reflection of what has actually happened in the rise of the number of seed investments completed over the past couple years. However, I would take issue with the near-consensus conclusion of what is to follow.
There is an incorrect implicit assumption in the Series A Crunch talk that all of the seeded companies are in the funnel to raise a Series A. Look back to the reasons why there was a Cambrian explosion of seed funding in the first place – a dramatic reduction in the initial capital requirements to launch a new company because of cloud hosting infrastructure, social graph distribution platforms, open source and low-cost development tools/methods, etc. It is for those same reasons that it is capital efficient to start a software bits-based company that it is also now just as capital efficient to operate a software bits-based company. What isn’t as efficient is aggressively scaling a business ahead of cash flows, which is the reason why companies of any sort raise capital (equity and debt) in the first place. Given the ability to plug into (often self-service) monetization platforms and/or employ freemium models which weren’t available or de rigueur five years ago, seed stage companies are able to transform into seed stage businesses (with real revenue!) to become not just ramen-profitable, but sustainably profitable.
The nuance which isn’t being recognized is that most of the companies of this latter profile, while viable businesses, aren’t venture-scale businesses. Businesses which should and do attract venture capital are ones which have the potential to be both high-growth and extremely large. Many startups which have been seeded in the past couple years just don’t fit this profile, but that doesn’t mean they’re not viable businesses which are going to hit a brick wall and Crunch, as has been prophesied. Instead, startups are now empowered to create focused services which benefit a small niche audience.
To use an analogy, think of starting newspaper/magazine in the previous century. At the beginning of the 1900’s, the only way to do so was make a capital investment in a large printing press, so the only audience justified was an entire metropolitan city. But as the printing technology improved dramatically, the ability for publications which served smaller and smaller niches became increasingly viable. Then not every newspaper needed to be as large as the New York Times or required the capital to do so. We’ve seen an accelerated & compressed version of this phenomenon over the past decade in bits-based startups, which has led to a proliferation of niche services. Just as a small community newspaper or a special-interest magazine didn’t need significant amounts of capital to become sustainable, so too today with many of the recently seeded startups which have focused services for a specific target audience or customer-set.
Not to say that there aren’t plenty in the category of photo-sharing apps or mobile games which required mass audience which never materialized. Or that entrepreneurs or their investors sincerely believed that they had a venture-scale opportunity in front of them, but it turns out that they didn’t. But a ramification of the Lean Startup movement which has been espoused and adopted is that you directly serve customer’s needs, even though the opportunity to do so might not in the end be large or high-growth.
So it doesn’t surprise me at all that in the CB Insights report cites that “seed deals in which VCs participate have a historically higher rate of getting follow-on financing as compared to seed deals in which VCs are not participating.” Despite the signaling issues present, VCs getting involved at the seed-stage have the lens to and propensity to recognize those sets of companies which truly do have the potential to become venture-scale businesses.
In the end, just as always: startups are risky and a majority of them do not survive. But good businesses are inherently that – good businesses, and the exceptional ones which can be both high-growth and extremely large will attract additional venture capital regardless of any Crunch. Others in this recent cohort of seed fundings will find alternative capital sources or will accelerate their path towards cash-flow sustainability. However, sensationalist headlines about thousands of companies “evaporating”, “dropping like flies”, or being “kill[ed]” will surely generate pageviews, but isn’t an accurate picture of what 2013 will actually bring. So the good news is that I don’t think startups should be entering 2013 with a Crunch-mode mindset, but rather, they should be entering in a business-building-mode mindset… which is a good mindset to have been in all along.
Most first and second pitch meetings with VCs are fairly lopsided, where entrepreneurs spend the bulk of the time sharing their businesses, rather than being a true exchange of both parties in developing a relationship. However, there is typically (and should be plenty of) time for founders to ask VCs questions about their approach and working-style to help determine if there’s a mutual fit.
Somewhere in the past few years a meme developed that a sophisticated best-practice question to ask a VC in early conversations is something like “Where are you in your fund’s investment cycle?” The idea is that if a venture firm is towards the end of its capital availability that they’re much less likely to invest in a new startup, and that there are even cases of “walking dead” firms taking entrepreneur meetings to maintain the appearances of being “in market” with very little intentions (or ability) to invest at all. These situations are certainly prevalent and therefore entrepreneurs need to be cognizant to avoid spending too much time with a venture firm where the end result of the conversations isn’t going to be fruitful. However, it’s rare that a venture capitalist is going to point-blank admit that his pockets are empty. There are too many ways to answer the question above without really addressing the heart of the issue: the likelihood of making a new investment. Because most venture capital firms reserve the bulk of their capital for follow-on investments, and a smaller portion for initial investments, it’s not difficult to spin the numbers to tell a story since about how there is still a pool of capital available… except it’s earmarked for something else. Moreover, the situation is more nuanced – given that some firms at the tail end of their fund have confidence in the ability to (or have already been able to) raise a new fund, whereas others do not, being at the tail end of fund isn’t necessarily a bad thing. Or it can be especially negative if a firm changes its strategy toward the end (like investing in a number of seed round with about capacity for any follow-on). It just all depends.
A little simple homework can rule out asking the question altogether. Nearly all VC firms follow an initial three year initial investment cycle on a ten-year fund life (with the possibility of extensions). So if you’re meeting with a firm which has raised a new fund within the past three years, it’s pretty safe to say there is available capital for new investments. A simple Google search can usually yield an answer, and it surprises me how many entrepreneurs fail to do this before asking about the fund’s investment cycle in a meeting.
Once a venture fund’s life is entering the fourth year and beyond, the situation can change. In this case, the best way to determine future behavior is to look at recent behavior and use it as a proxy. The better question to ask is: “When was the most recent new investment your firm made which had the size & shape of the one which we’re seeking?” Often you can fund this information on the web (like on Crunchbase) anyway, but sometimes, and especially with seed investments from larger firms, not always. A venture firm has a tendency to slow down towards the end of its initial investing cycle, rather than coming to a sharp halt, so the longer since a recent investment of the same profile, the less likely the capacity and willingness to add another investment. It seems as though there’s always room at the end for potentially one more investment in a fund, so venture capitalists always like to keep the door open, and may feel given that fact it’s not disingenuous to do so. So in the end, the grey area of a fund’s initial investment period end is going to be opaque at best. It’s productive then for entrepreneurs to play detective to ensure that they don’t waste their time on conversations with firms without the capacity to invest, but also to be realistic about the clarity of the answer uncovered.
Brian Halligan had a great post up last week about the lessons learned from raising a mezzanine round of financing. It’s really interesting, but perhaps only applicable to a more limited set of entrepreneurs. However, there was one gem of a small section in there with a more widely acceptable takeaway:
“It turns out that the terms from your Series A are most often cut and pasted into your later round deals. When you compromise on terms in the early stages, you will have to pay the price in the later stages. You generally don’t start from scratch and rehash the terms.”
As a seed stage investor here at NextView seeing our companies progress down fundraising paths, I think it’s extremely important to highlight that terms in early rounds do set precedent for terms going forward. And that’s not just for Series A deals; this phenomenon starts even from a Seed round.
One could cite that the reason for this behavior is pure laziness, as Brian alludes to in a “cut and paste” mentality of later investors. But the more meaningful reason that early financing terms endure into future rounds is that negotiation away from terms already in place are just that – negotiation. In other words, new investors must use their leverage in the discussions to proactively change those pre-existing terms rather than focus on price, new terms relevant only to this deal, or other aspects of this specific round where they have an interest in influencing (like syndicate composition or allocation). And even when that’s possible given the situation, the old terms provide an anchoring point for all new terms to be referenced against, so they don’t end up straying too far except if there’s a real meaningful reason for them to differ.
Given that this phenomenon is fairly pervasive, I think that there a number of takeaways for entrepreneurs who are raising early rounds of capital:
- While valuation is the most salient point in a deal and certainly important, terms matter quite a bit and A LOT more than most entrepreneurs pay attention to. Terms don’t start as in-your-face numerical figures… but they do end up that way when it comes time to exit.
- Earliest terms matter most, even and especially in the seed round, because they set not only the base literal structure, but also the “tone” for future financings. Once there is punitive-looking round, the more likely the company will be a punching-bag on terms in subsequent rounds moving forward. In contrast, valuation always has room to move up.
- Terms precedent is one solid reason (among others like founder-investor alignment) that entrepreneurs should have bias towards priced equity round vs. convertible notes in seed financings. While the intent of notes is often to delay setting a valuation until context is more crisp, kicking the can on terms can be dangerous. It’s preferable to set them early as possible when investors are most accommodating as in seed round (because they too have incentive for clean terms without bells & whistles which could eventually hurt them as well).
Yes, early terms endure. It makes sense then for everyone involved with early financings to consider not just the deal at hand, but also what it means for the future.