risk

There are 3 posts tagged risk (this is page 1 of 1).

Risk Tolerance

If there is one thing in Canadian startup land I have heard repeatedly since moving back from California it is in regards to the lack of ‘risk tolerance’ of VCs here. When I was on the operational side of things I didn’t know many Canadian VCs so I couldn’t really comment, but I heard the stories. In fact, I will be completely honest that the idea of joining a Canadian VC fund was the furthest thing from my mind.

risk and rewardBefore I share my thoughts on risk tolerance let me start with a few points. First, I think that we can all agree the landscape is improving. There is a new generation of  entrepreneurs, investors and community leaders emerging. I am blown away at how different things are now compared to five years ago.

Second, we need to once again state that Canada is NOT the Silicon Valley. It is a silly comparison even from a geographical perspective as comparing a small region with critical mass to one of the largest countries in the world is insane. Vancouver, Toronto and Montréal are not the Silicon Valley in the same way that Boston, Austin, New York and Des Moines are not either. Anyone who sees Canada as its own insulated eco-system is completely out-of-tune with reality. Capital and technology knows no borders. Mark nailed this earlier this week.

Lastly, there is a level of talent, experience and excellence in the Silicon Valley that can’t be found anywhere else. There is a reason Facebook moved to Palo Alto in its early days. There were entrepreneurs and investors who had been exploring the potential of a social web for almost a decade beforehand. No where else in North America could you find this. Pinterest moved from Kansas City to San Francisco for the same reason. One of iNovia’s portfolio companies, AppDirect, started in the Silicon Valley as the founders (Canadian btw!) knew that the talent they needed to build a large-scale enterprise platform was there.

So what can Canada, or anywhere outside of the Silicon Valley for that matter, do well. I can both observe and predict to answer this question. In recent years it has become apparent that B2B SaaS companies can be built anywhere. Look at the thriving companies across Canada – HootSuite, Shopify, Freshbooks, Lightspeed, etc. All SaaS companies. This is not unique to Canada either. ExactTarget was built in Indianapolis. MailChimp in Atlanta. eCommerce companies have similar characteristics. Amazon is in Seattle. Wayfair is in Boston. Groupon is in Chicago. Beyond the Rack is in Montréal. However, it is hard to name large consumer Internet, enterprise platform, networking or hardware companies outside of the Silicon Valley. Of course, there are a few outliers – Tumblr in NYC for example.

The other thing that Canada, or any region, can do well is build critical mass in a brand new and emerging market. RIM (BlackBerry) did this in the Waterloo region by leading the emergence of smartphones. Calgary has been the hub of most stock photography and graphics companies over the last 20 years. Route 128 in Boston dominated the minicomputer industry back in the 70s and 80s.

All of this results in the eco-system we find ourselves in and behaviour of investors. It is less likely that a consumer application with no traction will get funded in Canada because there are not funds big enough to make a long bet on it and there isn’t the talent that improves the chance of success.  We also lack senior management talent, especially in sales and marketing, as it generally resides were the majority of customers – in the US. This is why many Canadian startups build its sales and marketing teams in the States. We often proactively syndicate larger Canadian investments with US funds as they bring complimentary resources to the table and can significantly mitigate future financing risk as they have deeper pockets. All of these factors results in the eco-system we find ourselves in. Blame the system, not the players as David Crow would say.

One last factor in determining risk tolerance is rarely discussed and it is simple numbers. Investing very early in a company with no traction does require incredible intelligence, it requires incredible conviction. Savvy entrepreneurs know that to find the investor that has that conviction is going to be tough so the best approach is as a pure numbers game. This means they talk to a ton of funds. Tim Westergren, founder of Pandora, said that he had over 300 VC pitch meetings before getting funding. 300! In Canada there are not a lot of VCs, lets say 10. There are very high odds that you can talk to every fund in Canada and not find the conviction you are looking for in any of them. It is simple math – if you are looking for a needle in a haystack do you have better odds looking in 10 places or 300? Unfortunately, this is then chalked up to an issue with ‘risk tolerance.’ I can’t speak for every VC across the country, but I can report that approximately half of our initial investments are made before there is a dollar of revenue in the company.

My advice to entrepreneurs would be to start local as you may find the investor that has the same convictions you hold. They may be able to connect you to US investors to put a strong syndicate together as well. What you shouldn’t do is talk to the local VCs and then complain about risk tolerance – even if there is truth to it. The successful entrepreneurs get on their horse and find ways to get in front of investors from the Valley, New York and even overseas. Ryan found his first investors in the US. Yona found his first angel investor in Europe! Jack and Rian found their first investor in Germany!

We have seen a ton of US-led investments in Canada recently and this is great news. Often this is perceived as a problem in Canada. I disagree – it is great. In many of those cases local VCs passed or perhaps they lost out as the deal became competitive. That is completely fine as well. In the past Canadian investors were forced to be generalists, but I hope this recent trend drives more domain focus within Canadian VCs. As much as we need world-class entrepreneurs and startups we also need, to a lesser extent, world-class funds and investors. This is why I went against my initial instincts and joined a VC fund in Canada – the team was focused on becoming a leading North American fund and was actively investing in the US. I believed that this was the right approach and the only way we are going to be able to compete in the long run as capital becomes even more fluent across borders. Canada is a small player on the global tech stage and as a friend of mine used to always say “What’s so great about being the best hockey player in Kuwait?”

Lets all aim higher.

[Ed. note: This originally appeared on Kevin Swan’s Once A Beekeeper on August 12, 2013, it is republished with permission.]

Fundraising, Valuation and Accretive Milestones

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I keep having a similar conversation with early stage entrepreneurs about fundraising and valuation. “Do you think a $1.5MM valuation is good?” “How much should I be raising?’ Well, it depends.

I’m finding more and more, the conversation about valuation is one that resembles not being able to see the forest because of the trees. Early stage entrepreneurs tend to fixate on valuation and assume product is the biggest risk at the seed stage thus defining product launch metrics as key metrics. Often, valuation and risk mitigation are tied together. And the milestones or traction metrics required to mitigate risk can help establish valuation. 

Valuation

Fortunately, valuation is a topic that others have covered. Nivi and Naval, on VentureHacks, have provided incredible insight into early stage fundraising over the past 5 or 6 years. The advice is often summarized, “as much as possible is especially wise for founders who aren’t experienced at developing and executing operating plans”. The translation means that founders see rounds of seed stage companies raising $4.2MM at what must be a huge valuation.

 “‘As much as possible while keeping your dilution under 20%, preferably under 15%, and, even better, under 10%.’ ” – Nivi

You can make some basic assumptions about the valuation. Most seed stage companies should be looking keep dilution in the 15-20% range. The specifics will be determined in fundraising but you can start to do some back of the napkin estimates:

You start to see a range for how much a company will raise at what valuation. The numbers aren’t set in stone but they provide a framework for estimating the amount valuation. As Nivi points out the difference between a seed round and “a Series A which might have 30%-55% dilution. (20%-40% of the dilution goes to investors and 10%-15% goes to the option pool)”. The more you raise early, the more dilution you can expect. The goal becomes managing the different risks associated with startup. You also see why raising debt early, which allows companies and entrepreneurs to delay valuation until certain accretive milestones, is attractive.

“The worst thing a seed-stage company can do is raise too little money and only reach part way to a milestone.” – Chris Dixon

So given the back of the napkin dilution terms, what are the milestones that you will need to hit in order to raise the next round.

Raising the next round

So you’ve raised a round, how much should you raise at the next round?

I like the rule of thumb that Chris Dixon uses. “I would say a successful Series A is one where good VCs invest at a pre-money that is at least twice the post-money of the seed round.” The expectation is that companies are roughly going to double their valuation at each raise. This isn’t to say that a 2x increase in value is your target, it’s the minimum, the floor. The art of raising a round it to raise enough money to get to a significant milestone, and not too much money taking too much dilution too soon. So how do you define the milestones. The milestones

“partly determined by market conditions and partly by the nature of your startup. Knowing market conditions means knowing which VCs are currently aggressively investing, at what valuations, in what sectors, and how various milestones are being perceived.” – Chris Dixon

So part of the market conditions, i.e., raising money in Canada is different than raising money than in Silicon Valley, New York , Tel Aviv. You are measured against your peers, and this might be defined by geography of the company or the VC. Being connected with other companies, advisors and investors can help provide insight in to the fundraising environment. The second part is determined by the nature of your startup, but generally expressed as measures of traction. We’ve talked a lot about getting traction and what traction looks like to a VC.

“The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone. Building a product is only accretive in cases where there is significant technical risk – e.g. you are building a new search engine or semiconductor.” Chris Dixon

Entrepreneurs tend to focus on the product early. This is usually because the product is something that entrepreneurs can directly affect. But the product risk, is may not be the  biggest risk that entrepreneurs need to mitigate early. The trick is figuring out which risk you need to eliminate to satisfy potential investors. And you can try to figure this out yourself, but I like to see entrepreneurs engage investors and other founders to get their opinion. The discussion usually is a combination of what other startups are seeing in the market place as milestones from investors (yay, market place data). Then you can work backwards the necessary resources and burn rate to reach those milestones.

Thoughts?

Additional Reading

The Backwardization of Risk/Reward in Startups

I’ve always thought it weird that there is a perception that risk is front-loaded for startups, i.e. the person(s) who start it take all the risk. In some ways, the risk of starting a company (especially a web startup) is lower than ever:

  • there are great grant/tax credit programs like IRAP and SRED
  • there are more incubators, angels and providers of small seed funds than ever
  • its faster than ever to go from concept to commercialization -> you can have paying customers in < 6 months

It just isn’t as hard as it once was to raise $20-$50k and/or have a company generating a few thousand dollars in revenue to cover the early founder(s) costs. The big “risk” is that your life & business align to this cost structure. Your business needs to be able to run with only 1-3 people at first. Your life – no fancy sports cars, no big mortgage, no massive piles of credit card debt, etc. I’d hypothesize, there is a strong parallel between managing personal finances and being able to start a company.

Another big “de-risker”. You have control as the early founder! Only you can lay yourself off. And you control the culture and lifestyle of the company, i.e. you are a lot less likely to hate your job or get fired for hating your job or leave suddenly or have a heart attack or just generally hate life.

I won

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Reward-wise, you have a huge chunk of the reward. Shares, not options. Big founders cut. Maybe no vesting. Dividends. There are a lot of paths for you being well rewarded for the risk you took. On top of that, your experience as a first-time entrepreneur will make the second time around all that much smoother, it’ll be easier to raise money, easier to hire, easier to find business partners, and so on. You can have a career as an entrepreneur.

Now, lets compare that to what is traditionally thought of as the “low-risk” employee, lets say employee #8. Poor employee #8 takes on massive life risk, and often gets very little in reward.

Reward-wise, they get something like .5% of the company, so on a typical $20-$30mm exit they get $100-$150k. Hardly life-changing money. If you are a super-star in the company you may get granted up to 1 or 2% but they’ll be vested over an annoyingly stupid schedule such that you’ll have to be at the company for 6-8 years to “earn” them.

Now compare that to all the risks of being employee #8:

  • you are far more likely to get laid off than any of the founding team
  • you are far more likely to get laid off than a non-startup job
  • you may simply not get paid a few times… missed payroll is no uncommon event
  • you probably in fact took a pay cut, or at best, you’ll miss out on bonuses when there are a few tight years
  • you will likely work a lot longer hours
  • there’s no “fast” trade-off, you’ll need to work there 4-7 years to earn your $100-$150k stock option reward, and you may have given up way more than that in time & salary to get there

So, in summary, its a lot better to start your own company than to be employed by a startup. And in many ways its less-risky and better to start your own company than to “have a job”. And I wish I could make more people take the entrepreneurial leap themselves because its simply not as scary as it seems.