Can you build a unicorn business outside the Silicon Valley?

This is a follow-on post to my last blog post about building a global-first startup

The tl;dr for my last post is that these days geography is rather confusing. It’s quite common for a San Francisco Bay Area company to start hiring from day one an engineering team that is elsewhere and building up a real hub elsewhere even though everyone sees them as a San Francisco company. Or for a startup located outside of the US to sell to US companies.  The world is a lot smaller than it used to be.  

And so for these reasons, I believe that to start a company, you can start building a startup these days from pretty much anywhere. The most important thing in the earliest stages is to try to get to product Market fit quickly.

Knowledge has become commoditized at the earliest stages – you can pretty much read about Lean Startup anywhere on the internet.  But what about scaling a business? 

The numbers are actually pretty sobering.  I went ahead and graphed some interesting fundraising data from past portfolio companies that I’ve invested in either as an angel or as part of a team where I was a/the decision maker.  

I took my whole portfolio of all companies that I had invested in between 2014-2016 and created pie charts based on geography. N = over 250 companies in this dataset.

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You can see the vast plurality of companies that I invested in during this time were largely international companies  Note: for the purpose of this exercise, I separated out my Canadian startups from the rest of the world. (Canadian startups are so similar to US startups that I thought they deserved a category of their own.)

I did the best job that I could in labeling just one geography for each startup, but this exercise was a bit tricky. For example, a company that I had invested in is categorized as a San Francisco-based company even though the vast majority of their employees are now based in Dallas. The reason for this is that when I invested in them, the founders were and still are based in San Francisco, and the bulk of their decision-making and operations were happening here at the time.  On the flip side, I classified a number of companies whose founders had recently moved to the US from another country and were doing significant operations in that other country as “other int’l”, even if they were US Delaware C corps. As you can see per my last blog post, it gets a little bit complicated. 

I then went ahead and grabbed the companies that made it to the Series A level and graphed what the breakdown of those startups look like by geography.  The reason I say Series A level is that I have a number of portfolio companies who have done well in revenue and have not had to raise larger rounds.  So if a company had raised a series A, I labeled the company as a Series A company regardless of where the raise happened. Now, I understand that there are some issues with the nomenclature because a Series A in the Bay Area is so much later than a Series A in say Australia, but, this was the best I could do. In addition, if a company had not raised a Series A but had hit US Series A milestones – namely $2m+ “net revenue run rate”,  then I counted the company as a Series A company.

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What is interesting about this graph is just how much the percentages have changed.  Let’s come back to the analysis in a second.

I went ahead and did the same exercise with Series B companies.  I graphed my portfolio that had graduated to the Series B level. And again, for companies who raised a Series B – whether here in the US or abroad — were labeled a series B company.  For companies who had hit US Series B traction milestones – namely 10m+ annual net revenue runrate – I also added those companies to this category as well.

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You can see that this graph has changed even more.

Here are my takeaways: 

1) The San Francisco Bay Area punches above its weight. (not surprising)

One could try to argue that perhaps my San Francisco Bay Area founders are stronger. While I couldn’t tell you whether that’s true or not, intuitively, my gut feeling is that that is not the case.

What I do think is happening here is that the San Francisco Bay Area has a lot more capital, and so there are more startups that get more funding than in other parts of the world. And by proximity of being here, it is easier to access the capital (even though there is also more competition).

But the other thing that I think is happening is access to talent and knowledge, especially as companies scale. I tend to invest in businesses that require less capital. This tends to skew towards B2B companies or other businesses where the margins are nice. I tend to prefer investing in companies where if they could never raise a dime of VC funding again, they would still be able to survive and thrive.

And I’ve applied this lens across all geographies. So as a result, I would not expect such wild differences in ability to get to the Series A level or the Series B level even if there is less capital available in other markets. But you can see that there is a big difference.  

1b) One side note: also, if I remove startups who have founders with pedigree, then SF doesn’t punch above its weight and proportionally stays the same at each stage. 

2) International companies outside of the US & Canada have a much harder time raising money.

You can see that across-the-board, my international companies have had really had a tough time getting to the Series A or Series B level.

And again, I attribute this to less access to knowledge about scaling, less access to capital, and less access to talent that has scaled businesses before. One potential wildcard explanation for this lack of success is that the US & Canada have pretty established customer acquisition channels.  But, that isn’t the case everywhere globally, so it may also be that customer acquisition makes marketing and sales in the US & Canada just faster and that other international companies just need more time to make headway.  

3) Companies based outside of the SF Bay Area that have been successful have spent significant time in the Bay Area

The last interesting thing I would say here is that if you look at the Series B companies, anecdotally I can tell you that all of those founders have cultivated lots of relationships here in the SF Bay Area to get scaling knowledge and access to capital.

Takeaways:

I don’t think you need to be in the San Francisco Bay Area to start a company. In fact, I actually think that since your money goes so much further elsewhere and knowledge is commoditized regarding starting a business.  As an early stage founder, you really should just focus on product-market fit wherever you feel is best for you to live.

BUT!  If you want to start scaling a business – call it at the Series A level and beyond – that’s when you really need to start having connections ideally to the SF Bay Area to raise money from and have a network / learn from and potentially even a pool of people to hire.  

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Image courtesy of Giphy

If you are starting a business outside of the Bay Area and want to build a unicorn business, in today’s global economy, it is significantly helpful for you to start building from connections on day 1 to the SF Bay Area.  

How to think about different types of funding for your early stage startup

One of the things that I’m noticing is that the early stage financing scene is changing quite rapidly. It may not feel like it — it’s still hard to raise money of any form, but there are a lot more options now than say even 5 years ago.

Traditionally, you have a lot of tech startups flocking to venture capital firms to raise money, because VCs have done a great job, as an industry, in marketing themselves. But the vast majority of startups who seek VC funding are not the right profile for that type of funding. As an entrepreneur, this is something I didn’t understand — what types of funders are out there and who is a good fit for what?

For example, angels and VCs are often lumped together in the same category. Afterall, they both invest in early stage startups on an equity-basis (this includes investing in convertible notes and convertible securities as well)  But they could not be more different. (See my post on closing angel investors)

In this post, I want to talk about different categories of funding beyond equity-based financing. These are categories I’d not even thought about as a founder. Here are the rough categories of financing options for early stage founders:

1) Equity financing (priced / notes / convertible securities)
2) Revenue based financing
3) Debt financing

…and some permutation of the above!

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Image credit: Giphy

1) Equity financing

This is the one that everyone knows about or at least has heard about. In its simplest form, with equity financing, you as the founder sell shares in your company for cash.

Variations on this include using convertible notes and convertible securities (SAFEs / KISS doc). (see here for details on the differences)

What most people don’t realize is that this is the most expensive form of financing if you are successful. Why? Because your payback amount is delayed significantly and the amount you end up paying back is a LOT if you are successful.

Let’s say you sell 5% of your company for $100k. You think “whee! I have $100k to work with.” In 10 years, if you do incredibly well, and now your company is worth $100m and you sell your startup for an all-cash deal, you pay your investor $5m (assuming no dilution in this example). That is a 50x return for your investor.

Now let’s suppose you had a crystal ball and you knew this outcome would definitely happen.  Knowing that, would you take this deal? Of course not. $5m is a ridiculous amount to give up for a $100k investment. If you knew for certain that this outcome would happen, you would likely try to fund your business with other money so that you could retain the extra $5m for yourself. Right?

Now of course, the reason entrepreneurs take this deal is that you don’t know ahead of time if you will be successful in 10 years! And most founders don’t get to this outcome. A common phenomenon that I see successful founders face is that they are at first incredibly excited to raise their first couple of rounds of equity but then later, they become a bit frustrated that they have taken too much dilution.

Guess what — equity investors need to take a lot of your company in order to justify the risk they take so early on in your business. The heavy amount of equity you sell in your business needs to offset all the losers in a given investor’s portfolio (plus more).

People don’t realize that equity financing is one of the most expensive forms of financing — because you don’t feel it until years later.

The flip side is if you raise equity financing and your company does go belly up, you don’t owe anyone anything. The investor is taking all the risk here as well.

2) Revenue based financing

Revenue based financing is a bit akin of income-shared agreements (ISAs) for individuals. With revenue based financing models, an investor invests money not for shares in your company but for a repayment percentage until you hit a certain cap.

In this model, say we invest $100k and the deal is to pay 10% of your revenue every week until you hit 1.2x or $120k in total repayments. Let’s say that next week, you generate $10k in revenue, so in this model, you pay back $1000 that week. And the week after that, let’s say it’s a great week, and you generate $20k in revenue, so you pay back $2000 that week. Now let’s say that the following week, you have a bad week, and you make $0. You pay back $0. In this model, the investor is with you through the highs and the lows — always taking 10% no matter what. If it takes you 6 months to hit $120k in repayments, that’s a great fast return for the investor, and if it takes you 3 years to repay back $120k, that’s probably a lot slower than the investor would have liked with a much lower IRR. He/she is with you through the ups and the downs — that is the risk that he/she takes.

Investors in this model make money by essentially picking companies that are generating fairly consistent revenue that have low default risk, and they are trying to target quick payback periods so that their IRR is high.

Now, let’s compare this form of investing vs equity investing. Suppose again we are pretty certain we can sell our company for $100m in 10 years, I would rather take $100k in revenue-based financing. Afterall, I would only have to pay back $120k instead of $5m.

But, let’s say we are at the very very beginning of our startup, and we don’t have many customers and not a lot of revenue. Equity financing allows us to keep all of the cash we make to pour back into the business. We don’t have to pay anyone out each week, and that extra cash can help us get to the $100m outcome faster on an equity investing model. Moreover, we probably wouldn’t qualify for revenue-based financing at that stage.

3) Debt financing

The last form of common early stage financing is debt financing. Unlike revenue-based financing, this is time based. This is also the cheapest form of capital but also the riskiest to the entrepreneur. In debt financing, if an investor puts $100k into your company, he/she is looking to be repaid back with interest by a certain date. So, say we do a debt investment of $100k into a company, we might ask for $120k back after 1 year (the principle plus 20% annual interest).

In addition, often, you have to personally guarantee a loan if your company cannot pay it back. Sometimes, debt financing come with warrants as well — if an entrepreneur cannot pay back the debt within a certain time period, the entrepreneur must give up other things including equity in the business.

So even though this is the cheapest form of financing, it’s also the highest risk for the entrepreneur.

Tying this all together…

Let’s analyze all of these forms of financing. First off, usually debt is the cheapest form of capital and equity is the most expensive. Now you might think, “Wait, a minute! 20% annual interest in this last example feels really expensive!” But when you compare the interest to the revenue based financing model and the equity model, it’s not.

To compare all 3 of these financing options, we need to look at the returns on the same time scale.

  • An equity investment of $100k that turns into $5m 10 years later has an average annual IRR of 48% per year.

 

  • A revenue-based financing investment of $100k that turns into $120k in 6 months has an average annual IRR of 44% per year.

 

  • And of course, a debt investment of $100k with 20% interest after 1 year has an average annual IRR of 20% per year.

Of course, if the time scale for the revenue based financing model changes, that will impact the IRR. And if the company that raised money on an equity basis exits earlier or later, that will also change the IRR for the equity-based investment.

Now of course, we are just looking strictly at what capital each scenario can provide. However, it’s possible that with a value-add investor, he/she can change the trajectory of your company. In the equity example, what if it were your $100k investor who introduced you to your would-be acquirer? Then the $5m repayment seems totally worth it. Or what if he/she introduced you to your key hire that led to the acquisition? Totally worth it.

Wrapping this up…

Even though it’s a much cheaper form of financing, founders are typically averse to debt. It’s a natural reaction, because in our personal lives, we go around saying, “Oooooh, debt is bad.” In our personal lives, debt is often bad, because your own cashflows are generally not growing faster than your interest rate. You typically are not getting 20%+ year over year raises each year.

In a startup, if your revenues are growing 20% MoM and your interest rate is only 20% year over year, you are growing your business significantly faster than your debt. And so not only will you have the cash flows to cover this 1.2x multiple of investment, but cash that you can put to use today will make your company worth (1.2^12) 9x more valuable a year from now, while you are only required to pay back 1.2x of the cash you took in.

In the early days when you have no revenue (and maybe you cannot get other forms of financing), equity financing is the least risky for you as the entrepreneur, because not only are you NOT on the hook for losses, but you can pour all revenue back into your business. But once you start to get some certainty around your revenues and some predictability around your cash flows, it may make sense to look at a blend of different forms of financing.

For example, let’s say we’ve started a business, and we are doing $12k per month in revenue and growing on average 20% MoM. What if we did $90k in equity financing and 10% in revenue based financing? If our revenue and cash flows are growing at more than 20% year over year, then this could makes total sense.

On the surface, it may seem insignificant to only raise $10k in revenue based financing, but when you think about what that could potentially become in 10 years,  using the example above, it would be $500k in liquidity in 10 years on a $100m company exit, which is pretty significant.

I think that once you have some level of understanding of your cash flows, it makes sense to look at your composition of financing and try to figure out what proportions of various forms of financing make sense based on your risk tolerance and predictability of your cash flows. I don’t think we do this enough as business owners.

The one secret that Micro VCs keep when they reject a startup

As an entrepreneur, it never even crossed my mind to think about how investors decide which companies to invest in.  Lots of investors blog generically about how they invest in great teams, big markets, maybe some traction, yadda yadda yadda.  Regardless of the VC — whether it’s a big VC that will lead your seed, series A, series B, etc. rounds or a small micro VC that will only write a small seed check — they all generally think about the same characteristics of your company.  They may have differing theses on these characteristics and form different conclusions, but they all look into the same things.

Except one.

There is one criterion that micro VCs must consider when deciding to invest in a company.  And no one talks out loud about this.

Whether or not a company can get downstream capital from other investors in the future.

A micro VC, by definition, writes small seed checks and doesn’t do any follow-on investing.  This means that once they have written their check, the firm cannot carry the company further.  Certainly they could help with advice and introductions — but not with money.

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Gif I wanted to use but has nothing to do with anything

There are exceptional cases where a company will never need to raise again after a seed round and will still be able to continue its growth, but this is a bit of a rarity.  A micro VC must consider what will happen if a company is not able to raise beyond the seed check.  Will the company go under?  Will the founders be so tenacious that they will keep ploughing through no matter what?

This makes it difficult for micro VCs to make contrarian bets – investments in companies that few or no other investors will touch.  Most micro VCs will pass outright.  Contrarian investments are often companies that are in:

  • Competitive markets
  • Markets that other investors hate
  • Unusual markets that most investors don’t think about, think are small, or think are insignificant

At 500 Startups, we are not really doing follow on investments these days, and so when I meet a founder and have conviction to invest, I have to believe that he/she will be able to raise beyond my small check.  I’m pretty upfront with a founder in telling him/her that I think it will be difficult for him/her to raise further.  Often, I’d want to know what would happen if he/she were not able to raise beyond my check.

Personally, I’m comfortable making a contrarian bet — even as a small investor who isn’t able to write a follow on check (after all, Google was like the 8th search engine in a super crowded space…).  BUT, I have to have a lot of conviction that the company has above-and-beyond more tenacity and survivability than what I would expect from other companies AND that the outcome, if all went well, would be more lucrative to my firm than alternatives.  Essentially, I’m expecting them to prove out equivalent progress to their fast-growth peers and sit out one round of funding, hoping that the next set of downstream investors will pick them up after proving out more.

Competitive markets

If I’m making a bet in a competitive market where there are multiple alternatives, usually, I’ll drill into the details, differences, and nuances of the product and user experience a lot more than, perhaps, a company in a more empty market.  It’s these details  — this experience — that often makes all the difference.

It has to be a BIG difference, not just incremental, in order to win in a competitive market.  Sometimes it’s not the product or the user experience that makes this 10x difference — sometimes it’s in the business model — but I’ve found it usually ends up trickling down to the user experience as well.

Markets that other investors hate

Markets tend to be cyclical.  One of my pet peeves is that markets go in and out of favor – usually for no good reason (though not always).  Usually what happens is that investors have poured too much money in a given space, and then a few high-flying companies in that space end up going belly up.  Then, everyone else up-and-coming in that space suffers because investors are no longer excited about investing in more companies in that space.

Unfortunately, if you’re in one of these spaces, there isn’t a whole lot in your control.  It will simply be harder to raise money.  It doesn’t mean you have a bad business – it just means that there may be less investor appetite for your business at this time.  The good news is that all of these markets are cyclical, and so your business may come in favor with investors in a few years again.

Unusual markets

I think this is changing but still has a ways to go.  If you’re serving a customer base that either few investors understand or understand as a lucrative or big opportunity, then investors may just pass outright.  In the past, this has been more of an issue because a lot of investors have traditionally had a similar worldview.  With newer investors and firms emerging with different perspectives, you may be able to find someone with a similar thesis if you look hard enough.

All-in-all, if you have a company that falls into one of these categories, you should know that micro VCs, in particular, will need to find more conviction than usual in order to invest in your company.  They simply cannot carry you beyond their initial check and rely so much on downstream investors to help their companies in the later stages.

How do VCs measure their success (and why should you care)?

When I was an entrepreneur, it never crossed my mind to wonder how VCs measure their success — but I should have thought about it.  Following the money can really help illuminate VC behavior and their incentives.

The #1 problem with the venture capital game, in general, is that actual success is measured over decades, not years.  It means that investors will not know if they are any good at investing for decades.  Any investor who tells you otherwise is BSing you.

So, as an entrepreneur, you might be pitching to people who may not even be good investors.  I’ll be the first to admit that I don’t know if I’m a good investor or not, and realistically, I won’t know for at least another decade when I see how all my investments shake out.  It takes a long time to see the results of a startup that does well.

This means that in order to measure milestones along the way, investors must come up with proxies for success.  This is necessary but far from perfect.

So while I’m waiting for my portfolio companies to either die or go IPO, what am I looking at as indicators of success and failure?  Primarily these things:

  • Companies dissolving
  • Companies exiting
  • Companies raising equity rounds

All of these are concrete events that attach a numerical value to a company.  Obviously, when a company dissolves, it’s typically worth $0 (in most cases, there are no sellable assets).

Companies that exit are valued at whatever the sale is.  If it’s an all-cash deal, it is easy to understand, and the value is what it is.  If a company sells for stock or partial-stock, then it’s more complicated, depending on whether the acquirer is a public company or a private company, and we don’t need to dive into that in this post.

And, lastly, when companies raise an equity round, there is another investor who has (in theory) done due diligence and assessed that a company is worth a certain amount.  But as we’ve seen, these valuations can be hocus-pocus — even at later stage rounds, we’ve seen lots of companies of late fall from grace and become massively devalued overnight when they cannot raise their next round at a higher valuation.  If a company raises a good round, it gets marked up to the new value. If a company takes a down-round, it gets marked down.

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Originally posted by newsweek

But what if a company is growing revenues but hasn’t raised a round in a while?  Shouldn’t they get a bump up in valuation?  Intuitively, you might think, “Yes! They are now worth more than before.”  But let’s say we have a company that raised a convertible note round at $3m cap 12 months ago.  At that time, they had no revenue, and now they are doing a $500k revenue run rate.  When people invested in that round, there was an inherent assumption that the company would make money at some point and that the expected value of the company over its lifetime would be $3m.  That’s what that valuation means (in theory): how much the company is expected to be worth over its life.  Otherwise, there is no way investors would ever value companies that are making no money at $3m.  So, now that the company is doing $500k run rate, should the valuation go up?  Well, maybe not. After all, we expected them to make $3m over their lifetime — this was already baked into the prior valuation.  Many investors would choose NOT to mark up the company at this point even though they are making more money.  (For those who want a more sophisticated read on this, I highly recommend Scott Kupor’s post on valuations.  However, these other methods do not apply particularly well to early stage investing, in my opinion.)

Now let’s say we have two portfolios of companies.

Portfolio 1:

  • 3 companies
  • Last valuation for all: $3m cap convertible note
  • Recent raise: $1m for each company.  Equity rounds of $10m pre.
  • Traction at last raise: None have revenue.
  • Current traction: None have revenue

Portfolio 2:

  • 3 companies
  • Last valuation for all: $3m cap convertible note
  • Recent raise: none.
  • Traction at last raise: None have revenue.
  • Current traction: All are doing a $1m run rate

For simplicity, let’s say all companies in both portfolios are in the same industry so that we can compare apples to apples.  You and I might say, “Wow. Portfolio #2 is crushing it.  These founders are really selling.”

But at a VC firm, we would mark up the companies in portfolio #1 because they have all raised equity rounds at $10m pre.  Portfolio #2 hasn’t, and for the reasons above, we would not mark them up even though they are making money.  Interesting…

Now, let’s take this a step further.  A common intermediary milestone for most investors is IRR (internal rate of return) of the fund.  This is calculated based on the events above.  Dissolutions and cash-exits are accurate representations of a company’s value, but most events tend to be fundraising events since dissolutions and exits only happen once in a company’s lifetime.  So, there are a lot of unrealized gains built into the IRR of an early fund.  Furthermore, we’ve established that companies don’t get credit for revenue — this does not get factored into IRR calculations.  IRR calculations are based on two things: changes in a company’s value and the time-scale on which this happens.  So, one way to maximize your IRR is if you have a portfolio of companies who are able to raise quickly and frequently and at higher and higher valuations.  In many cases, companies that can achieve this are typically also making a lot of money (hopefully profitably), but this isn’t necessarily true.  Also, think about the flip side.  Companies that are making a lot of money profitably and don’t raise do not help an investor increase the IRR of his/her portfolio.

Let’s take this one step further. Typically, VCs raise a fund every three years.  Investors in VC funds — referred to as Limited Partners (LPs) — look at a number of factors in deciding whether to invest in a VC firm, but the IRR of past funds is an important criteria.

Putting this all together:

1. VCs are incentivized to bring in portfolio companies who can boost their portfolio IRR quickly.  This helps them raise their next fund.  This is what keeps investors in business — raising fund after fund.

2. VCs mark up portfolio companies when they raise money at higher valuations, and these markups get factored into IRR.  Company progress on KPIs, including revenue, typically do not get factored into IRR.

3. Therefore, VCs are incentivized, in the short term, to invest in companies that can raise their next round relatively quickly.  This is easier for investors to achieve when they pick companies that:

This is why investors like it when startups think about growing fast to raise the next round (as opposed to getting to profitability and growing more slowly on profits). This is why investors don’t want to hear about entrepreneurs selling early (sub $1B businesses).  Obviously, in the long-term, investors do care about the actual outcomes of its portfolio companies because ultimately, that is what matters. Since that is so far off, however, this explanation should hopefully illuminate how the VC industry views the short-term — and you should care because VC incentives explain so much about why VCs act the way they do.