Is there a venture capital formula?

venture capital formula
Yes, there is.

But the venture capital formula doesn’t work like you might think.

This basic formula cannot boil a complex financial analysis into a single set of inputs and outputs. But it can deliver useful insights.

What is the VC formula and who developed it?

Bill Sahlman is a Harvard Ph.D. who has taught entrepreneurship at Harvard and written prolifically about startups and venture investing for years. In 2011, he was also part of a special task force pushing for reforms to the IPO process. Which is to say, he is one of the country’s most thorough observers of the venture capital industry.

In 2003—revised in 2009 after the financial crisis—Sahlman published a paper entitled The Basic Venture Capital Formula. In the article, he describes a formula used by some venture capitalists as they screen prospective investments. (He later developed this into a business case for Harvard.) The formula is:

(1+IRR)^time * (investment)/(valuation at exit)

What does this mean?

1+IRR shows the internal rate of return desired by the investor. How much does he/she need this investment to yield in order to make it worth considering?

Time is the number of years capital is deployed in this investment until an anticipated exit.

Investment is how much capital gets invested.

These three factors form the numerator. The denominator is the total enterprise value at the investment horizon or the anticipated exit. This can be further broken down into two factors, a multiple and an exit value.

The multiple is the industry average or comparable multiplier for exit values of similar companies.

Exit value is a key performance metric for the company, such as revenue or earnings.

Combined, we might say the company’s terminal value is estimated using a revenue multiple of three. This means a company generating $1 million in annual revenue in the year we expect to exit the investment, would be valued at $3 million. $3 million is the number we would use in the formula.

That’s how the formula is calculated. But why would investors use it?

The result of calculating the valuation formula is a hurdle rate. That is, a minimum percentage of equity required to hit the investors desired rate of return.

The venture capitalist must own enough of the company at [exit] to realize [the desired] return on the investment.

—William A. Sahlman, The Basic Venture Capital Formula

Sahlman shows how this formula can be used by VCs to see,

  • How many new shares need to be issued at what price per share
  • Pre- and post-money valuations
  • A breakdown of carried interest for any investment round
  • Accommodation for dilution.

On a basic level the venture capital formula also creates parity between how investors view a company’s value and how the founder(s) view it. It serves as a useful way of getting these two on the same page or identifying where they see things differently.

Finally, the valuation formula contains critical building blocks of putting a deal together. It addresses valuation multiples, investment horizons, and returns. This is the reason I include it in my graduate venture courses at the University of Utah, it’s a quick way to bring context to a discussion of each of these elements.

The venture capital formula contains critical building blocks of putting a deal together. It addresses valuation multiples, investment horizons, and returns. Click To Tweet

But is it really that simple? Just plug and chug your data into the formula and away you go? Of course not. There are weaknesses to putting too much weight in the valuation formula.

Additional Reading: You can read more of my breakdown of valuation fundamentals here.

Where does the valuation formula fall short?

It can be tempting to see a formula like this as a secret code to mitigate risk, or see it as a kind of shortcut for due diligence.

The formula is at best a quick gut check to see if the basic terms of a deal make sense. It can tell investors if they are expecting mutually exclusive outcomes in a deal. Such as, if they need 100% return from your investment, but getting it requires that you own an impossible 200% of the company.

What it cannot do is verify the accuracy of the inputs.

That’s like trying to predict the future. There’s no guarantee that a company will hit its revenue or earnings projections, even if its CAGR is on track. There’s no guarantee that an investment will have an exit opportunity that lines up with the investor’s investment horizon.

At its best, investors have a back of the napkin heuristic for sniffing out terms that will definitely not work. The venture capital formula won’t tell them much about an investment that will work.

Venture investing is not about mitigating risk

The nature of venture capital, especially with first or early investments in a company—the angel, seed and series A investments, is not about mitigating risk.

Wait, what?

Certainly startups often have obvious weaknesses and risks that most venture investors will see as signaling a bad investment.

But almost every company raising money in its early stages contain flaws that could metastasize and kill the company. That includes those that pass the initial screening and due diligence. So of the startups VCs determine to be candidates for investment, there’s no sure way to pick winners from losers. There’s no formula for that.

That’s because these bets aren’t calculated risks, they are just well-informed guesses.

In finance, people often use the saying, “Nobody wants to buy a racehorse until they see it run.” This is why repeat entrepreneurs just have an easier time raising money than first-time founders.

But among the ranks of first-time startup founders are winners that nobody has seen run yet. Nobody knows who the winners are until they win.

The best explanation of this I have heard was given by Jerry Neumann in an interview with Patrick O’Shaughnessy (excellently summarized here). Neumann explains that risk is an actuarial problem. Risk can be quantified as a probability and hedged against.

What startups contain is not just risk, it’s uncertainty.

And uncertainty cannot be mitigated by a formula. While the formula can help investors be thoughtful. Unfortunately, it cannot do anything to guarantee winners.


Read more venture capital tips for founders at 101 Venture Capital Pro Tips

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches graduate courses in venture financing @uutah

Venture capital ROI

I once listened to a CEO pitch his company to a panel of investors.

At one point, they asked him about his growth rate. He replied that he was intending to grow the business 5–10% per year for the foreseeable future.

One of the VC investors shared the honest feedback that such growth was insufficient to attract his interest. I thought this investor had shared a valuable insight for the CEO about where his company wasn’t matching up with the profile he was looking for.

The CEO became defensive and took this feedback as an indication that the investor thought he had built a bad company. He totally missed that the investor’s comments were’s about the quality of his company at all. His company might be great, but it wasn’t going to grow fast enough to generate sufficient returns for a venture investor.

In #23 on my list of 101 things founders ought to know about venture capital, I’ll explain why that is.

Returns? Go big or go home

VCs must typically generate 100% internal rate of return (IRR) or more on each winning deal to make the economics of a VC fund work. Why?

They need to generate a minimum of 20–25% return to LPs across the fund’s portfolio despite losses. Otherwise, LPs would be better off investing in the much less risky S&P 500 (which returns around 10% for long-term investing).

Consider the task for giants like A16Z who raised $1.5B or Greylock Partners who raised $1B (both in 2016). These funds need to generate 20% plus compounded returns on over 1 billion dollars investing in startup companies. That’s around $300 million a year!

Data shows that in reality most VCs struggle to generate returns which beat the S&P 500. But those that do may generate 1,000’s of percent returns.


The content of this post originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 99 additional tips for founders looking to understand the world of new venture financing there.

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

How venture capital makes money

How does the business of venture capital work?

How VCs make money

Although not common knowledge, it isn’t too complex.

The celebrity side of venture with its huge windfalls and spectacular failures can be a distraction from reality. Amid all that noise, what about the bread and butter of going to work every day as a VC and actually making a living?

The following is an excerpt from my massive tear down of how venture works, and how to build a company that fits venture investing. Here’s pro tip #22:

The 2/20 Rule

A VC firm usually makes money two ways:

  1. a management fee charged to a fund for managing capital deployed and considered “under management”
  2. and carried interest, which is based on the long-term success of the fund’s portfolio, where the VC will share in the upside of deals that reach a successful exit.

The typical scenario for these two channels is a management fee of 2% on capital under management, plus 20% in carried interest.

Carried interest means that the first 20% of capital returned to the fund goes to the VC as the general partner. The remainder of returns are divided pro-rata between all investors based on how much they invested in the fund.

Here are the entities and relationships of a typical venture management company (firm) and its fund(s).This structure follows a rule of thumb structure, it isn’t a law—funds can and are structured differently at the discretion of those creating them. But it’s a good primer in fund basics.

Additional Reading:
The Meeting That Showed Me the Truth about VC’s and How They Don’t Make Money, by Tomer Dean
So, That’s How Venture Capital Firms Work: VC Demystified, by Sahil Khosla


The content of this article originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 99 additional tips for founders looking to understand the world of new venture financing there.

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

What’s life like in the startup funding business?

8 tips for funding your company, so you can change the world and the rest of us can live better as a result

funding startup businessesSome folks tell me they don’t think it’s important for founders seeking startup funding to understand VCs.

I get it. VCs occupy a complex world and often there’s a highly contextual finance component that might be foreign to some founders.

But in my experience, it’s a real advantage.

You wouldn’t build a presentation without considering the audience, or start a marketing campaign without learning in detail about your target customer. Funding your startup is no different.

Understanding your counterparts won’t transform a bad company into a good one, but all things being equal, it gives you a competitive edge.

If you know the enemy and know yourself, you need not fear the result of a hundred battles. –Sun Tsu

The world VCs live in

Many founders have images of VCs as deified rich folk who maniacally force entrepreneurs through complex hoops before whimsically bestowing unlimited cash on a lucky few.

The reality is that venture capital is a dynamic but risky and difficult business. This section outlines key concerns and realities that VCs deal with, which may not be well understood by founders.

#1 One thing every investor believes

Entrepreneurs often mistakenly view the role of investors as validating them and their company. They think investors are waiting around looking for causes to believe in or moral justification for handing over the cash and that they will invest if the founder can just convert the investor into a believer in their company.

But investing isn’t philanthropy.

And all types of investors make investments for the same reasonthey believe the value of their investment will go up.

While investors may ultimately be swayed by a belief in the company and its founders, that doesn’t happen unless they first believe that they will see a return.

#2 Startup funding arbitrage

Venture capital businesses generates returns by funding startup companies at early private valuations, then selling at later (often public) valuations which are higher. Early companies are way more risky, but there’s also more equity available for the investment dollar.

A stark difference between these investments and investing in public companies, is that VCs can influence the outcome. They can do things to improve their chances of a return.

Venture capital isn’t just a ho-hum stock purchase, it’s a value-changing event for the portfolio company, both now and in the future. After investing, VCs often nurture the value of their investment by providing important connections, mentorship and advice, board oversight, and connection to subsequent stage capital.

Privy to intimate details and in a position to influence the outcome, funding startups is in many ways a legal form of insider trading.

#3 The price of liquidity

Why are public companies typically worth more than private ones?

The answer is that they provide greater liquidity to investors.

While private, you often have no market or path to turn your equity into cash. This is what it means to have an illiquid investment.

Your chance for a return comes when the company sells or goes public.

Contrast that with an investment in publicly traded stock. If things start going poorly for a public company, you can sell anytime.

Fred Wilson, startup funding venture capitalist with Union Square Ventures

Fred Wilson, Union Square Ventures

Most obvious during 2015–16, the relationship between public and private valuations got a little upside-down for a few private companies. This prompted the following comment from New York-based Union Square Ventures founder, Fred Wilson, on CNBC in 2015,

Public markets are doing a good job of valuing technology companies, but the same cannot be said for private investors. The big problem: Start-ups can get much better valuations in the private market, so when they go public, their shares may end up trading below their last round of financing. Private markets need to be ratcheted back, but how that will happen remains to be seen…

A deeper look at startup funding and private overvaluation is available in Rise of the Paper Unicorns and the subsequent overcorrection in Irrational Cynicism.

#4 VC is the X-games of investing

Most startup companies fail, making funding startups an extremely risky choice for building an investment portfolio.

In 4 Strategic Startup Risk Components for Investors, I mentioned that VCs need great fortitude to invest in startup companies where the SBA says these companies have a 50/50 chance of going out of business before their 5th birthday.

If you wonder why your VC is picky to the point of paranoia, it’s because of VC is the X-games of investing. One false move means a devastating loss of capital.

If you wonder why your VC is picky to the point of paranoia, it's because VC is the X-Games of investing. Click To Tweet

Only the very experienced or the dangerously inexperienced play here.

Additional Reading:
204 Startup Failure Postmortems, CB Insights

#5 Four exits only

After startup funding there are only 4 possible exitsVCs may not be able to predict the future, but there are really only four possible ways an investment can end.

In other words, each startup investment only has four potential exits: it could IPO, it could be bought up via M&A, it could limp along throwing off cash, but never really growing to significant size, or it could crash and burn.

Only the first two are acceptable to venture investors.

They risk the last, in order to have a shot at the first.

#6 VC firms are often startups themselves

While its true that there are a number of legendary name brand mega-VCs, many venture capital investors are young and investing from relatively small and nascent funds. They are in effect, startups themselves.

It’s hard to build a successful VC firm. In the past 10 years, 20 percent of firms have gone away. As of 2015, there were 798 VC firms in the U.S. and not all of those are “active.”

A recent article in Fortune suggests that there are less than 100 active VCs investing in technology and that there are many “zombie” VCs which are riding out their funds but no longer make new startup investments.

Which serves to increase performance pressure and the risk aversion among startup investors.

#7 VCs don’t invest (much of) their own money

Most of the money VCs use to invest belongs to limited partners (LPs) who are in turn investors in the VC fund.

These LPs are essentially investing in the VCs and hiring them to invest their money competently. As a result, VCs typically do not invest from the fund the same as they might invest personally.

They are often constrained by their fiduciary obligations to the investors in their fund. Which means they may have their hands tied no matter how much they like your company personally. Their obligations may limit their ability to invest.

No matter how much a VC likes your deal personally, their fiduciary obligations to the fund may limit their ability to invest. Click To Tweet

timing affects startup funding#8 Capital as inventory

All of that LP money is burning a hole in the VCs pocket.

Quite literally the clock is ticking to generate returns on the LP investment. In the VC business, money is like inventory that must be turned if they are going to generate a profit.

 

All of this is to say that your VC may not view the dollars he is considering investing in your company the same way you are.

It will be much less personal, and she may feel urgency and constraint around terms that you aren’t even aware of.


The content of this article originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 84 additional tips for founders looking to understand the world of new venture financing there.

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

Killing it in 2017, an inspired year for Utah VC

Startups going slow to go fast

Utah slipped a few spots in the VC rankings for 2017, but still turned in an outstanding year.

I’ve been pretty excited to report Utah’s per capita venture funding as third highest in the U.S. in 2015, or last year seeing Utah’s VC numbers top $1 Billion (disappointingly revised down to $814 million). I love Utah and I was excited to see it bucking national trends and getting some recognition that I felt had been late in coming.

So how did 2017 shape up?

Utah companies raised a respectable $1.047 Billion across 109 deals (according to Pitchbook’s VC Monitor report).

It ranks 5th in the nation for venture capital raised per capita. That’s about $350 in VC money for every resident in the state. Ahead of the beehive state were the predictable biggies and DC. Respectively, MA, CA, DC, and NY

Utah also ranks 11th in total capital raised in the U.S., behind CA, NY, MA, IL, WA, TX, FL, CO, GA, and PA.

2017 was clearly a very solid year for companies here in Utah’s Silicon Slopes.

But you know, I admit to being just a little stung that, as the VC industry as a whole enjoyed a good year with over $80 Billion in investments, Utah’s culture, growth and startup momentum didn’t quite keep pace with the biggest states for VC.

Of course I immediately recognized my foolishness, and was reminded of a story and the principle of switchbacks.

I was born outside Seattle, but did most of my growing up in Utah.

One of the things you first notice about Utah is the landscape, the mountains. The majestic peaks are everywhere, noble sentinels whose vision reaches back before human memory and forward to a future way beyond any of us.

I love the mountains.

Something started at UC Berkeley in 1905 but perfected in Utah — akin to glorified institutionalized graffiti — is the tradition of tagging our mountains with letters. Big letters.

The Y at Y-Mount

The most prominent of these letters is the Y. The Y sits on the relatively smallish peak of Y-mount which kneels, like a short kid in the class photo, in front of the much larger Cascade mountain.

A common passtime in Provo is to hike the Y.

A short 1.5 miles and 1,000 vertical feet gets you to this giant letter and an impressive view of Utah Valley: the mountain peaks on all sides and Utah’s oversized Sea of Galilee in the distance.

The first time I hiked the Y, I was in the Boy Scouts. That was awhile ago.

There were no benches and fewer signs (the trail has improved much since then). We parked at the bottom and I remember looking straight up the steep grade to the Y. I could see it directly above us on the face of the mountain.

So I and two other boys started hiking — straight up the face.

I hadn’t noticed the trail head to the left or that the adults with us were corralling the other boys toward it. In my enthusiasm for the hike I just started off in what I believed was the shortest route from point A to point B, a straight line.

It was tough going.

We scrambled through sage brush and around stands of scrub oak; over rocks and tall grass. In the unrelenting heat we climbed straight up. We hurled our boyish energy and enthusiasm at the mountain, and eventually we conquered it, arriving at the Y spent and exhausted—to see the rest of our troop sitting down eating their packed lunches and enjoying the view.

It had been work for them too, just not nearly as much.

What we had accomplished on our own through brute force, more energy, and more risk, they had accomplished tapped into the wisdom of generations before and arrived at the same destination with energy to spare, by taking a switchback trail and effectively going slow to go fast.

I recently hiked the Y again.

It was harder than I remembered. Probably because my body is older.
But my mind is stronger. I never once doubted that I was getting to the top. That made it easy to never give up.

I realized that this metaphor applied to Utah businesses and our culture of relentless execution.

Don’t get discouraged because people pass you on the trail. Just keep going.

One of my favorite principles is the 20 mile march. This was touted by Jim Collins in Great by Choice, and echoed by Utah’s own inimitable Gavin Christensen of Kickstart Seed Fund  in Modern Vikings and Entrepreneurship.

Utah’s 2017 was it’s solid 20-mile march as it continues to build one of the greatest environments to start companies, solve problems, and change the world. If you’re looking for a place to live, work, or do great things, you’re selling yourself short if you don’t consider doing it in Utah.


@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

12 Reasons VCs Say “No”

(That Are Rarely Shared)

Life as an investor is about saying “no” a lot of the time.

It's a no.

For founders looking for one “yes,” it can be maddeningly impossible to decipher why VCs are telling you “no.”

Around 1 percent of companies seeking venture money get funded. If your company stinks or you have a black hole for a personality, it’s easy to see why a VC would turn you down.

But what if you’re a rock star with a great team and a a stellar company?

There are a lot of subtle and hidden reasons why your company isn’t a fit for any particular VC firm. Running into them can feel like beating your head on the sidewalk, especially if the reasons are a mystery to you.

Over the years I’ve been blessed to interact with a handful of investors. Here are 12 common reasons that don’t often get shared.

#1. You aren’t swinging for the fences

This is probably the least mysterious of the 12. VC investing is a risky endeavor. Most startups don’t make it, therefore most VC investments turn out to be failures.

If that’s true, how does a VC make any money?

Well, the few winning companies have to make up for a lot of losers.

Y-Combinator founder Paul Graham blogged,

“In startups… the distribution of outcomes follows a power law…. The big successes are so big they dwarf the rest. And since there are only a handful each year (the conventional wisdom is 15), investors treat ‘big success’ as if it were binary. Most are interested in you if you seem like you have a chance, however small, of being one of the 15 big successes, and otherwise not.”

VCs are trying to figure out which companies in their portfolio are going to be those all-important winners.

As for founders, you must at least be trying to win big. You’ve got to have big vision and big energy behind it.

In other words, if you aren’t swinging for the fences—VCs literally can’t afford to consider investing in your company. In that case, it’s super easy to calculate your probability of hitting a home run (and of getting VC investment).

Zero.

#2. It’s hard making a living at the horse track

Venture investing is a lot like betting on horses.

It’s not purely gambling. You can learn how to judge horseflesh and jockeys. And the right odds can set you up for a windfall.

But it’s hard to consistently pick winners and you lose more often than you win.

With startups, it isn’t just about telling a good one from a bad one. I love what Jerry Neumann spoke about recently on Patrick O’Shaughnessy’s podcast: Startup investing is not about risk, it’s about uncertainty. Risk can be adjusted for. But nobody knows what will happen in an uncertain situation. Great investors are those who have the stomach for uncertainty.

All startups are by nature riddled with flaws that could become fatal. There’s always a genuine reason NOT to invest.

(Check out Bessemer Venture Partners’s Anti-Portfolio, highlighting the great companies, which they passed on in the early stages.)

The moral of the story is that VCs are justifiably picky and there is always a legitimate reason to say, “No.”

You have to accept that the reason may not make sense to you. In this case, you’ve just got to move on.

#3 The cream didn’t rise fast enough

VCs are looking for big winners. A VC may say “No” because it wasn’t obvious enough, fast enough, that your company had the potential to be a big winner.

Or, the competition beat you out for the top spot on their roster.

VCs screen a lot of deals, but invest in relatively few. If your company is awesome, but the third best deal they’re reviewing, you may get a pass. If it takes too long or your company doesn’t rise to the top of the list, that can make the difference.

You will likely not know who you are competing against or what the factors were that ultimately tipped the scales against you. Since there isn’t a lot you can do about that, your best bet is to stay focused on relentlessly building the best company you can.

#4 You lost momentum

So much of raising money is about timing.

Momentum matters in the VC community. A sense of inevitability around your company builds FOMO and signals to investors that yours is a train they need to be on.

Momentum matters both in your company’s pace for hitting milestones and in the critical mass of your relationship with prospective investors. Don’t be annoying, but don’t allow the pace of your contact and interaction to stall.

That can be a difficult line to walk.

And means you have a lot of timing issues to navigate. What’s your timing in the market? What’s the timing of your company’s milestones? Where’s the urgency? Where should it be?

At one company I was at we were raising a Series A, and we started in an awkward phase where our ARR was on track to be 200% YOY plus we had just inked a key partnership deal that would double our new revenue for the year. We were set to have a 400% growth year!

The problem? These revenues were tied to industry seasonality and wouldn’t materialize until that fall, eight months later.

Key performance measures were in place. The work was done and nothing else was required on our part.

But the timing was off for us to show the momentum we saw inside the company.

Ultimately, we used the Spring and Summer to plant seeds with prospective investors and painfully waited until fall to kick our fundraising into high gear. This allowed us to paint an up-and-coming story with investors, which was borne out as the revenues we had secured materialized.

We easily could have made the mistake of going out to raise without momentum which would have been injurious to the business and our fundraising prospects.

Bottom line is that VCs are human beings. Human beings sometimes behave like magpies and are quickly distracted by shiny new things. If your deal slips into the old news category, you have the now much harder job of trying to breath life and excitement back into it in order to secure investment.

Additional Reading:
A VC Explains Why It Takes So Long for Startups to Raise Money, by Diane Fraiman of Voyager Capital. (An excellent article on why it can take longer to raise money than you think, and how to keep up the momentum.)

#5 No dry powder

It turns out VCs don’t have unlimited funds.

And the timing within the lifecycle of a VC fund affects how deals are evaluated.

A typical VC fund is created with a ten-year lifespan. Roughly speaking, the first half of the fund (both time and dollars) is for making new investments, while the latter half is for follow-on investing and pushing deals to exit in order to finalize returns to the fund’s investors as the fund draws to a close.

A new fund is raised each 2-4 years.

Depending on the deal flow, VCs often don’t have a constant availability of capital to invest.

VCs may be asking, would this deal fit better in the new fund? Is this deal appropriate as the final deal in a fund that is nearly all deployed? Am I distracted by issues related to raising the new fund?

This means two things to founders. First, the lifecycle timing of a fund can affect the attractiveness of your deal to the fund. It’s important. Second, there’s only one way to discover anything about a particular VCs fund lifecycle dynamics. And that is to ask them.

There’s only one way to discover anything about a particular VCs fund lifecycle dynamics. And that is to ASK them. Click To Tweet

In my experience it is uncommon for this information to be volunteered, but is generously offered when asked for.

VCs are constantly on the lookout for great deals, so they will not necessarily balk at taking a call or appointment with you even if they have no dry powder to make an investment.

Find out if the VC has dry powder.

#6 The Goldilocks principle

When a VC fund is created, it typically has a set of governing documents—a charter, an operating or partnership agreement—which spell out how the fund will operate. VCs typically focus on a fairly narrow band in terms of investment amount. A minimum or maximum investment size may be spelled out in the documents, such as no single investment will be over $5 million or 15% of the size of the fund.

As a result, VCs can’t have their deals too big or too small. Just like Goldilocks, the deal size needs to be just right.

Find out whether the amount you are looking to raise is within the allowable and typical deal size for the VC.

If you’re outside the sweet spot, they may have no choice but to say “No.”

#7 Industry alignment

Venture fund organizing documents or management philosophy may limit investment activity to certain industries. VC firms may choose to invest only in technology companies such as Graylock Partners famously does. Or it might be biotech, SaaS, medical device, real estate, manufacturing, etc.

The key is to know what sectors your VC is active in, so they don’t have to tell you “No.”

That way you can focus your energy on investors where you have industry alignment.

#8 You’re in the wrong place

VCs may limit their investing to certain geographies. You need to approach those who ARE investing in your area or move your company to a place where investors are active.

The highest concentration of VCs is on the coasts. Silicon Valley in Northern California has more VC activity than anyplace else in the world bar none.

In the East, New York and Boston are the hubs. Some VCs in these areas will invest anywhere, while others like to stay close to home. If they have deal flow locally, why fly across the country for board meetings?

Less prominent communities still may have a strong startup ecosystem, such as Austin, TX or Salt Lake City, UT. It’s typical for those communities to have more local funding for early investments like Series Seed and Series A, while often companies must still turn toward the coasts when it’s time for a larger round.

Being in the wrong place is a reason VCs say, “No.”

#9 Portfolio construction

As a founder, a round of investment is a singular thing. You aren’t often raising multiple rounds at once.

This is not true for your investor. VCs invest capital in a portfolio of companies.

While invisible to you, the relationship between companies in the portfolio can be very important to the VC. They may already have invested in a competitor, in which case they are unlikely to fund you. They may be looking for synergies between portfolio companies where there is a mutual benefit. They may be looking for companies to shore up other dynamics between portfolio companies, such as exit horizon, access to talent or technology.

Portfolio construction is a common reason for a “No.”

#10 An ugly capital stack

Most companies don’t raise money the moment they are born.

That means they bring history to the table, which might include an ugly cap stack.

If you need to clean up your capital structure, that can add time, legal expense, and the potential for fights with existing shareholders (who may be unsupportive of corrective measures). Messiness, prospective hassle, and expense are turn-offs to investors.

Capital structure corrections are common, but given the choice between otherwise equal companies, one that requires extensive correction and one that doesn’t, VCs are likely to avoid the hassle.

Cleaning a messy capital structure is something you may want to tackle before you approach investors.

If an IPO is a potential exit, your capital stack may contain problems that need to be fixed before the price of your shares and the number of shares required for the public float are appropriate for a successful entry into the public markets.

The cleaner your cap stack, the more attractive you will be.

#11 Lack of social proof

VCs, like the rest of us, are influenced by social proof.

Whether its recommendations on Amazon or Yelp reviews, we feel more confident in making decisions when we see others making the same decision. Psychologist tell us that we’re wired to look to others for signals as to what the correct behavior is in any situation.

Social proof is also why warm introductions are better than cold ones.

It’s way more effective to be introduced to a new investor by one who has already committed to your deal, or via the CEO of one of the investor’s portfolio companies.

The intro comes with a tacit recommendation, which is disarming and safe.

When it comes to landing that first investment, no investor wants to be the first kid in the pool. It’s much easier to invest when another investor is already in the deal or when you know others are seriously looking.

Ideally, you want multiple investors chasing you right through your first investment, providing the confidence to each other that your company is a hot item.

Conversely, lack of social proof makes VCs afraid everyone else knows something they don’t and wonder why nobody else is interested.

Absent social proof, you’re chances of a ‘No’ go way up.

#12 You’re missing a champion within

As you build a relationship with a VC firm, you are likely to meet multiple people serving various roles. It’s common for VCs to have an investment committee where partners sponsor prospective deals.

Throughout the process, you need to establish a champion inside the firm. That’s the person who is likely to go to bat for your company. It rests on them to win internal support for issuing a term sheet and shepherding your deal through the due diligence process to funding.

Find a champion and make sure that she never regrets sticking her neck out for you.

#13 Know when to say “No” yourself

This is a bonus tip.

It is tough for a founder to turn down bad money. When you’ve pursued a long sometimes arduous process with a VC, saying “No” when the term sheet comes in can go against everything in you.

You owe it to yourself to understand your ultimate goals and know when terms represent workable compromises versus unreasonable requests.

Additional Reading
There’s No Shame In a $100M Startup, by Eric Paley and Joseph Flaherty of TechCrunch

You should know when something is a deal breaker for you—it can be terrible to be tied to bad money.

Good luck out there.


The content of this article originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 84 additional tips for founders looking to understand the world of new venture financing there.

2016 Sees Utah top $1B in venture capital for the first time

2016 saw Utah companies raise over $1 billion in venture capital, a huge milestone for the Beehive State.

99 Utah companies raised $1.17 billion in 2016 according to the latest Venture Monitor report, from NVCA and Pitchbook, closing out 2016 Q4.

2016 saw total VC investments nationally shrink from their peak in 2015 (with $69.1 billion invested vs. $72.3 billion in 2015) as some of the unicorn bloat shook out of the market and skittish VCs withdrew from seed stage deals and bet heavy on later stage rounds. That’s pretty good news.

The great news is that Utah bucked the national trend with a banner year in 2016. What’s behind Utah’s growth running counter to the rest of the country.

Well, Utah does a lot with a little.

In 2015, Utah firms reported $875 Million in capital under management. That’s after coming in a respectable 8th place in the country for new commitments to venture funds: $284 million for 2015.

But in terms of total capital, that puts Utah 18th in the U.S. (even D.C. is ahead of us and they aren’t even a state). If the 2% rule held true, you could pay the management fees for every single VC Firm in Utah for less than $18 million. Muy poco.

Look at the giants in VC. CA by contrast reports over $90 billion and NY and MA are each over $20 billion under management.

Historical VC raised in Utah 2010–2016

So Utah’s capital resources are puny.

In other words, despite Utah’s local venture firms growing their funds at a healthy clip—and those firms doing an awesome job at getting Utah companies off the ground with their seed and A rounds—the companies in the state still need and capture outside investment.

Modest as locally available capital is, the remarkable thing in Utah isn’t the age or maturity of its locally sourced capital. Utah’s story isn’t about a venerable history of finance (no disrespect to the firms that have operated in the state for years). No, Utah’s story is the explosiveness of its growth.

Utah now represents 1.7% of all venture raised in the U.S., Utah isn’t the heavyweight Lennox Lewis, it’s welterweight Sugar Ray Leonard punching way above its weight class and coming on with a fury.

Utah’s on a three-year tear. As anyone who attended this month’s Silicon Slopes Summit can tell you, it’s showing no signs of slowing down.

It’s interesting to note that over half of Utah’s funding falls into the growth equity category. Ironically, this is evidence of Utah companies focusing on building their businesses in a more traditional sense, focused on revenue growth rather than growth at the expense of revenue. Utah startups, even in tech, tend to be prematurely profitable, conservatively run businesses with legitimate traction measured in long-standing metrics—crazy stuff like consistent revenue growth from paying customers.

Utah ranks 8th in the nation in terms of total capital raised in 2016 (behind CA, NY, MA, TX, FL, WA and IL respectively), but is coming off a 4th place ranking in 2015 for growth equity raises at $538 million.

Utah has maintained its 3rd place ranking for per capita venture capitalsince 2014, beating out New York for the #3 spot again in 2016 with $390.45 per person in the state.

The moral of the story is that if you’re looking to leverage a disproportionately favorable startup ecosystem, which won’t require you to mortgage your firstborn to rent an apartment nor to sacrifice your health and family for phantom productivity, follow in the steps of companies like Chatbooks and wherever you started, find a way to locate your startup here.

Source: NVCA/PitchBook 2016 Q4 Venture Monitor Report


Irrational Cynicism

unicorn bubblesFaux Bubbles

I have a theory about bubbles. I am developing a theory about faux bubbles too. I think the past six months have seen the popping of a faux bubble in valuations of private companies, especially apparent in those that are venture backed.

My theory about bubbles is that they occur when there is a disconnect in how the free market operates. There are lots of folks decrying the free market and throwing up examples about how the free market didn’t prevent this or that from happening. For me the market boils down to supply, demand, price and the motivation of self-interest ala Adam Smith. A bubble happens as an unintended consequence of trying to manipulate these principles. Because manipulations sully them.

What we have in the private VC correction is a faux bubble. It’s based not in an actual manipulation or disconnect, but rather in a fluctuation of demand created by the emotions of the herd. The overcorrection is likewise caused by the herd, not by the underlying fundamentals of the market. There isn’t enough erosion in the fundamentals for these to be long-lived.

In a recent blog post by Redpoint, the case is made that the current correction in SaaS valuations is a result of an emotional market, not one that weighs the fundamental value drivers.

I agree 100%. The current landslide in SaaS valuations is a temporary correction. Ultimately companies will trade based on their fundamentals and the industry average multiples for their group. IMO we are seeing a backlash against unicorn valuations and investors are timid about being caught out investing in stocks that everyone and their dog felt were out of whack. Current conditions are driven by fear of looking dumb to your friends because you have money invested in Snapchat and Uber.

Utah Tops the Big Apple in Per Capita Venture Capital

Hard to believe? Note the per capita qualifier. In fairness, NY based startups raised over $4.2 billion in venture funding in 2014 compared to Utah’s paltry $800 million. *sniff* Utah didn’t bring home more total money, but they brought home a lot and did it with a much smaller population. So, I don’t find it too far a stretch to say that Utah entrepreneurs are akin to the 300 Spartans at Thermopolae—only at winning over venture capitalists instead of Persian immortals.

Online Graphing

Utah’s growing ability to capture venture funding has enjoyed some pretty good press. In straight-up comparisons, Utah fares pretty well. It’s been a good season for Utah. Accolades for Utah and the companies here have been voluminous. One Inc. article even taunted Move Over Silicon Valley: Utah has arrived. Now if you’re in Silicon Valley, that seems a bit silly. But that’s because the Bay has such a HUGE lead. In fact, Utah is probably drafting Sandhill Road, close enough to fly out and back in the same day, and catching some of the slush that washes over the gunwales from the Bay Area. No matter, Utah companies are getting it done. Local firms and their ability to attract both number and dollar volume of funding deals has been outstanding in 2014.

What interested me was trying to see how Utah stacked up against the usual venture capital suspects per capita. I wanted to look at those numbers. I mean Utah lags way behind any of the biggies if we are just looking at the totals. I hadn’t seen anyone do a per capital comparison. Why would that matter? Well, I assumed that the amount of funding captured by a given population would represent a certain funding fitness that summed up all the elements at work in producing funding-worthy companies and entrepreneurs. You know, out of n population, we generated x number of fundable deals. There are other measures, for instance the Tech Startup Density reported by NerdWallet (Salt Lake and Provo made the top 20 in the U.S.). But that doesn’t tell me much of what I want to know. If I’m an entrepreneur, where do I go to marinade in the right ecosystem to build and fund a successful company. … And, what if I don’t want to live in the Bay Area?

So I compared state census data and a report from the NVCA and PwC, and came up with the following top 10 states based on venture capital dollars raised per capita. The numbers were stronger than I expected. Utah came in third in per capita venture funding raised. We were behind New York and Boston… way behind, but still in front of 47 other states and that includes New York! Utah was almost twice the national average, which skews high because of the monolithic golden state (take CA out of the mix and Utah is over 4x higher than the U.S. average per capita).

It’s no surprise to find CA in first place. Silicon Valley is practically synonymous with Venture Capital. Utah at number three, was a surprise. Edging out NY for per capita VC raised is pretty much the greatest upset since the BYU women’s basketball team upset No. 1 seed Gonzaga in the WCC tournament.

I’ll posit that the per capita venture capital garnered in Utah and other states, is predictive. It’s a canary in the proverbial coal mine, the tip, the surge within the peloton that forms a leading indicator of awesomeness to come. So, if you’re an entrepreneur with a great idea and an indomitable spirit… and you happen to live in Alaska or Montana (two states that garnered a combined total of zero funded deals in 2014), pack up your things and come out to Utah!

 

A Bias for Action

Sam Robinson was an early mentor in my career. Currently tearing it up as the CEO at Sam Villa, this is a man who has forgotten more about business (and particularly retail) than I will ever know.

I met Sam when I was running the marketing for the retail division of Provo Craft. The company had just completed its first $100 million year and was taking private equity money from a local PE firm. With the money came a lot of changes. Changes in management, policy, goals and culture. Sam was brought in as the new head of the retail division and became my new boss.

One of the things Sam was great at, was navigating change with repeatable sayings. He consistently preached that, as a department, we would exhibit a “bias for action.”

Now the concept of action bias made its way into the American lexicon as a result of several psychological studies, including examining soccer goalies. The keepers displayed action bias by lunging one way or the other when their best bet for defending the goal was actually to stay put. In these studies, action bias reflected detrimental impatience and instability. But despite this lesser-known reference, Sam’s use of the expression was infinitely more useful, practical and positive for us. He wasn’t reading psychology anyway—he was getting stuff done.

In Sam’s parlance, a bias for action was all about execution. No management process represents airtight communication. Nor should it be. Sam understood that the culture should dictate most of the decisions of individual employees, rather than top-down instruction through the chain of command. A culture around a bias for action was his way of instilling an ethos of productivity. If you found yourself at a momentary loss for what to do, just find a way to act. Chances are it will move the company incrementally forward.

This maxim is rooted in the same principle as “Even if you are headed in the right direction, you’ll get run over if you just sit there,” “A rolling stone gathers no moss,” and “Execute, execute, execute.” It was GTD at the most elementary level.

Since that time, I have tried to incorporate the principle of action into my habits (along with several other nuggets of wisdom I owe to Sam), and been much better off for it.