Ask HN: How VC funding works?
6 comments
If you look at the numbers of a service like Dropbox (which I know is not a direct comparison, but is at least in an approximate neighbourhood), then you can see why an $1.8m investment in this sort of service would make sense - it can theoretically be useful to tens, if not hundreds, of millions of users.
Yes the odd terrible company gets funded, but if you cannot see where the value in a new service lies then it might be down to a number of other factors:
1. You are not being shown the complete product (i.e. you are seeing a v1 or even an MVP, but internally the company is demoing a killer app)
2. You are applying your own tastes/needs when evaluating a service. A famous ad exec once said (roughly): "We are not our target market". Don't assume a new product is being marketed toward you, try to think who it is really for and whether or not they might think differently.
3. Your ability to forecast user numbers / revenue for a new service might not be as good as you think.
Yes the odd terrible company gets funded, but if you cannot see where the value in a new service lies then it might be down to a number of other factors:
1. You are not being shown the complete product (i.e. you are seeing a v1 or even an MVP, but internally the company is demoing a killer app)
2. You are applying your own tastes/needs when evaluating a service. A famous ad exec once said (roughly): "We are not our target market". Don't assume a new product is being marketed toward you, try to think who it is really for and whether or not they might think differently.
3. Your ability to forecast user numbers / revenue for a new service might not be as good as you think.
Generally speaking, VC's aren't interested in getting their money back with revenues from the company they're funding. They aim for a 'big exit', in the form of an IPO or acquisition by another company.
Imagine Kicksend gets to 10,000,000 paying customers in a few years. And you own 20% of that.
That's how VC's think.
That's how VC's think.
The best way to understand how VC funding works is try to become one.
We are currently in a huge bubble. I wouldn't try to ascribe rational valuations to anything investors do in the middle of a bubble.
When a company like GRPN, who lies about its own revenue in its own S1 filing, loses money on every deal, and whose idea of scaling is "just add more sales people", pops off a wildly successful IPO in the middle of a very volatile public market, that's when you throw your hands in the air and stop trying to see rational behavior where there is none.
If you're old enough, you would remember this story from 1996-2001 repeating itself.
Of course, there's no end to the supply of twenty-something startup hipsters who will breathlessly inform you that this time it's different. Sure it is, kid. Sure it is.
When a company like GRPN, who lies about its own revenue in its own S1 filing, loses money on every deal, and whose idea of scaling is "just add more sales people", pops off a wildly successful IPO in the middle of a very volatile public market, that's when you throw your hands in the air and stop trying to see rational behavior where there is none.
If you're old enough, you would remember this story from 1996-2001 repeating itself.
Of course, there's no end to the supply of twenty-something startup hipsters who will breathlessly inform you that this time it's different. Sure it is, kid. Sure it is.
At least in the US, nearly all the money invested by VCs is from 'limited partners', and the usual suspects are employee pension funds, university endowments, life insurance companies, hedge funds, sovereign wealth funds (think a fund with Mideast state oil money), and wealthy individuals.
The VCs and/or LPs need some 'criteria' on how to invest the money. That is, one venture partner, at least before he has an astoundingly good track record, who has some very different ideas about how to invest money will likely fail to get approval from his other partners or the LPs. So, if you will, there is a 'herd'.
Here are some of the main points about the 'criteria':
(1) The Sexy Sectors.
The two biggest sectors for VC investing are 'information technology' (IT) and biomedical technology. There is also a little for 'clean tech', and then everything else is in the 'single digits' or the roundoff error. In IT, the sector splits into hardware and software. In software, the biggies now are the Web 2.0 and mobile.
(2) The Traction Thing.
It is fair to say that VC is just 'early stage private equity' (PE) investing. Well, in later stage PE, audited financial statements are important. Since in early stage asking for audited finacials is usually asking for nothing significant, the 'herd' likes to see a near substitute and that is the somewhat ill-defined but still quantitative 'traction'.
'Good traction' is, for say a Web 2.0 site, the number of 'unique users' ('uniques') per month significant, say, over 100,000 and growing rapidly. For a mobile app, 'traction' might be number of monthly downloads significant and growing rapidly.
Of course, 'traction' the accountants can count is better, e.g., revenue, and, of course, best of all, earnings.
(3) The Market Thing.
If do some arithmetic on how VC money flows, then can see that VC needs surprisingly big 'exits'. For that a good first guess is that an entrepreneur should be attacking a relatively large 'market'.
Hopefully that market already exists, but, of course, the entrepreneurs may be creating the market they are attacking. Or, e.g., well before the first iPhone, what was the 'market' for such a device? Well, that 'market' is big enough NOW, but Apple, with help from Nokia, RIM, Motorola, etc., created it.
The joke goes: The entrepreneur proposes building a toll bridge across the river. The skeptical investor notes that there is no traffic across the river at the entrepreneur's proposed location and, thus, concludes that there is no 'market'.
There is an old saying: "Selling new technology is hard. Attacking a new market is hard. Selling new technology for a new market is too hard.". This saying is mostly a joke but does describe some common, real concerns.
(4) The Money Thing.
A common assumption in IT VC is that a lot of 'traction' is very significant even if there is so far no revenue. So commonly it is assumed that if can get 100 million people a month to aim their eyeballs, then somehow there will be a way to extract money, that is, to execute 'monetization'.
(5) The UI/UX.
A definition of art is "the communication, interpretation of human experience, emotion". A lot of 'pop culture' art seeks to create an 'engaging user experience'. So, a Web 2.0 project might emphasize a good 'user interface' (UI) and 'user experience' (UX). Some VCs will 'play with' the product and evaluate how well millions of users might like the UI/UX.
(6) A Buffett 'Moat'.
Of course, W. Buffett likes each of his investments to have a 'moat' that keeps out competition like a medieval castle had a moat that kept out the roving barbarians, hungry peasants, greedy neighbors, etc.
Coveted moats used to be (A) crucial, core, technical 'secret sauce' that was powerful, gave especially valuable results, and was difficult to duplicate or equal, (B) patents for crucial, core, technical secret sauce, (C) user 'lock in', e.g., high user 'switching costs', (D) 'network effects', (E) deals for 'distribution channels', etc.
Now more popular is just, from F. Wilson at USV, "large networks of engaged users", and there one approach can be to create a 'fad' among the 'A-list' people!
(7) Some Other Things.
Some VCs believe it can help if (A) there is a good 'team', (B) the team has good 'passion', (C) the team has some people who concentrate on the 'tech' and others who concentrate on the 'market' and/or 'management'. (D) the team is young and understands the 'vibe' of the youth market, and (E) the CEO of the team, to paraphrase a movie, "has always made money for his investors".
New Theme.
There is now a new 'theme' in IT VC which might be called the 'lean startup'. So, over the past few years, there have been some big changes that make startups much cheaper, faster, and easier to do:
(A) Bandwidth.
A T-1 line was 1.5 million bits per second (Mbps) and cost over $1000 a month. Now commonly can get 15 Mbps upload bandwidth for less than $100 a month.
(B) Computing.
For $100 or so each can buy a 4 core processor with a 3.0 GHz clock, a motherboard, 16 GB of main memory, a power supply a case and keyboard, and a 2 TB hard disk drive. Net, if just plug together some parts, $1000 will buy one heck of a computer that not so long ago could cost 1000 times more.
(C) Infrastructure Software.
In either the Linux world or the Microsoft world, there is a LOT of powerful 'infrastructure' software -- operating systems, programming languages, software libraries, data base systems -- available for free.
So, the 'bottom line' for this 'new theme' is: If half fill 15 Mbps 24 x 7 with simple Web pages with simple ads, then have a good shot at making $1 million in pre-tax earnings in one year.
New Approach.
So, a new approach to startup investing is just to back a lot of promising teams with, say, $25,000 to $200,000 each and see what they can build.
So, don't spend a lot of time or effort evaluating a 'business plan' and, instead, just let the team try.
Old Theme.
An old theme in 'innovation' was (A) pick a problem where a much better solution would be valuable (B) do some difficult, advanced (Buffett moat) R&D to find a much better solution, (C) sell the solution.
Here there are two challenges, the entrepreneur doing the R&D and the investor evaluating the R&D.
This old theme is likely still important in biomedical investing but has fallen out of favor in IT investing.
One assumption is that research has nothing to contribute to IT or Web 2.0. While there may be some exceptions to this assumption, for now clearly the exceptions are rare.
The Rarity Problem.
IT VC has a big, huge problem: It needs big exits, essentially 'home runs'. As in some blog posts of VC Mark Suster, for the past 10 years on average VC returns have been poor; often returns have been negative. So, there is a 'return problem', or the needed 'home runs' have been too rare.
If look at a good list of the home runs of the past -- GroupOn, Zynga, Twitter, YouTube, Facebook, Google, LinkedIn, Yahoo, Oracle, HP, Seagate, Cisco, Microsoft, Intel -- then (A) it is difficult to see a single pattern and (B) the world has changed a lot over the decades of these home runs with only a few home runs per decade to use as a 'pattern' for that decade.
So, home runs are 'rare', and finding them in 'early stage' investing is a 'rarity' problem.
As the US DoD has known and exploited well for about 70 years now, with more examples from academic research in applied science and engineering, especially biomedical technology, one approach to this 'rarity' problem is some good R&D. For such work, it is common for, say, DARPA, NSF, or NIH to evaluate proposals just on paper and for the funded proposals to have a nicely high 'batting average'.
It would appear that IT VC could do better by borrowing this solution to the rarity problem. Maybe biomedical VC does, but in IT VC it may be that the entrepreneurs are doing too little 'research' to make this solution effective.
Still, the coveted home runs are so rare that there is still a chance that good R&D, even if also rare, could significantly increase the rate of home runs.
If such R&D is being neglected by the VCs, then the 'flip side' of this problem should be an opportunity for any entrepreneur who can do some such research!
The VCs and/or LPs need some 'criteria' on how to invest the money. That is, one venture partner, at least before he has an astoundingly good track record, who has some very different ideas about how to invest money will likely fail to get approval from his other partners or the LPs. So, if you will, there is a 'herd'.
Here are some of the main points about the 'criteria':
(1) The Sexy Sectors.
The two biggest sectors for VC investing are 'information technology' (IT) and biomedical technology. There is also a little for 'clean tech', and then everything else is in the 'single digits' or the roundoff error. In IT, the sector splits into hardware and software. In software, the biggies now are the Web 2.0 and mobile.
(2) The Traction Thing.
It is fair to say that VC is just 'early stage private equity' (PE) investing. Well, in later stage PE, audited financial statements are important. Since in early stage asking for audited finacials is usually asking for nothing significant, the 'herd' likes to see a near substitute and that is the somewhat ill-defined but still quantitative 'traction'.
'Good traction' is, for say a Web 2.0 site, the number of 'unique users' ('uniques') per month significant, say, over 100,000 and growing rapidly. For a mobile app, 'traction' might be number of monthly downloads significant and growing rapidly.
Of course, 'traction' the accountants can count is better, e.g., revenue, and, of course, best of all, earnings.
(3) The Market Thing.
If do some arithmetic on how VC money flows, then can see that VC needs surprisingly big 'exits'. For that a good first guess is that an entrepreneur should be attacking a relatively large 'market'.
Hopefully that market already exists, but, of course, the entrepreneurs may be creating the market they are attacking. Or, e.g., well before the first iPhone, what was the 'market' for such a device? Well, that 'market' is big enough NOW, but Apple, with help from Nokia, RIM, Motorola, etc., created it.
The joke goes: The entrepreneur proposes building a toll bridge across the river. The skeptical investor notes that there is no traffic across the river at the entrepreneur's proposed location and, thus, concludes that there is no 'market'.
There is an old saying: "Selling new technology is hard. Attacking a new market is hard. Selling new technology for a new market is too hard.". This saying is mostly a joke but does describe some common, real concerns.
(4) The Money Thing.
A common assumption in IT VC is that a lot of 'traction' is very significant even if there is so far no revenue. So commonly it is assumed that if can get 100 million people a month to aim their eyeballs, then somehow there will be a way to extract money, that is, to execute 'monetization'.
(5) The UI/UX.
A definition of art is "the communication, interpretation of human experience, emotion". A lot of 'pop culture' art seeks to create an 'engaging user experience'. So, a Web 2.0 project might emphasize a good 'user interface' (UI) and 'user experience' (UX). Some VCs will 'play with' the product and evaluate how well millions of users might like the UI/UX.
(6) A Buffett 'Moat'.
Of course, W. Buffett likes each of his investments to have a 'moat' that keeps out competition like a medieval castle had a moat that kept out the roving barbarians, hungry peasants, greedy neighbors, etc.
Coveted moats used to be (A) crucial, core, technical 'secret sauce' that was powerful, gave especially valuable results, and was difficult to duplicate or equal, (B) patents for crucial, core, technical secret sauce, (C) user 'lock in', e.g., high user 'switching costs', (D) 'network effects', (E) deals for 'distribution channels', etc.
Now more popular is just, from F. Wilson at USV, "large networks of engaged users", and there one approach can be to create a 'fad' among the 'A-list' people!
(7) Some Other Things.
Some VCs believe it can help if (A) there is a good 'team', (B) the team has good 'passion', (C) the team has some people who concentrate on the 'tech' and others who concentrate on the 'market' and/or 'management'. (D) the team is young and understands the 'vibe' of the youth market, and (E) the CEO of the team, to paraphrase a movie, "has always made money for his investors".
New Theme.
There is now a new 'theme' in IT VC which might be called the 'lean startup'. So, over the past few years, there have been some big changes that make startups much cheaper, faster, and easier to do:
(A) Bandwidth.
A T-1 line was 1.5 million bits per second (Mbps) and cost over $1000 a month. Now commonly can get 15 Mbps upload bandwidth for less than $100 a month.
(B) Computing.
For $100 or so each can buy a 4 core processor with a 3.0 GHz clock, a motherboard, 16 GB of main memory, a power supply a case and keyboard, and a 2 TB hard disk drive. Net, if just plug together some parts, $1000 will buy one heck of a computer that not so long ago could cost 1000 times more.
(C) Infrastructure Software.
In either the Linux world or the Microsoft world, there is a LOT of powerful 'infrastructure' software -- operating systems, programming languages, software libraries, data base systems -- available for free.
So, the 'bottom line' for this 'new theme' is: If half fill 15 Mbps 24 x 7 with simple Web pages with simple ads, then have a good shot at making $1 million in pre-tax earnings in one year.
New Approach.
So, a new approach to startup investing is just to back a lot of promising teams with, say, $25,000 to $200,000 each and see what they can build.
So, don't spend a lot of time or effort evaluating a 'business plan' and, instead, just let the team try.
Old Theme.
An old theme in 'innovation' was (A) pick a problem where a much better solution would be valuable (B) do some difficult, advanced (Buffett moat) R&D to find a much better solution, (C) sell the solution.
Here there are two challenges, the entrepreneur doing the R&D and the investor evaluating the R&D.
This old theme is likely still important in biomedical investing but has fallen out of favor in IT investing.
One assumption is that research has nothing to contribute to IT or Web 2.0. While there may be some exceptions to this assumption, for now clearly the exceptions are rare.
The Rarity Problem.
IT VC has a big, huge problem: It needs big exits, essentially 'home runs'. As in some blog posts of VC Mark Suster, for the past 10 years on average VC returns have been poor; often returns have been negative. So, there is a 'return problem', or the needed 'home runs' have been too rare.
If look at a good list of the home runs of the past -- GroupOn, Zynga, Twitter, YouTube, Facebook, Google, LinkedIn, Yahoo, Oracle, HP, Seagate, Cisco, Microsoft, Intel -- then (A) it is difficult to see a single pattern and (B) the world has changed a lot over the decades of these home runs with only a few home runs per decade to use as a 'pattern' for that decade.
So, home runs are 'rare', and finding them in 'early stage' investing is a 'rarity' problem.
As the US DoD has known and exploited well for about 70 years now, with more examples from academic research in applied science and engineering, especially biomedical technology, one approach to this 'rarity' problem is some good R&D. For such work, it is common for, say, DARPA, NSF, or NIH to evaluate proposals just on paper and for the funded proposals to have a nicely high 'batting average'.
It would appear that IT VC could do better by borrowing this solution to the rarity problem. Maybe biomedical VC does, but in IT VC it may be that the entrepreneurs are doing too little 'research' to make this solution effective.
Still, the coveted home runs are so rare that there is still a chance that good R&D, even if also rare, could significantly increase the rate of home runs.
If such R&D is being neglected by the VCs, then the 'flip side' of this problem should be an opportunity for any entrepreneur who can do some such research!
For example, TC reported that Kicksend got $1.8m funding. They are a some sort of a file sharing service. Even if they charge 10$/month, they would need 15,000 paying costumers that will subscribe for whole YEAR to just get the money back.
How does it make sense? How much revenue is expected from a company that raises $1M?
I see a lot of companies getting funded, where it would take years to just get their first 1M in revenue.
Thanks.