Fred Wilson has a spectacular post up on how VC funds should think about reserves. It’s even more valuable to entrepreneurs so they can understand how the best VCs think about reserves, giving the entrepreneurs ammunition to ask their investors how they are thinking about reserves.
I only noticed one thing missing from Fred’s post which is a statement about cashflow which I commented on.
“Fred – phenomenal. The only thing I noticed missing was a comment on fund cash flow. To recycle, you have to have the cash flow. If you don’t have the exits to generate funds to recycle, you can hit a cash flow wall where your reserve model breaks (since you don’t have the cash to fund the reserves.) There are several solutions to this, including recalling capital, having an annex fund, and suspending management fees, but the best is having the cash in the first place …”
In addition to the post being great, the comments have a lot of rich stuff in them as well.
Reid Hoffman, founder / executive chairman of LinkedIn and partner at Greylock has started blogging. Well – he’s started writing long form essays on a blog that my understanding is will come out about once a month.
The first post is If, Why, and How Founders Should Hire a “Professional” CEO. It is outstanding and I expect Reid’s blog should be on your must read list. My only complaint is there are no comments open – I’d encourage Reid to engage with people reading this, rather than just lecture to us!
Q: When building a financial projection model for a pitch to VC’s, should you include future rounds of funding in the model or simply show what measurable goal you are trying to achieve with the current round you are seeking?
A (Brad): It depends on the stage of the company. But first, it’s important to understand how a VC is going to look at your projections in the first place.
- Early and pre-revenue: Investors are going to be most interested in your near term burn rate and how long their money is going to last. Focus on putting this information front and center – don’t hide it. Recognize that your revenue is totally speculative so the “base case” is going to be zero revenue.
- First product in the market, < $100k / month of revenue: Revenue matters here and the projections out into the second and third year will give a good indication of how you are thinking about the ramp of your business. However, if your revenue is modest, a smart investor is going to look at your gross margin also. If you are a recurring revenue business, the month-over-month growth – both of revenue and gross margin, is going to be important.
- Meaningful revenue, > $1m / quarter: You have entered the zone in which you have a real business and likely can have a credible growth plan out three or more years.
Now, in every case, a VC is going to be interested in how long the current round of financing is going to last. In early cases, they are going to focus on cash / monthly-burn-rate. In later cases, they will factor in some amount of revenue and gross margin projection, but likely discount both, viewing you as being overly optimistic on revenue as well as the gross margin percentage.
Then, building off of this, they will be interested in how much additional money you think you will need to get cash flow positive. They’ll calibrate this against whatever your current plan is. The earlier the life of your company, the more skeptical the VC will be of any projections of revenue, and any time horizon greater than one year.
Update: I just noticed a twitter comment that said “I would suggest that it should take you up to their expected exit as that is most definitely their primary concern.” While some investors may ask for this, it’s the exception as most rational investors will want to understand what it takes to be cash flow positive. It’s impossible to predict the exit as there are too many variables at play, including the notion that you can’t force an exit. However, you can run a business indefinitely without additional financing if you are cash flow positive. So I’d assert that showing the plan getting to cash flow positive is much more important than showing the plan getting to an exit.
In 2008 my partner Seth Levine wrote what I think is the definitive post about how to get a job in venture capital. His post followed an insightful earlier post of his that he wrote in 2005 titled how to become a venture capitalist. Each post is required reading for anyone interested in a job at a venture capital firm.
I get asked this question at least twice a week and use Yesware to send out an automated answer that includes a link to Seth’s post. Today, I noticed a new post from Alex Taussig (Highland Capital Partners) titled 3 ways to land a job in VC. It’s a good addition to the two posts that Seth previously wrote.
I always notice that the number of inquiries I get for jobs at Foundry Group increases in February and March as all the second year business school students in the US start looking for a gig. My advice – read the three posts and start your search a lot earlier.
Fred Wilson (USV) has today’s VC Post of the day titled Herky Jerky Investing. In it he refers to a WSJ article where several very prominent VCs have recently said they are backing off investing at frothy valuations and now going and looking off the beaten path.
Fred – as usual – has very a very focused reaction to this:
“I am not a fan of this start and stop style of investing. Nobody can time markets. You can’t deliver great returns to your investors by being a momentum investor during some periods and a value investor in others.
I believe the only way to be a top performing investor in any asset class is to have a disciplined investment strategy and approach and apply it consistently and actively in all markets all the time.”
I (Brad) strongly agree and weighed in with my own comment with a cynical view:
“I had the same reaction to the WSJ article. Actually, I had a stronger reaction: “what a load of bullshit – why does the WSJ publish stuff like this and why do VCs say things like this?”
The only thing I could come up with is that it’s actually a head fake from the people saying it with the goal of getting some of their fast followers – VCs who are investing with them, competing with them on “hot deals”, and driving prices up to “slow down and blink” so there’s less competition.”
The comment thread on Fred’s post is very interesting – I encourage you to go take a look and form your own opinion.
Question: How do VCs mitigate risk in their investment portfolios? Are VCs simply looking to diversify the type and stage of companies in which they invest, or do they employ other financial hedging strategies?
I’m not aware of VCs using classic financial hedging strategies. In many cases, they are prohibited from doing this by their LP agreements and/or investment documents in the companies when they make an investment. While I’m sure there are some folks that do this, I don’t believe it’s prevalent.
The primary ways VCs mitigate risk are (1) time diversification, (2) stage diversification, (3), sector diversification, (4) pro-rata or over pro-rata investing over time, and (5) number of investments in the portfolio.
1. Time diversification: Most VC funds are committed over a three to five year period. The commitment period for most funds is five years – by spreading out the commitments over a three to five year period, a fund gets time diversity and theoretically smooths out some of the macro cycles. Most VCs who have been investing since the mid-1990’s understand this well as many funds raised in 1999 and 2000 were fully committed in one year. As a result, the funds were invested during the rapid rise and peak of the Internet bubble, resulting in horrible performance for 1999 vintage funds due to their lack of time diversity. The firms that committed their 1999 over a three year period vs. a one year period ended up making a number of investments as the bubble burst, including many that ultimately ended up being successful.
2. Stage diversification: Some funds have an early stage and late stage investing approach. The VC industry went through a phase post 2000 where there was a shift in some early stage firms to mid and later stage investing as well as a phase in the late 1990’s where early stage firms created growth funds to augment their early stage strategy. Today most of the firms that did this have settled on an integrated early / late stage approach within a single fund. Recently, many larger firms who had drifted away from seed stage investing have created new seed programs.
3. Sector diversification: Historically, a number of VC firms had broad sector diversification, investing in software and life sciences companies out of the same fund. With the rise of clean tech investing in the mid-2000’s, many software oriented VC firms started clean tech practices. This ebbs and flows.
4. Pro-rata or greater: Most firms reserve the right to invest their “pro-rata” ownership in future rounds, allowing them to keep their percentage ownership in the company. This is both a downside and upside strategy. More recently, some firms have started aggressively buying additional ownership in their winning companies.
5. Number of investments in the portfolio: There is conventional wisdom that each fund should have 25 – 30 companies (or “names”) in each fund. Recently, some firms have taken a more extreme approach with upwards of 50 or more companies in each fund. Regardless, if you are playing for big wins, making sure you have enough investments in each fund is important.
There are other diversification approaches like geography (e.g. investing in the US, China, and Israel), but these tend to be limited to a few very large firms.
Question: We are looking early stage funding for our startup and came across some people claiming to be “VC Broker”. Is there such a concept in the investing world?
It’s highly unlikely that they are legit. I’ve never heard the specific term “VC broker” before and generally don’t think much of people who represent to early stage companies that they “can raise money from VCs for you for a fee.”
There is definitely a category of consultants that prey on early stage companies. These are people who offer to “do something for you for a fee.” You should approach all of these conversations with skepticism if the person wants to charge you money for this.
If they represent themselves as being a conduit to VC financing and you want to explore more, the first thing you should do is ask them for a comprehensive list of all of the people and contact information with whom they have done work for in the previous two years. You should then systematically contact each of these people and find out how things went. In most cases, the mere act of doing this will flush out all of the nonsense.
Interesting, there was a similar question asked in 2007 – see the post Are There Venture Capital Brokers? for a somewhat broader treatment of the topic. There is also a good post up on The Smart Startup site titled Beware of Venture Capital Brokers.
Finally, there is, not surprisingly, a site called VC Brokers. Ironically, the link to “Entrepreneurs” is blank and throws a 404 page not found error.