Sunday, February 03, 2013

$1bn has 'gone' in 4 years

English: Diagram of the typical financing cycl...
Diagram of the typical financing cycle for a startup company. (Photo credit: Wikipedia)

Should tech angels stop investing in startups?

The current debate raging in relation to the so-called Series A crunch has highlighted for me the importance of startups and more specifically, angel investors, working more closely with VCs.

The Series A crunch is absolutely nothing new. Sometimes called the ‘valley of death’ for a startup business, the period between raising the initial friends and family or seed round and the first institutional money is a very difficult one and requires very careful navigation.

Sarah Lacy at Pandodaily has called this situation absolutely correctly and referenced a good piece of research from CB Insights who clearly state:


For me , the question is what should startup companies do to mitigate and how can angel investors minimize the ‘death rate’ of their investments?

At TAG we know a thing or two about the valley of death and the Series A crunch having invested in more than 60 tech startups.

Understandably, startups are obsessed with getting their seed round closed so that they can get on and make their first hires and building their products and markets. A bit more work and thought needs to go into where to get their seed funding and just how much cash is necessary.

A lot has been written about the so-called ‘signaling effect’ of taking seed funding from a top tier VC. The phenomenon and the concern is easy to understand. An investment from a top VC at Seed who then does not follow-on (for any number of reasons) provokes suspicions in prospective Series A investors.
The research by CB Insights proves the fallacy of this widely held theory.

On average, 39.4% of seeded companies go onto raise follow-on financing. Interestingly and contrary to what the punditry have often said, 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.”

This result makes perfect sense to me. VCs are better at predicting what VCs are likely to want to invest in at Series A.

This truism has been at the cornerstone of the TAG Seed philosophy from the very start and is largely the reasons why more than 70% of our seed investments have gone on to raise Series A.
Raising a Series A is, of course, no guarantee of building a decent business. Many companies need further rounds of capital to get to the point where they are generating cash. Getting a VC to back your series A is just the beginning. Sustaining and building on the relationship by delivering results is what will cement the partnership.

No fewer than 4 of the current TAG portfolio are generating profits in excess of £1m per MONTH and another 7 of them have reached profitability while growing strongly.[No prizes for guessing the names, list excludes profitable 'sold' companies].
The majority of these companies are less than 6 years old.

These companies have had the financial and other support to get them there – as well as the necessary talent and hard work – but their focus on being capital efficient and on profitable revenue marks them out. 

Raising funds for startups is generally much more difficult in Europe than it is in the US – particularly in the valley. As a result, the companies that do get funded tend to be more conservatively managed and focus on getting to breakeven quicker and on revenue and profitability at the expense of growth in users/customers.
During tough fund raising cycles, this approach has its advantages – but also leads to better habits and company culture – in my experience.

In addition to the usual criteria for investing in great entrepreneurs addressing large markets etc, angel investors really need to look at the opportunities with “VC eyes”.
A good understanding of the workings of Series A investors is a decided advantage. My time at Atlas Ventures in London – a day a week as Venture Partner - and more recently with Index has given me insight as to what to look for in a solid venture backed opportunity.

How will the founders play to an investment committee of a top tier VC firm? Can you envisage the business being large enough to ‘move the needle’ for the fund which is likely to be a candidate for series A?
Will we have sufficient runway to hit the milestones necessary to make it clear that product/ market fit has been achieved? Will we have the time and the resources necessary to ensure that the “go to market” strategy has been tested and validated?

So, Angels should definitely NOT stop investing in tech startups but do need to define their entry criteria really well.
It should seldom be about valuation but always revolve around the person or people being backed, their vision and how they are thinking of going about building something big. The initial valuation should take into account what has been achieved with scant resources but more importantly must reflect what the ultimate value of the company is likely to be.

Angels need to cultivate strong relationships with a few VCs and take time to understand them and their needs.
In turn, most VCs are on the lookout for active angels – often their best source of quality dealflow.
A big dose of mutual respect goes a long way.

Returns available for angel investors who take the time to study the markets and apply the appropriate disciplines are really very strong indeed and the opportunities available today exceed anything I have seen in 15 years of active investing.

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  1. Anonymous7:32 pm


    This is a fab post.

    I have a couple of questions. The data is so sparse and you obviously sit over a lot of it.

    In general, what kind of capital is required before a company generates £1m in revenue and then £1m in profits per month? Could you share the mean, as well a the most and least capital that was required? How long did it take those companies to get there?

    What do the revenue and traction curves look like for businesses that end up breaking out. Some of this (at a financial level) is available at companies house. And a business like Wonga (which appeared from the outside to look like it went like a rocket from the getgo) is less interesting, because of its success, than some of the others that are successful but perhaps let's adrenaline-fueled!!

    I'd personally be fascinated to understand MindCandy or Erply to see what their first five years looked like? (Is Erply even five?) What were the operational metrics that gave people comfort that this thing was going to be big? (How many users, user growth, attrition, unit economics, etc)



  2. Robin,

    I think it's interesting to contrast attitudes to repeat revenue funding. As I read it the key objective in the US is growth as king, with monetization and profits playing second fiddle.

    By contrast in the UK and Europe breakeven is the ultimate protection from whims of an unpredictable finance industry.

    So consider a company with an opportunity to market growth in profitable repeat business say LTV / CAC > 3

    In the UK the temptation is to under-invest and save for a rainy day. (A cohort of metrics may go south)

    In the US the temptation is to push for growth. Why not spend until Marginal cost = marginal Revenue

    Clearly both are right !

    This is a trade-off between market risk (growth can secure a dominant position) with financial risk (cash-flow is essential to keep a company afloat).

    In this context, it makes sense that UK companies are more conservative (more likely to survive) but somewhat less likely to "knock it out of the park".

    Our attitude to failure maps in the same way, and is reflected in the relative cost of early stage funding.

  3. James, You are spot on! The issues you highlight are at the heart of the argument: 'why doesn't europe create world beating companies'.
    My belief is that the next 10 years will produce many more than the last 10.
    As you say, both approaches are valid.

  4. Robin,

    Great insights, and from James in the comment above. When I dug into the CB Insights data a bit, and looked at another of their reports, I found that the size of seed deals has been increasing significantly over the past 2 years. I am sure some of this is a function of VCs moving downstream and putting more money to work earlier, but I believe it is also a function of smart entrepreneurs looking for a middle ground between the two approaches James outlines. By taking more money at seed (even with more dilution) they can chase growth and still have a decent runway.