In Our Thoughts

A few weeks back I had the pleasure of presenting to the Silicon Valley Innovation Center, an organization which works with many Eastern Europeans on introducing them to and making connections in Silicon Valley. They wanted me to talk to them about the state of startup investing, and I chose to present on the state of early stage investing, the area where I do most of my work.

The events in Ukraine prevented many from coming, but two people did make it to my presentation. The presentation was not an upbeat one; I showed slides from many data sources stating that I believed there were some serious issues for seed investors to operate and profit from. After the presentation, I was surprised that they said I was only the presenter who didn’t have an extremely optimistic outlook on events in Silicon Valley.

Here is the presentation – it is updated to information to late March and is missing some new data that has appeared:

Just to be clear – I have no issue with entrepreneurism. I admire people who start businesses to either make money to support themselves and their families to those who go for the gold. It’s not easy to do, and it’s the Golden Age of Entrepreneurism right now. Nowhere in history has it been easier to raise some money to go pursue the dream of starting a company. Nowhere in history has there been so many resources dedicated to helping companies start. Nowhere in history has there been so much fame and attention assigned to entrepreneurism. You’re a superstar if you start your own company today.

Each day, more and more investors emerge. With the passing of the JOBS Act, soon the normal average US citizen will be able to invest in startups. And we are seeing the appearance of so many new funds. Where are they coming from? Some are angels in disguise, some are family funds, some have international origins, some we don’t really know. Still Silicon Valley is awash with money looking for somewhere to go. We can partially thank the Fed for some of this – holding interest rates at zero, making bonds a non-investment – they’ve pushed everyone out on the risk curve, and investing in startups is one of those places investors have been pushed to.

Each day, more startups emerge. Most startups I meet already have 4-6 competitors – or more. By the end of 2013, we had done our own counting and thought there would be 2500+ startups out there. Unique-ness is a hard competitive advantage to achieve. Raising a ton of money when you have little traction is much easier by far.

Who to pick to invest in? I’ve heard many methods out there ranging from “just pull the trigger if you like them”, to doing a ton of research into the market as if you were putting millions in, to “if so and so is in, I’m in too.” Still, the brutal reality is that risk is way up because it’s so easy to start a startup and thus competitors sprout the moment they are seen on Techcrunch.

Even as risk is up, valuations are also up. At one time, if something was more risky, you’d pay a better price for it. Today it’s not like that with startups. Risk is up but so is their price. The going rate for seed stage startups is generally $5-6M cap on a note, or pre-money, with jumps up to $8-12M. When I started investing back in 2006, the norm was $2.5-3.5M pre-money – there were no notes back then.

Manu Kumar just published an excellent post called The New Venture Landscape. In the section entitled, “Re-jiggering of deal stages and sizes”, he states:

Seed is not the first round of financing any more. In fact after noticing this trend last year, I have transitioned to calling most of my initial investments “pre-seed” rounds, where the company raises close to $500K, before raising a full seed round. The Seed round is larger — closer to and sometimes upwards of $2M. The Series A is now the fourth round of funding for a company — the first is usually friends and family, or an incubator (~$50K), then pre-seed (~$500K), then seed (~$2M), then Series A (~$6M-$15M).

So I can’t even call myself a seed investor any more – we are sometimes part of the $2M “seed” round but more likely we are part of the “pre-seed” round. Even at pre-seed stage, we pay a higher price generally, but yet the company doesn’t raise enough to survive on that alone and usually needs to raise more later (aka the bridge round) to keep going, assuming it gets somewhere at all. Thus, risk is up yet again but there is no reflection of that in the price we pay.

That is why I believe that while this is the Golden Age of Entrepreneurism, it is also grown to be the riskiest place by far for former-seed-now-pre-seed investors. Other stages are not immune to what is happening, experiencing things like Series A Crunch and even the potentially looming Series B Crunch. However, IMHO the issues manifested themselves first at early stage which is where things begin and the other stages don’t feel the issues until much later as it takes years for startups to grow to those stages.

What are the issues?

1. Valuations are up, but yet risk is also up. We are either paying more for a startup at the new seed stage, or in order to get a slight consideration for price we enter the more dangerous pre-seed round.

2. Competition is way, way up. It’s too easy to start a startup, so for us pre-seed investors, how do we know that it’s my startup amongst a group of 4-6 similar startups who will win?

Still, we see those who seek to disrupt the current winners. After Whatsapp’s $19B exit, how many messaging apps have appeared?

3. According to Berkery-Noyes, in 2013 the median of exits is hanging around $12-15M. Contrast that to 2008 when the median was around $20M. Remember also that valuations back then were lower than they are today – startups that exited in 2008 probably started in 2006-7.

When you invest in a startup and the median of exits is less than or equal to 2x that of where most startups will exit, you might be happy with a 2x return in today’s world where our economy sucks and we can’t make money elsewhere. The problem is that your ability to make money is not sustainable in the long run as a startup investor. Your losers will far outpace your winners and investing in startups hoping for a 2x return the median exit will ultimately lead to you going negative pretty quickly.

To give you a look into the failure rate of startups, CBinsights reports that for a given cohort of startups vintage 2009, 75% die, 21% get acquired, 4% are potential over-returners (or the elusive unicorn). That means that you have to invest in 25 startups statistically to get 1 over-returner.

Contrast that to when I started angel investing back in 2006, the venture fund folks I chatted with all told me that if you invest in 10 startups, about 5 will die outright, 4 will either return your money or 2-4x, and then there will be one that will return everything you’ve lost and then some. But that was also at series A stage; there were very few seed funds back then and the seed stage was mostly supported by angels and angel groups.

Let’s play with some scenarios. Assume you put equal amounts of money into every startup you invest. Assume that you invested in 25 startups.

First, let’s apply the current $5M pre money/cap on note metric for funding and assume a $6M post money, and use the low range of median of exits of $12M. Using the CBinsights data from 2009, 75% of your 25 startups or about 18-19 of them will just die outright. Then, 21% or about 5 will most likely return 2x, meaning that you only cover 10 startups worth of investments that failed; you have another 8-9 which still need to be covered in order for you to break-even. That means that one startup which over-returns must do so at 10x to just break-even.

Note that I’ve also made the important assumptions on the 21%. These are:

1. The 21% didn’t raise any more money and you were not diluted.
2. I also assumed that you could actually take into account ownership at the valuation of the round. Most rounds these days are notes with caps and you can’t always assume the ownership is there. In my experience, if you don’t own stock, all sorts of things can happen to your detriment even at a 2x acquisition on current valuation of the company.

I think you can assume that the above case is the BEST case scenario and all other scenarios return less than here for the average person. It also assumes you can get into right deals and not bad deals. Your own investing record can vary widely from the above.

Now for another important metric. By CBinsights count, there were 472 seed funded startups in 2009. In 2013, that count jumps to 856. Again, we are back to more competition with each other and for customers, thereby increasing risk for the average startup that is out there.

How do I cope? Largely, there are three coping strategies:

1. I keep strict valuation discipline.

2. I generally invest only in startups with no competitors.

3. I am always out there searching for the unique, special stuff and looking in places where others are not. I am patient to wait for when items 1 and 2 above align.

(Pre) seed investing has gotten to be an interesting place. I still believe opportunity is out there, but it is largely shifted towards later stages where traction, survivability, and sustainability can be proven, and for investors who can continue to invest throughout the stages of a startup, versus only being able to invest once and either follow on not at all or very sparingly.

NOTE: The strategies I employ at Launch Capital are not necessarily the strategies employed by the other directors.

UPDATED/EDITS: I wrote this post quickly and under uncomfortable conditions! Reading it over I found the need for edits. Here they are:

1. The calculation with the CBinsights data is incorrect. If you return 2x on the 5 acquired startups (21% of 25), you cover 10 startups you invested in. However it forgot to cover those 5 acquired startups so there are 5 additional startups worth of return to cover the 19 dead startups. That means you still have to cover 14 startups, not the 10 I said previously. So the 1 over-returner needs to return 15x just to break even, not 10x. That is even more difficult by far!

2. I said that this was the “best” case. I think this is the wrong word. I think “average” case is a better descriptor. Then my statement about other cases being worse is not quite correct. You can of course return better than 2x in the acquisitions, and return over 15x in the one over-returner.