The Differentiated VC
Note: This article was previously published on Linkedin on July 5, 2023.
VCs are such f****** hypocrites. Myself excluded. Maybe.
Perhaps I should explain.
I have often said that it is absurd how we insist that our portfolio companies be visibly and obviously a quantum level better than their competition and yet most venture funds’ value propositions are virtually identical:
“We are very smart and highly connected people who can make extremely valuable introductions and offer you critical guidance at key points in your startup’s journey” (usually followed quickly by) “and as former founders ourselves, we truly get what you are going through.” – Every VC ever born
Honestly, other than the logo and color scheme, most VC websites are basically the same.
But buried deep in the piles of same-same-but-different funds, there are some truly differentiated strategies that a VC can take. To be clear, I am not talking about competitive advantage. A fund can be just a little bit better and win a hot deal. I am talking about approaches that are so clearly different from all but a few other funds that startups (and LPs) lean back and say, “Now that’s different.” That is what I want from my portfolio companies and I do not think it is fair to expect any less from myself.
With that in mind, let’s start with the more traditional untraditional VC strategies:
Be the Top Fund (in your Sector)
“Hey, we are Andreessen Horowitz / Kleiner Perkins / Sequoia / etc so we get the best deal flow. Having us on your cap table is a strong signal to other investors, customers, and partners.”
Say what you want about this fund or that being overrated, if a founder thinks it is the best, there is a very good chance that he or she will go with that fund even if they don’t offer the best terms. Great strategy albeit not one that a new fund can readily take advantage of.
A variant on this strategy is to be the best in your sector. A battle of term sheets between the best generalist fund and the best specialist fund could go either way. Plus, if your sector is new enough, the ‘best’ slot may still be up for grabs.
How do you know if you are the best? Ask the startups you want to invest in. If you aren’t consistently coming up in the top 3, it ain’t you.
The CVC (or PE fund sidecar)
“Hey, we can be an investor and bring you both critical revenue and be a great referenceable client with which to get more customers and investment.”
Also a great option but only available to large corporates… who typically fail to execute it properly. That said, get this right and you should be able to get into virtually any deal you want.
An interesting variant on this is when a private equity fund sets up an ancillary venture fund to invest in the tech used by the companies owned by the main fund (e.g., a REIT with $1B in office properties carves out a sidecar to invest in proptech). As with CVCs, startups get access to a large and varied pool of customers but the air gap between the VC fund and the end customer is even wider.
How to make this strategy work is very, very tricky. If you’d like a taste of the complexity involved, here is a series of articles I wrote on the topic.
The Fund with Strategic LPs
“Hey, all 20 of my LPs are large multi-family developers or operators who are looking for pilots.”
This strategy is the logical progression from the CVC approach. The value proposition is similar, often with even more potential customers, but the weakness is even more pronounced. If the LPs cannot operationalize piloting with startups on their own, it’s even harder to do it with a separate VC fund that is an arm’s length away. On the other hand, when a corporate makes a large external investment, sometimes they are perversely more responsive to the VC than they would be to an internal team. Either way, this strategy takes thought and process to make it work. Getting the investment from the LPs is just the beginning.
Now let’s get into some of the less common and IMHO more interesting strategies.
Accelerator (or Venture Studio) Led
“Hey, we will roll up our sleeves and work with you from the beginning.”
Been there, done that for six years. For a top accelerator, it (arguably) works but for the rest, there is a lot of adverse selection as more experienced founders opt out. And it is a massively heavy lift. Definitely differentiated but more work, risk, and time to exit. Happy to discuss the circumstances when an accelerator makes sense offline but since anyone reading this article is likely familiar with accelerators, I include it mostly for completeness.
CTO Led
“Hey, we all have extremely deep technical expertise and will save you a lot of time and make sure you get startup-killing tech decisions right.”
Now things are getting interesting. Even startups with strong dev teams often lack specialized skills and rarely have the depth of experience that a ‘been there, done that, several times’ veteran CTO brings to the table so I see the appeal here. I do not have the tech chops to know how well this works across industries so it might need to be (or might work best when) paired with sector focus.
Business Development Led
“Hey, we have a dedicated business development team who will bring customers in the door and help shape up your sales team.”
This one interests me a lot. After all, what startup does not want more revenue? Many funds claim to make customer introductions but having a dedicated team takes it to a different level. I have seen it first hand; Customer Sprints were one of the most attractive elements of the Dreamit v2.0 platform that I helped build.
But bizdev is too time consuming for a fund’s partners to do ‘on the side’ and staffing even a smallish, sector-focused team is too expensive for smaller funds who invest in startups who can most benefit from this differentiator.
Side note: I am exploring a structure that might make this viable for small, seed stage funds. If you are interested in learning more, send me an email.
Recruiting Led
“Hey, we have a dedicated team of recruiters who will help you fill key roles.”
This one also interests me a lot for many of the same reasons as the prior example… with most of the same caveats.
One possible difference: a startup’s staffing needs grow exponentially as they scale and a mid or later stage fund could be large enough to support a dedicated team. But at that stage a startup can find recruiters on its own so how valuable would this actually be? I am not sure….
Design (or Development) Led
“Hey, we are an award winning design firm and can help you create beautiful sites and apps with the best user experience.”
I see this approach from time to time and it is always a design firm that decides to reduce its fees in exchange for equity, never a true fund. The problem is they are not qualified to assess a startup for investment so the equity basically becomes a lottery ticket and their program devolves into a way to cut prices when times are slow without actually admitting it. The proof? They never turn down full price paying customers to free up staff to work on a startup.
Another variant is the dev shop that builds sites and apps for non-technical founders for equity. In addition to the problem above, tech is often a critical component and VCs will simply not invest in a startup that outsources development. More subtly, having limited but in-house tech leads to focusing on which features deliver the most bang for the time to build; outsourced dev means asking “is this feature worth the cost.” The former makes a startup move fast, the latter is a recipe for delay.
Now let’s get into the even rarer, structurally differentiated VC strategies
The Un-fund
“Hey, we are not structured like a typical VC fund so we don’t have a 10-year expiration date that will put pressures on us that have nothing to do with your business.”
This approach includes both evergreen funds that recycle the proceeds of the exits into new investments as well as family offices and corporations investing balance sheet capital. Both these investors often tout their ability to be a more patient source of capital. Traditional VC funds definitely have an expiration date; they rarely invest after year 6 or 7 and by years 9 and 10 start to get pretty antsy about getting out of their remaining investments so they can close the fund. That said, they often have raised later funds that can continue to invest in growing portfolio companies and even (with a bit of care to avoid conflicts of interest) have those later funds buy out their earlier fund’s stake.
On the flip side, these types of funds are subject to their own pressures, Economic headwinds, slower than expected exits, corporate or family politics etc. can make it hard to access the promised funds and it is times like those when these investors wish they had dedicated capital like a traditional VC fund.
So IMHO this structure isn’t inherently more or less risky than traditional VC, just different. But is it differentiated enough that some startups – and more importantly, some of the best startups – prefer this kind of investor to a traditional VC? Honestly, I don’t know.
The Pro Rata Specialist
There’s no “hey startup” in this strategy. Funds like this don’t make the initial investment in startups. Instead, they partner with other funds and accelerators to buy up unused pro rata. They can then choose to invest in the companies that are succeeding and that they would otherwise have to fight hard, and often unsuccessfully, to get into. Think of it as a backdoor into great startups. It is not an easy strategy and there is definitely the risk of adverse selection as the funds who made the initial investment are less likely to sell the pro rata in their very best funds. Also, there may not be room for many funds to take that approach. A few funds have been doing it for years. You just don’t hear about them often because they tend to fly under the radar.
A related strategy is the secondaries fund. As a traditional VC fund approaches the end of its term, it typically has a few investments that are doing just OK. They are typically profitable but too small to sell or the founders still own enough equity that the fund cannot force them to sell. Since these startups are likely to be small exits and have already been in their portfolio for a decade, the ROI on them is low. So as far as the VC is concerned, they are basically a loss. But the startups have some value and for another fund that can buy out the original VC’s stake for pennies on the dollar, those startups can be fairly cheap lottery tickets. Most startups will never hear of these secondary funds but experienced VCs know them well.
There are not a lot of things in venture that are 100% but here’s one of them: I am 100% sure that I have missed some interesting, differentiated strategies so if you know of one, please drop me a line.
Is The Current Market Cycle A Golden Opportunity for Corporate Venture?
Note: This article was previously published
in CREtech on August 15, 2022.
Corporate Venture Capital has a bad reputation in the startup world. While there are some notable exceptions, this reputation is all too often well deserved. The best startups have their choice of investors and corporate venture funds are rarely at the top of that list and as a result even the best CVCs sometimes don’t get the opportunity to invest in those top startups. But recent economic conditions have dramatically reduced the supply of venture capital so this could be a golden opportunity for CVCs to get a seat at the table.
Why CVCs often cannot access the best deals
The reason CVCs have this reputation is manifold. Well intentioned but time intensive approval processes mean that CVCs often move slower than traditional VC funds. Misguided attempts to wring every bit of strategic advantage out of a deal often lead to offers with strings on them (e.g., rights of first refusal) often make taking strategic money feel like a deal with the devil. Even simply dealing with corporate legal departments who are more used to dealing with contracts, joint ventures and (perhaps) M&A deals line with typical early stage financing lead to over engineered term sheets that are often overcomplicated and ill-suited to the tasks at hand.
And the results show up in the returns. Although returns data for CVCs are notoriously difficult to compile, unpublished analyses by Correlation Ventures show that dollar-weighted (by round size), realized, cash-on-cash multiples for all U.S. venture financings in companies exiting, were 2.2X for all financings vs. 1.8X for all financing with at least one CVC participating.
The usual explanation for this is that CVCs invest for strategic reasons so are less price sensitive. So all other things being equal (viz., exit values), if the valuation at the time of investment is higher, returns on exit will be lower.
While there is no doubt good anecdotal evidence to support this thesis, there’s one big flaw. If CVCs are offering startups higher valuations, wouldn’t startups prefer to have them leading their rounds?
I suspect that the truth is a little more subtle. If CVC’s negatives are causing the best startups to ignore those investors then CVCs are fishing in a shallower pool to begin with. In that case, the average quality of an investment made by a corporate venture fund will be lower simply because the top performing startups have opted out.
How can a CVC capitalize on the current situation?
Even with increased receptivity from startups, if a corporate venture fund continues to operate as business as usual, it will miss out on this golden opportunity. So here are a few things that a CVC can do to fully exploit the situation.
- Be prepared to deploy smaller “runway extension” checks… but with built-in upside
Normal rules of thumb around raising in increments of 18 months of runway and typical round sizes do not apply now. Startups approaching the end of their runway whose investors cannot or will not fund them are not only willing to take investments that buy them another 6 months but actually may prefer it since valuations are significantly lower now than they were just a few months ago… and hopefully will be higher once the immediate crisis has passed. Furthermore, in the current economic environment even startups with a healthy runway may want 24+ months of runway to compensate for potentially longer sales cycles and may be interested in reopening their recent round to top up.
But lower check sizes mean lower ownership stakes and conventional VCs often have ownership targets so it can be hard to bring them in for these rounds. CVCs can often be more flexible this way. Plus, they can have their cake and eat it too: While CVCs should generally minimize non-standard terms, now is the time to ask for super pro rata rights. Write that check for half the normal size… but ask for 2x pro rata rights into the next round.
As a fringe benefit, if the corporate parent is under pressure to reduce costs, the capital efficiency of this approach lets the CVC “do more with less.”
- Be prepared to move quickly
It’s not unusual for a CVC to have to get C level approval for even small investments. And these executives are often dealing with $100M issues so it’s not surprising that it’s difficult to get on their calendar for a $1M check.
So now is the time to ask for a streamlined approval process. Explain the new strategy of smaller investments for super pro ratas and impress on them the narrow window to take advantage of this opportunity (a k.a. FOMO). Push to get temporary discretion to deploy investments below a certain amount without full investor committee approval.
In the long run, CVCs need an appropriate level of discretion in order to compete with traditional VCs. Fortunately, if you successfully deploy into high quality startups without the myriad of unspecified disasters that management fears occurring, you will be in a strong position to make the case for making this authority permanent and for raising the discretionary threshold.
- Be prepared to pilot quickly
While some CVCs invest well before the startup’s product is ready to be deployed with the corporate parent, most are looking for pilot-ready startups to provide more immediate strategic impact. From the startup’s perspective, the promise of pilots is a CVC’s most valuable assets. Unfortunately, they all too often fail to live up to this promise.
There are many reasons these pilots fail to happen, beginning with the damning fact that it is exceedingly rare for line management to be bonused or promoted based on the number of pilots they engage in. So if their compensation isn’t on the line, any initial excitement soon peters out as managers return to business as usual.
But for now, temporary enthusiasm will do. Reach out to the business managers who will be needed to conduct pilots. Impress upon them the nature of the opportunity ahead and how they’re going to be able to partner with the highest quality startups. Stress the high level management attention that these pilots are going to garner. For now, build a band of believers who are genuinely excited about the innovation opportunity and work with them to identify projects (e.g., new construction projects slated to begin in the near term) and assets (e.g., stable multifamily rental properties with smart, tech friendly building managers) that might be available and pilot-ready.
If all goes as planned – and with a little bit of luck – the early successes from pairing top quality startups with this informal group of self-motivated managers will create the credibility needed to push for the greater structural changes that are ultimately needed to for a CVC to thrive in the long run.
Conclusion
Right now, the door is open to to CVCs as it has rarely been before. With a the right strategy and small changes to how it does business, this is a once in a generation chance will not only rack up a few key wins but will also be the catalyst to change the game with the corporate sponsor and lay the foundation for a stronger, healthier, corporate venture fund.
Don’t blow it.
Acknowledgments:
I often speak with dozens of colleagues while conceiving of and writing articles. I’d like to thank David Coats (Correlation Ventures), Raj Singh (JLL Spark), Jeanne Casey (Nuveen), Momei Qu PSP Capital), Mike Mannix (Band Capital Partners, Coril Holdings) for their data, ideas, and feedback… and apologize to the many others I may have forgotten to credit by name.
Video interview from CREtech NY 2022: Why now?
Here is a short (~7min) video interview I gave at CREtech NY 2022* covering two “Why now?” questions:
- What are the key factors that contribute to today’s unique investment landscape and why now is a golden opportunity corporate venture
- How startups can answer “Why now?”and why that question is crucial for VC and angel investors.
* this time the delay in posting is not my fault. They just published the clip on Jan 3
Blueprint 2022 Panel: How To Do CVC Right
Great panel discussion at Blueprint 2022 with Kyle Beatty (AmFam Ventures) Momei Qu (PSP), and Elie Finegold (Crow Holdings) covering many of the common pitfalls of Corporate Venturing and solid advice on how to do it effectively and to maximize the value of the corporate parent to the startup and vice versa.
Reports of the Demise of the Office are Greatly Exaggerated
Note: This article was previously published in Propmodo on January 18, 2021.
Many (self-proclaimed) visionaries have been spending the year shouting, “The office is dead!” Meanwhile, old-school commercial real estate players, the ones that own most of the building stock, see the pandemic as a painful, protracted episode that will ultimately pass. These owners have resigned to minimizing the damage while they weather the storm and wait for the world to return to normal.
They’re both wrong.
Stripping away sensationalism and wishful thinking, here is what we know. Face to face is the most robust communication. We can try to replicate it with video calls and maybe even VR one day but it will never create the same connection that we get with talking to someone else in person. True, meaningful collaboration needs high bandwidth, being in the same room with someone is the best way to avoid distractions. Human beings have evolved to prefer group interactions and most big projects need multiple people working together in order to be completed well.
At the same time, on the real estate side work schedules will shift to a different mix of in-office and remote work. If and when hybrid work (part in-office, part work from home) and desk sharing arrangements (“hotdesking”) become more popular, real estate needs will change.
The office state of mind
Would you rather have a bad commute or pay high rent? Who wouldn’t want to choose “neither?” Ever since the invention of the telephone, futurists have predicted the rise of remote work and the demise of the city. They made similar predictions when faxes came along and again with email. Somehow, this prediction still hasn’t come true. With widespread adoption of video conferencing, those prophets are at it again.
Anyone who has been on a four plus person Zoom conference is painfully aware of the limitations of video conferencing. Focusing on multiple participants, confined to small windows on a laptop screen, strains the eyes, and muddles the conversation. You miss the non-verbal cues, the body language. Participants zone out, get distracted, turn off their cameras. In short, they aren’t as present as when they are physically present.
One-on-one video calls are less taxing and do convey more nuance than phone calls. For most routine communication, video isn’t much better than audio alone but for newer relationships and/or complex discussions, they are an improvement, albeit still not as good as meeting in person.
To borrow a term from computing, the problem with remote working arrangements is bandwidth. Bandwidth is the maximum rate of data transfer across a given path. You get more information across in a 100 word phone call than in a 100 word email and even more via videoconference. But you get the most data in the least time face to face. It’s simply the highest bandwidth form of communication.
Some tasks, like working on a spreadsheet (or writing this article) don’t require that much bandwidth. For the occasional input from a colleague, a quick Slack or call is fine.
Other tasks like new product development involve cross functional teams and rapid iteration where the high bandwidth of face to face makes a big difference. To be clear, it’s not that you cannot do high bandwidth tasks remotely, they’re just harder and slower that way.
People in jobs with a lot of low bandwidth work can work remotely for a long time without major losses in efficiency but there are limits even there, especially when it comes to establishing new relationships like hiring senior people or investing in a startup or infusing new hires with your company culture. These are tough even under normal conditions, try doing them entirely remotely. Doable, but again, it takes longer to get to that same level of comfort and camaraderie.
Every job from Starbucks barista to investment banker consists of high and low bandwidth tasks. The “optimal” mix of remote vs in person varies from role to role but it is almost never anywhere near 100 percent remote.
Historically, employers have underestimated how much work could be efficiently done remotely. In part this was a trust issue. Also, in the past organizations lacked collaboration software, data security capabilities, and proper training. For many, it simply wasn’t necessary to build these out.
COVID changed that. It suddenly became critical to remove those roadblocks in order to survive. Having built those capabilities (and trust!), employers won’t just turn them off later. If an employee asks to work remotely a few days a week, an employer is now likely to consider that request against a more accurate assessment of what elements of that role can efficiently be done remotely.
But while employers are likely to be more flexible about work arrangements, the (vast?) majority of work will still get done in the office.
Another point that the prophets of remote work missed is that most people find extended remote work isolating and disheartening. Some anthropologists, like Yuval Noah Harari wrote in Sapiens, argue that it is precisely our ability to collaborate that made homo sapiens successful. And the more that collaboration made us successful, the more successful effective collaborators were at passing on their genes and behaviors. Quite simply, we evolved to be happier when working in a group.
That said, working remotely isn’t synonymous with working from home. To satisfy this social need and as an added convenience, an employer could set up a string of satellite offices where their employees can be comfortable and professional. WeWork reintroduced no-commitment daily and hourly desk rentals and several startups are already pitching large employers on purchasing blocks of desk-days for employees to use on demand. As satellite offices are likely in lower rent locations, the cost savings may be meaningful.
How employers adapt
Still, if on average everyone worked remotely one day a week, doesn’t that equate to a 20 percent reduction in central space needed? Wouldn’t that be a huge win? Well, you can’t cut 20 percent of a desk. You need to remove 1 desk in 5… and that means sharing desks.
We’ve tried hot desking before and it wasn’t fun. Even as a consultant in the 90s, at client-site four days a week, we all came back to our own desks on Fridays. Why? For one thing, it was no use coming in to find that the colleague we needed to meet chose that day to work remotely. Also, we had files. Actual, paper files.
Fortunately, calendaring and coordination software have come a long way so that issue is solvable. Plus, paper is passe. In my last office, I had WeWork take the file cabinet out. I needed the legroom more.
So will hot desking succeed this time? Only time will tell. And with commercial lease terms of 3, 5, 7, or more years, even with perfect hot desking it would be a while before tenants could realize savings.
Manhattan isn’t cheap but it is a good compromise location if you have employees commuting from surrounding boroughs and suburbs. Geography doesn’t change when employees work remotely. You have to get very deep into remote work before a prospective employee thinks, “It’s a really long commute but it is only one day a week…”
With years left on most leases, employers have time to implement flexible work policies, set up satellite locations, and get hot desking software in place before making renewal decisions. They can afford to wait and see how occupancy patterns change, gradually taking desks out of “inventory,” to find the new equilibria before deciding if they can shed square footage and/or if they want to move to a different location.
The impact of COVID is playing out on top of other long term trends. Businesses have been moving lower complexity or value added functions out of the traditional high rent urban headquarters to lower rent offices in the suburbs or from expensive first tier cities to more moderately priced second tier cities for decades. While there may be some interaction on the margins (e.g., satellite offices in suburban coworking space may substitute somewhat for the backoffices in the suburbs), in general these trends should continue to play out in parallel with the repercussions of the pandemic.
How offices adapt
Here is the most likely scenario I see playing out.
Employers give employees latitude about how quickly they return to the office. Smart landlords and property managers will want to speed the return to work by helping employers reassure employees by clearly communicating the processes they have put in place to prevent and contain COVID outbreaks and by being as transparent as possible (within the constraints of privacy rights) about exposures. Until we have a vaccine, lower occupancy equates to higher comfort, so to the extent that the BIS can provide data around overall building and floor occupancy rates, elevator usage patterns, etc., that data should be exposed to the tenants. The landlord may even want to make rapid testing available to all employees as a service to their tenants. Landlords who have vacant space in their buildings, like coworking tenants who have defaulted on their rent obligations, may want to repurpose that as flexible overflow space that any tenant can use at no charge if any of their returning employees are uncomfortable with the occupancy rate they encounter on any given day that they are in the office.
These informal understandings during the return to work phase gradually morph into guidelines baked into job descriptions by HR. Human Resources and Corporate Real Estate departments coordinate to set up satellite locations in co-working spaces and build processes and software (and sensors?) to support this network. If a landlord owns office space outside the urban core, this is an opportunity to bundle HQ and satellite office leases and capture this new demand. If not, the landlord can contract with outlying coworking spaces and offer packages of “coworking credits” as retention sweeteners. It might even make sense for the landlord to source the hot desking software and offer it to tenants for free so that it seamlessly connects with the flexible overflow space that they have created—and to give the landlord visibility into usage trends in advance of lease renewals.
Over months or years, excess desk capacity becomes apparent to all and hot desking is gradually rolled out. Excess space is sublet (if possible) or reconfigured as conference rooms or common areas. As leases approach renewal, central office space needs will likely be moderately smaller. Uptake in remote work will likely happen roughly evenly across the employee pool so the geographic center of gravity won’t shift much. All this means that central offices will shrink but won’t shift much. This excess capacity will hurt owners in general but smart landlords will want to get ahead of this trend and try to find tenants for the extra space in advance of lease expiration. With a new tenant in hand for excess space, landlords might even be able to increase revenue and/or lock in the existing tenants for longer terms by letting them shed the excess space in exchange for exit fees and/or early lease renewals.
In short, the office isn’t going anywhere. Even though it doesn’t make for snappy headlines, the office of tomorrow looks a lot like yesterday’s, just a little smaller and a little more diffuse. Nimble and adaptive real estate players will thrive on the new opportunities but the dinosaurs will suffer. But, then again, this has always been the case. The wheel continues to turn and those not prepared for it will always inevitably get steamrolled by it.
Blueprint 2021 Predictions: The Office is Not Dead
Note: This post was part of a collection of predictions made by proptech investors and entrepreneurs compiled by Blueprint in late 2020.
For any job, some tasks (e.g., financial modeling) require relatively little interaction with colleagues; others (e.g., launching new products) require a lot of communication across many functions.
For these latter tasks, face-to-face is still the “highest bandwidth” communication form. Anyone on a multi-person Zoom conference knows how hard it is to focus and how you lose nuance and non-verbal cues, especially as participants zone out, turn off cameras, et cetera. One-on-one zoom calls are better but try hiring someone for a senior position or getting comfortable with a startup investment. It’s doable, but harder and slower.
While in-person work isn’t going away, employers now have the comfort and capability (e.g. collaboration software, data security, training) to be more flexible — so incrementally more work will be remote.
But most people find extended remote work unsatisfying. Millions of years of evolution have
honed humanity’s collaboration skills. We evolved to work in groups. Fortunately, working remotely isn’t synonymous with working from home. Employers may set up satellite offices for employees to work remotely without the sense of isolation.
The most likely scenario I see playing out is:
- Employers give employees latitude about when they return to the office.
- Informal understandings gradually morph into formal HR guidelines.
- Corporate Real Estate departments set up satellite locations in coworking spaces and build processes to support this network.
- Over months or years, excess capacity becomes apparent and hot desking is rolled out. Excess space is sublet or reconfigured.
- As leases approach renewal, central office space needs will likely be moderately smaller.
- Remote work is roughly evenly distributed across the employee pool so the geographic center of gravity doesn’t shift much.
- Central offices shrink somewhat but don’t shift much.
Want to see all the predictions? Click here
How Family Offices & Real Estate Firms Can Source Great Proptech Opportunities
Note: This article first appeared the Fall 2020 edition of Family Office Real Estate Magazine.
Publisher’s Insight: For years now, I have been a big supporter of property technology or “proptech.” It is an area that will change and disrupt the industry, mainly because the industry is so fragmented and because it is one of the sectors that typically lag other sectors due to the nature of the business. This article is insightful and helpful in identifying some of these opportunities, primarily because this is the future of real estate.
Many family offices that invest in real estate property startups (“proptech”) are real estate operators with reasons for investing from strategic insights to benefit their assets. For the family office that is heavily invested in real estate, the case for investing in proptech startups or Venture Capital funds is doubly strong.
But it is much easier said than done. This scenario is quite typical:
- A family office with real estate roots decides to find great startups to invest in or partner with.
- Someone, usually from the younger generation of the family, with a fair amount of real estate knowledge, but virtually no startup experience is tapped to lead the charge.
- Once the word gets out of the interest in investing in proptech companies, they are bombarded with startup and fund pitches, not to mention a host of investment advisors.
- Many of these investments are not even proptech, but enough are that he or she spends tons of time wading through pitch decks.
- A few of these startups look pretty good, so the family office decides to invest and/or set up pilot projects with the operating company.
- These fail miserably.
- The family office decides that engaging with startups is a waste of time.
There is, however, a better way to go about this.
HOW TO IDENTIFY GREAT STARTUPS TO PARTNER WITH AND/OR INVEST IN
As the Cheshire Cat told Alice, “If you don’t know where you are going, any road can take you there.”
If the goal is to partner with a proptech startup to get a leg up competitively or even if the operating company vets the startup’s solution, you need to be looking at startups at the right level of maturity. This means looking for startups raising Seed ($1M-$2M) or, to be safer, Series A ($4M- $8M+) rounds.** Earlier stage startups are still cocktail napkins and science projects; the later stage isn’t cutting edge. The founders are also less experienced, and the product is still a bit raw, so while it’s tempting to want to get in earlier (and you can write smaller checks and still be a player), you probably want to start with the slightly more mature guys. This filter, by itself, will weed out many startups and save tons of time.
* * Important note: you would not be investing this amount in the startups. The lead investor will generally fund half or more of the total investment round. A family office participating in the round would likely invest 10-25% of the whole round. An investment of this size would equal roughly $100K-$500K+, depending on the round’s size.
MAKE SURE YOU PICK THE RIGHT PARTNER
In-depth domain knowledge isn’t enough. You wouldn’t let someone with no development experience pick real estate assets to invest in, so why would you let someone with no startup investment experience pick startups? You need to pair up the industry experience with the VC skills. Fortunately, it’s possible to find people with 5+ years of venture experience and at least some proptech investment experience. It is those investors who will ultimately want to raise their venture funds. If approached with this kind of opportunity, they will look to invest in 10-20 startups over the next year or two with the expectation that, if all goes well, you would jointly look to bring in outside money to turn this into a formal VC fund. To give you a sense of what this translates into financially, assume that you are focusing on (relatively) more mature startups raising Series A rounds (average $5M) where you are committing to 10% of the round (average $500K check size), so for 10-20 investments, this comes to a $5M-$10M commitment.
As an alternative, some family offices invest in a proptech VC fund to get early access to a range of portfolio companies. Depending on the size of the fund. It will generally want a $1M-$5M investment (technically, a “commitment”) to be called over 4-6 years. With a smaller investment, an investor would not necessarily have access to as many proptech startups. The exception would be if an investment were made into multiple funds.) A downside would be you would most likely not receive the same insights into the rapidly evolving real estate world you would otherwise get from investing directly.
Often you need someone with more than just a proptech VC experience. Many investors with real estate operating companies use the business line to help assess how well a startup’s product or service fits the market; in some cases, their entire purpose of investing in proptech startups is to find innovation for their own real estate business. If piloting with the parent company is vital to your strategy, then having your business units work with the startup for some time (viz., a “pilot” or trial project) is critical. It would help if you had someone who can work internal politics. You can’t pilot with startups if you don’t know who in the line is genuinely interested in innovation instead of just paying lip service to it: you need someone who can work internal politics. This is not part of the typical VC experience, so you have to look at the candidates’ backgrounds for other indications. Prior experience at large companies (including consulting), business development work, a stint at an accelerator, etc. are all some clues that a candidate might have the right political antenna.
THE TRUTH ABOUT INVESTMENT ADVISORS
Having third parties bring you deals in exchange for a commission is entirely normal in the real estate world. This could translate into a kiss of death in the venture world; the best startups are never represented by an investment advisor.
VCs are the most networked people on the face of the earth. VC professionals present at panels or judge pitch events all the time. They meet dozens of entrepreneurs every week and know – and have often co-invested with – virtually every other VC in the same space. If a founder can’t network into a warm introduction to a VC, how will he find customers? Plus, the very fact that the founder thinks he can wave his hand and have someone else take on something this crucial to his business for him is a huge red flag. Those startups are invariably hairy, old, over-shopped deals that every halfway serious investor has already turned down.
DON’T GO TOO DEEP INTO TOO MANY STARTUPS
When you get a startup’s pitch deck, the temptation is to read it all, think about the business as a whole, and come to a holistic, well-reasoned thesis. That kind of deep-dive takes much time, and there are many startups to review. The startup needs to earn that much of your time. Your first pass review should be much quicker, just a few minutes, to filter out startups that can’t make the cut. It takes time, domain expertise, and much deal flow to build the kind of pattern recognition that lets you immediately filter out the proptech startups that are too early or too fatally flawed to be worth the extra time.
SETTING UP SUCCESSFUL PILOTS
There’s a saying in business: You get what you measure.
Do you measure the number of startup pilots a division undertakes? Is this a factor in whether a manager gets promoted? If you do track pilots, how do you track them?
One of the more subtle mistakes companies makes a focus on success. In most cases, a failed project is a black mark that can cost a manager their bonus and promotions. If a project isn’t performing, the manager will often throw more resources at it until they can claim some victory, delaying resolution, and wasting time and money.
Instead, the focus needs to be on learning quickly. Pilots should explicitly be for 3-6 months, and the questions should telegraph that even negative results are a win, as long as they get there quickly, and the results are actionable. To make this a bit more concrete, here are a few examples:
THE RIGHT QUESTIONS TO ASK:
- “It’s been three months; what have we learned so far? What actions should we take?”
- “Have we learned enough, or do we need another three months?” What specifically would we learn if we extended?”
- “What would teach us more and generate more actionable results: extending this pilot or moving on to the next one?”
THE ANSWERS YOU WANT TO HEAR
- “We’ve tried syndicating XYZ deal on a real estate blockchain exchange but didn’t get any qualified investors.” (Close this pilot and try something new.)
- “We proved that we could charge an $$$ per month premium for smart apartments, but the product itself was buggy.” (Is it fixable, or should we ditch this startup and pilot with a competitor?)
- “Our tenants love the amenity portal, and the software seamlessly coordinates access for the dog walkers, fitness pros, cleaners, etc. with the front desk. Plus, the founders are a pleasure to work with.” (Stop the pilot and roll out more broadly.)
SUMMARY
For the family office with significant real estate assets, investing in proptech startups is not just a financial opportunity; it is also a strategic opportunity in many cases. But it is much easier said than done, and how you do it and whom you pick to do it for you to make a huge difference.
Accessing Innovation: So You Think You Want To Set Up A Corporate Venture Fund
Note: This post was previously released as a series of articles in BUILDER Online, Architect Magazine, and MULTIFAMILY EXECUTIVE published August through November 2019.
Part 1: What’s the value in a corporate venture fund?
Setting up a corporate venture capital fund (“CVC”) can be one of the most efficient and effective ways to attract external innovation to a large enterprise. Done wrong, it can also be a colossal waste of money, brains, and time.
Unfortunately, it is typically done wrong.
Returns data for CVCs is notoriously difficult to compile, but according to unpublished data by Correlation Ventures, which includes data from DowJones VentureSource as well as other primary and secondary sources, dollar-weighted (by round size), realized, cash-on-cash multiples for all U.S. venture financings in companies exiting (viz., out-of-business, acquired, or IPO) from 2008 through 2017, were 2.2X for all financings, as compared to 1.8X for all financing with at least one corporate VC participating.
The difference in returns gets less pronounced the later the stage but persists across all stages. In other words, the earlier the round, the worse CVC investments do relative to deals with no CVC.While financial data is hard to get, innovation sourcing efficacy is effectively impossible to measure. That said, anecdotal data points to higher staffing turnover and higher than normal fund closure rates for CVCs as compared to traditional VC, all of which imply that the parent corporation is not satisfied with the CVC as a vehicle for sourcing innovation either.
So while a CVC should, in theory, be a fast, cost effective, way to access cutting edge innovation, all too often they move slowly, make mediocre investments, and miss out on the hottest deals.
The reasons for this fall under two general categories. Let’s break down what goes wrong… and how to do it right.
Failure to function effectively as a VC fund
- Inability to attract high quality venture professionals due to inadequate incentives
- Corporate executives improperly involved in the process
- Investment funds incorrectly allocated
Failure to integrate effectively with the corporate parent
- Target startup investment stage not matched to corporate capabilities
- Allocation strategy suboptimal
- Startup sourcing strategy fails to play to parent corporate’s strength
- Engaging the corporate organization at the wrong time
- Passively assuming that innovation will be received by the corporate parent
Failure to function effectively as a VC fund
- Inability to attract high quality venture professionals due to inadequate incentives
The rap on CVCs is that they are for people on the way up or the way down. The newly hired general partner is either an up-and-coming star looking for a good platform before raising his or her own fund or someone with a failed fund who is looking for a soft landing. While an overgeneralization, there is a kernel of truth: why would anyone who could raise their own fund put up with corporate politics?
So how can a corporate snag a rising star versus a falling one? It can start by replicating traditional venture fund economics so the best talent doesn’t opt out. When JLL set up their $100M CVC fund JLL Spark, they were careful to set it up as an independent fund, giving the general partners the same kind of carried interest they would get if they were running their own fund.
Farsighted corporations think even further ahead: If the first CVC fund does well, the general partners will want to raise a second, likely larger fund, and will naturally be tempted to go out on their own. A savvy corporate will not only expect this but will encourage it by being the lead investor in the second fund while allowing the general partners to bring in outside money to make the fund even bigger. As long as the money doesn’t come from a direct competitor – unlikely in any event – the corporate sponsor should be thrilled: they get more firepower for the same investment on their part.
In addition to structuring Toyota AI Ventures as a standard “2-and-20” VC fund with Toyota Research Institute as the sole LP, Toyota has structured this fund as a template that other Toyota business units can use, either solely or with outside LPs, for their own CVC funds.
Part 2: Corporate executives wade into unfamiliar territory
Because senior management may have a deep understanding of the sector and the specific needs of the corporate sponsor, it seems easy to assume that involving them in the selection process will help the corporate venture capitalist (CVC) pick the right startups to support? However, that’s not the case. I’ll explain.
As part of due diligence, a skilled venture capitalist confirms market demand by talking to a startup’s potential customers. Sector-focused investors can quickly get a feel for what customers in their sector are interested in and what they are leaning into from an investment standpoint. So, at least for a first cut, involving management in the selection process is not necessary.
Not only is it not necessary, it actually can lead to worse decisions. One of the main reasons to set up a CVC is to help its mid- and senior management recognize innovative startups, access them, interface with them, and absorb that outside innovation. So why expect them to be good at it from day one? In practice, inexperienced innovation teams often spend too much time engaging with immature or—to the eyes of a skilled venture capitalist—obviously fatally flawed startups. They waste time, money, and, worst of all, the attention of the business lines, souring them on startups in general.
Once the CVC has winnowed out 9 out of 10 (or 19 out of 20) potential investments, there’s definitely a place for the line management to vet the solution in greater depth… stay tuned for another in depth look at this topic in another part of this series.
How is fiscal oversight managed? When a corporation allocates $50 million or more than $100 million to a project, it is only natural that they want oversight. In this case, it often means that senior management wants to sit on the investment committee and approve investments. But these senior managers often run multi-hundred-million dollar divisions where their “day jobs” always come first. Asking them to find mutually convenient time to meet to review a $1M deal is a recipe for delay. Plus, when a fund has a reputation for moving slowly, the hot deals pass them by.
A smarter balance between speed, flexibility and oversight is to allow the CVC to make routine investments, subjecting only especially large follow-on investments for approval by senior management.
In theory, investing off the balance sheet from budgeted funds should be as effective as committed capital within a formal venture capital fund structure. In practice, it rarely is. Budgets get cut, routine approvals become bargaining chips for corporate horse trading, investment committee members push for pet projects, in addition to potential acqui-hires (hires through acquisition). Creating an arm’s-length contract that obligates them to meet capital calls and also creating governing documents that clearly establish the fund’s mandate and general partners’ sole authority to make investments, up to a certain threshold, insulate the CVC from these pressures, empower it to operate on par with traditional venture capital funds, and enable it to attract top talent.
Another more subtle reason for an arm’s-length fund commitment is to avoid failing by success. When a venture team has a large exit that makes the partners some of the most highly compensated people in the company, there can be a lot of pressure from line management to renegotiate that deal. Since salary is easier to cut than carry, top venture capital talent often shy away from CVCs.
But structuring a CVC to be able to function as effectively as a traditional venture capital fund is only half the battle. The best startups have their pick of investors. How does a CVC make it so that it is a hot startup’s top pick?
Part 3: Making good with the corporate parent
Structuring a corporate venture capital (CVC) to function effectively as a venture capital firm (VC) is only half the battle. Even phenomenal VC returns often amount to a mere rounding error on a Fortune 500 company’s financial statements. So if the CVC doesn’t meet the strategic objective of injecting innovation into the mothership, it is a failure regardless of returns.
At the same time, there is a lot of venture money out there chasing great startups. So how does a CVC mobilize the corporate sponsor as a unique competitive advantage over other VCs?
Fortunately, the same plan solves both problems.
In most cases, a CVC should be investing at the seed or series A round stages. If they approach investment at an earlier point, the startups are still basically cocktail napkins and science projects; any later, they aren’t at the cutting edge of innovation. If an organization is good at working with the earliest stage startups and patient with founders who are still figuring out how to work with large corporations, engaging at the seed stage yields the most exposure to innovation for the buck. Unfortunately, very few corporations meet this description.
Most corporations have little or no structural process for introducing startups to the business lines and provide little or no training to line management on how to work with entrepreneurs. In these situations, working with entrepreneurs who have some experience making corporate pilots work significantly increases the odds of success.
Now let’s take a look at how to optimize the allocation strategy. A typical Series A round in New York City is currently somewhere between $4 million and $8 million. So funds in that stage are looking to make initial investments of more than $2 million, if they want to lead the round, down to as little as $500,000, if they are following a lead. Most VC funds want a mix of deals to lead and follow. After all, if they don’t lead some deals, why would other VC funds syndicate their deals to them? So, it is safe to assume an initial average $1 million check. Assuming also that a fund would like to make at least 10 investments a year over the three-year initial investment, that would add up to $30 million for initial checks. Furthermore, most funds like to reserve about half their fund for follow-on investment. This implies that $60 million is the ante for a traditional series A VC fund, which would also yield 30 portfolio companies.
A CVC is tasked with maximizing its exposure to innovation, so what are some ways it can get more shots on goal for the same or less committed capital? For one thing, it might not need capital for follow-on investments. While the general partners of the fund would want the dry powder to make these investments in order to maximize their ROI, follow-on investments don’t increase the corporation’s net exposure to innovation. So a CVC could have zero reserve for follow-on investments and opt to invest off the balance sheet on an opportunistic, case-by-case basis. This means that a CVC could get exposure to the same 30 portfolio companies with just a $30 million fund.
Remember, though, that attracting top investment talent to the CVC is critical. So to align incentives with the general partners, if the corporate sponsor does invest, the general partners get their usual carry on that investment; if it does not, the pro rate investment rights revert to the general partners to syndicate in any way they see fit.
But what if the CVC found a way only to follow on rounds that other funds lead? In that case, the initial check size drops to $500,000 and that same $30 million fund now gets 60 shots on goal. So how do we pull that trick off?
Part 4: Target startups to leverage your corporate strengths
All too often, a corporate venture capital (CVC) will over-negotiate from a position of strength and demand nonstandard terms. For example, a CVC may demand a right of first refusal on sale. From the corporation’s perspective, this is a reasonable way for them to protect their innovation advantage. From the startup’s perspective, this deters other buyers from bidding on their startup, the startup is limited to extend resources if the corporation can exercise a right of first refusal. Senior management may also seek to block the startup from selling to competitors, limiting the startup’s ability to grow. At best, these demands slow the process down; at worst, they kill the deal… or the startup.
Instead of over-negotiating from a position of strength, a CVC needs to take the startup’s prospective and structure a strategy that plays to the corporate parent’s strengths.
What do all startups need more than anything else? Customers! A CVC has unique and unfair advantage over traditional VC funds in this respect. Done properly, they can introduce a portfolio company into the organization, generating not only significant revenue but also meaningful proof points that will make the startup itself more investable overall. A smart startup makes room for strategic investors like this.
This means that a “follow-only” strategy may be a viable option for a CVC. Consider this value proposition to a startup, which you can get in writing with either a carefully constructed, but not over-lawyered, Investor Rights Agreement or warrant coverage:
“We will get you a pilot within the organization. If the pilot goes well, we will hard-commit to invest $500,000 in your next round*, as long as it is led by an institutional VC fund. If we cannot get you a pilot or if the pilot does not go well, we will not invest.”
It’s clear, it’s concise, and it’s compelling. Climb a hill, plant your flag, and start yelling it from the mountaintop. Startups will come to you.
No capital allocated to follow on investment lets the CVC halve the required fund size from $60 million to $30 million. A pilot-to-invest strategy that only a CVC can deliver on, enables it to double the number of startups it can invest in out of that same half-sized fund.
How do you engage at the right time? The above strategy only works, however, if the CVC gets the timing right. If the CVC engages too late and the startup raises its series A round before the pilot is complete, the effort is lost.
Pilots within a large organization can take six months (or more) to connect, structure, execute, and evaluate. CVCs need to understand what a reasonable timeline is for their organization and then target startups at the appropriate time. Engaging with startups three to six months after their seed round gives them time to complete the pilot nine to 12 months post-seed, which generally coincides with when the startups are beginning to raise their series A.
Part 5: Manage the innovation process
Through this series, we have focused on maximizing the quantity of innovation that a corporate venture capital fund can deliver to the corporate parent. But, where otherwise effective CVCs often fall down is in assuming that bringing an innovative startup to the organization will automatically result in pilots and innovation transfer. Line management is busy running their own business units. After the initial flurry of focus, engaging with startups is typically nowhere near the top of their priority list.
There are two basic strategies for aligning focus so as to maximize a large organization’s exposure to innovation and to accelerate the CVC portfolio’s growth:
Informal – Someone affiliated with the CVC works hard to develop personal relationships with key decision-makers throughout the organization. This person gets to know who is serious about and amenable to working with startups to find innovative solutions to problems and who is merely paying lip service to the creed. He or she uses a bit of salesmanship, some moral persuasion, and the knowledge of the possible to make pilots happen. This approach requires minimal change to the corporate parent and can be implemented the fastest. The disadvantages are that it takes a very skilled person to pull this off and that, in many cases, the fund will have to pass on startups that really could make a difference to the parent organization simply because they are not able to convince anyone within the corporation to conduct a pilot.
Formal – This involves creating a series of structures designed to involve mid- to senior-management in the innovation ecosystem. This includes but goes far beyond simply scheduling pitch events throughout the regions where the corporate parent operates. To be truly effective, management’s job requirements and compensation structure have to change. While the possibilities are endless, here are a few examples:
- Incorporating into six month and annual reviews metrics quantifying how many pilots a business unit attempted. Avoid over-emphasizing pilot success – that ends up deterring experimentation. After all, several quick-and-cheap failed pilots are also valuable.
- Setting up a standing committee of senior management that meets once every few months under the guidance of the CVC to identify one or two key areas of innovation (e.g., smart apartment technology for a REIT holding multifamily rental properties) that they want to be the CVC’s primary focus at that time. This has the added benefit of effectively pre-committing the business line to piloting with the startup (or startups) that the CVC finds.
- Requiring all middle management to evaluate prospective startup investments using a simplified scoring rubric designed by the CVC. Innovation is infectious; expose someone to 20, 30, 40+ groundbreaking startups and they will catch the fever. (If they don’t that tells you something about that manager….) Plus, when one of the startups they reviewed favorably is selected, they will be that much more open to more innovation.
The more formal the approach will, of course, yield better results. It requires touching the most sensitive place: compensation. It also means that a lot of people who are not very well-versed in the startup world (e.g., HR) have to construct an incentive structure that encourages engaging with the startup world. But it is doable, and, when it works, it’s pretty awesome.
Bonus Content:
Capturing Talent: What’s needed for corporate venture fund leaders
A corporate venture capital fund (CVC) is similar, but different from, a traditional venture capital fund. As such, the skill set a managing partner needs to run it effectively is akin but not identical.
Let’s break down the critical and the optional skills that a successful candidate will display.
Critical skills of a CVC managing principal:
- Marketing – As we discussed in parts three and four of the series, “pilot first with a hard-commit follow-on if it works” is essentially a “pull strategy”. Instead of a “push strategy” of beating the bushes hunting for startups, here you need to climb a hill, unfurl a large flag, and yell at the top of your lungs while waiting for startups to come to corporate. Since this relies on getting the word out far and wide, the marketing moxie to pull this off is essential.
- Political savvy – Ensuring that line management ultimately does engage with startups requires a mix of politics and process so that the managing partner must create informal relationships to smooth the path to pilot. Not all managers are equally excited about innovation, so finding someone to gently cajole and smooth ruffled feathers is key.
- Process passion – The managing partner also has to work out a series of touch points and events with corporate. Also, since you get what you measure, he or she will have to help modify the evaluation processes and compensation structures to make sure that working with innovative startups is something that gets his or her partners in management their bonuses and promoted. So, you need someone with some serious operational expertise to sweat these details.
Less critical:
- Domain expertise – Ideally, you want both venture and industry experience, but that’s a pretty hard combo to find. Fortunately, believe it or not, domain expertise may not actually be all that important. A good generalist investor can get up to speed on a new industry quickly, especially given the deep bench strength of industry knowledge the corporate sponsor brings to the table. So, in a pinch, finding someone for the CVC with experience in the field is less critical than it would be for a standalone fund.
- Industry relationships – By the same token, the CVC can lean on the cumulative relationship base of the corporate parent. Furthermore, since the primary set of relationships that the CVC needs to forge are internal, between startups and the business lines, not external, extensive industry relationships are also “nice to have” only.
- Sourcing – With this pilot-to-invest strategy that attracts the startups to the CVC, traditional VC sourcing techniques are less important.
- Valuation – The lead investor in the startup’s round sets the valuation. Since the CVC is following, the managing partner just needs to accept the valuation set by the lead investor or simply pass on the round. Also, since strategic imperatives often outweigh pure ROI for the corporate parents, it is not the end of the world if a CVC occasionally overpays a little.
- Deal structuring – Deal structuring also is determined by the lead investor. As long as the CVC gets the same protections as the lead, there is not much to do here.
- Due diligence – The CVC can free ride on the lead investor’s diligence if it wants, especially since it has already piloted with the startup and has had an extended inside look under the hood.
Where to find this kind of investor? Large corporations interested in starting a CVC are 99.99% likely to use a recruiter to fill this role. But for hyper-specialized roles where clients themselves don’t know what they actually need, a recruiter is only as good as the guidance they get.
For a traditional VC, a good recruiter might look for someone on the rise at another venture fund who also has startup experience in the industry. For a CVC role, finding a VC rising star still makes sense, but rather than looking for additional experience at a very small company, operational experience at a large company and/or top consulting firm is more likely to check the critical skills boxes above.
Acknowledgments: I’d like to thank David Coats, David Gerster, Blake Luse, David Teten, Linda Isaacson, Jill Ford, Stacey Wallin, Ameet Amin, and everyone else who contributed their thoughts to this article.
Why is Traction So Squishy?
Note: A version of this post appeared in my semi-regular column on AlleyWatch.
“Let’s talk again when you have a bit more traction”
I don’t think there is a founder on earth who hasn’t heard that from an investor. Is it legit or is it the infamous VC “soft no”?
The savvy founders know to follow up with some variation of, “I completely understand. So that I know what milestones I should be aiming for, can you tell me what metrics you would want to see before I’m in your strike zone?”
The savvy founders also know that, if the investor squirms a lot and is reluctant to offer up a specific number, it’s probably a soft no.
But then why do many investors who are genuinely interested and who confidently answer with hard numbers also seem a bit uncomfortable with this question?
The answer is that traction is a squishy concept.
Squishiness #1 – What’s the slope of the line?
Which startup impresses you more: the startup that got to $1M Annual Recurring Revenue in 6 months or the one that took 6 years to get there?
‘Nuff said
Squishiness #2 – With what inputs?
All other things equal, a startup that gets to $1M ARR on $500K investment is more impressive than another that needed $2M to hit that same mark.
But this one isn’t that open and shut. What if the second startup spent the first $1.5M on a different type of product or attacking a different customer and then pivoted. In this case, version 2.0 of the startup used the same $500K to get to the same milestone. So how do we view the first $1.5M they spent? Is it all truly a sunk cost, with no bearing on the future of the business, whose only impact is that the founders of the second company are more diluted than the first? Or do we view it as a potential indicator that they aren’t as attuned to the market or perhaps not as cash efficient as the first startup?
Squishiness #3 – What type of revenue is it?
It’s no secret that recurring software-based revenue is the gold standard. When you are selling electrons, the marginal cost of rapidly growing your revenue is near nothing. Add to that long term / auto-renewing contracts and it just doesn’t get any better than that.
But what if some of your revenue comes from one time set up fees or hardware sales? Those revenue streams come with hard costs in labor and/or material so investors generally discount these revenues. Many investors even mentally write them down to zero.
Then there is transactional revenue. How do you value revenue when the Customer has to go back to a website or app and actively purchase the item again? If the revenue is consistently growing and the vast majority of the customers reorder repeatedly on a well-understood timeframe, that kind of repeat transactional revenue is pretty close to recurring revenue. But if sales vary dramatically from month to month and there is little data to support the claim that customers will frequently and repeatedly purchase the product or service, the startup will get considerably less credit for that revenue.
Service revenue is the least valuable. To increase sales you have to throw more bodies into the mix. That means you have lower margins and you can’t scale as quickly. Most VCs will completely ignore your service revenue unless you can somehow convince them that it will soon convert into a different kind of revenue. For example, let’s say you built a “wizard of oz” prototype – your service looks automated to the customer but you are processing their requests manually for now because you want to prove that you have product-market fit before building the automation. If you can convince me that everything that goes on behind the scenes can and will be automated as soon as practical, I’d likely credit this revenue as if it were repeated transactional or recurring revenue.
Lastly, most investors will completely ignore revenue that was generated under a business model or product or service that you’ve discontinued. For example, if you sold $500K of your product to large enterprises but have decided to switch to selling direct-to-consumer, the $500K from B2B sales tells me nothing about how you’ll do B2C. Remember: where you are is a proxy for where you can go. If you don’t do it that way anymore, your current traction is useless as a predictor.
Squishiness #4 – What kinds of customers?
I would rather see a B2B startup with 4 mid-sized customers than 1 big customer. The former tells me a lot more about product-market fit and the startup’s ability to sell. When a startup has just 1 or 2 big customers, they might be the founders’ former employer or they might have a close relative at that company championing them.
On the other hand, big “name brand” customers count for more than mom & pop customers. It’s harder to get to the right decision makers and navigate through the order process at larger companies, especially for a startup.
So how does a startup with 2 big, name brand, customers stack up against one with 4 mid-sized, less known customers?
Uhh, let me get back to you on that one…
Squishiness #5 – Is the Go To Market scalable?
Startups like to brag, “…and we did it all with zero marketing spend!”
They have no idea how nervous that makes investors.
What it says to me is that they don’t know how to acquire customers at scale. A startup can often get its first few customers or first couple of thousand users simply by reaching out to their extended network. But when they’ve exhausted that avenue, where do they get the next 10x growth? On the other hand, a startup that can, for instance, point to Google or Facebook ads spend as driving the revenue growth and show that their cost of customer acquisition is many multiples lower than the lifetime value of the customer, that’s a startup that can scale. As long as the inventory of keywords that are effective for them is large, they can multiply their advertising spend by 10x or even 100x and grow their revenue correspondingly.
If a startup cannot show that what got them to where they currently are will continue to get them where they need to go, their traction is less impressive than it otherwise might be.
As Angels See It 