Startup funding is not intuitive: you invest large amounts of money in companies that have proven very little, with a really high rate of failure.  At first glance, it is even total nonsense financially speaking: you put money in companies that have no profit AND don’t plan to pay dividends before *long* (hello Amazon) while not being liquid either (you can’t sell the stocks easily since they are not publicly listed). So it is very normal that this topic raises questions. Our goal here is to share the underlying lessons and assumptions of VC when they look at a startup.

1. The 8 Things Everyone Should
Know About Startup Funding
daphni

2. click here to read the article!
#1Growth
is the only way

3. Growth could be the only metric
Why is growth that important? Two words: talent and money.

4. Because if you don’t grow fast, someone else will
(big market = high level of competition).
Growth and big market are tightly linked
Big market is a requirement for growth
Growth is a requirement in big market.

5. Since the risk of success is very low, you need to have a
very high target value in case of success
Growth is the only way in a high-risk
environment
E(X) = probability of success * value in case of success

6. Growth is a race toward an uncertain
solution to a certain problem
Starting a startup is linked to 3 principles:
(1) uncertainty, (2) full commitment, (3) winner-takes-all
(1) startups are built around searching: the problem/solution fit, the product/market fit, a scalable model
(2) growth is neither short term race (burnouts are not rare enough in the ecosystem) nor a lifetime walk
(3) digital startups are built on network effects, leading to a race where the winner takes most of the pie

7. Continuous high growth leads to
exponential growth
Growth matters all along because growth is cumulative
There is a very well documented bias in psychology and behavioural economy
which is called the misperception of exponential growth: we tend to grossly
underestimated exponential growth.

8. Bottom line
Startups are designed to solve certain problem with uncertain
solutions in big markets with a high risk of failure but an
exponential growth if well done. So growth could be the only
compass. Startups = growth.
click here to read the full article!

9. click here to read the article!
#2Growth Before Profits,
Sorry, No choice!

10. If you build a marketplace or a SaaS product, having 40 clients or 39
clients is almost the same: a new user brings no additional cost or very
few (the costs of storage and bandwidth are getting incredibly low).
startups don’t care about profits*
* for quite a long time
Tech startups are operating with very specific cost structure:
(a) their marginal cost are very low, (b) their returns to scale are very high

11. Growth OR Profits
Why do startups turn a blind eye to profits?
Because otherwise it would slow growth.
If your activity makes some earnings, you reinvest everything into growth.
No dividend tolerated in a race to size.

13. Look at Amazon’s financial data:

14. Bottom line
if you want to grow as fast as possible, you minimize friction
(eg: your product is free) as long as possible and raise funds so
you can be the biggest kid in town (and eventually monetize
with your huge user base). This is why startups have often
negative results and focus at maximizing gross value before
they start to maximize profits.
click here to read the full article!

15. Gross profits scale well once startups found
their product/market fit, profits come later:

16. click here to read the article!
#3If Growth Forecasting
Were Easy, There Would
Be Only One VC fund:
Nostradamus Partners

17. [Declarations] of high confidence mainly tell you
that an individual has constructed a coherent story
in his mind, not necessarily that the story is true.
— Thinking Fast and Slow, Daniel Kahneman

18. Sadly, it’s not possible to know whether the beginning of a strong growth will last
and if it is a linear growth or an exponential growth.
Traction, which should be defined as quantitative evidence of market
demand, is very often related to the actual usage of the product.
Is Traction The Ultimate Heuristics?

19. Because indicators influence one’s activities, you should guard
against overreacting. Always pair non-correlated indicators, so
that together both effect and counter-effect are measured.
Beware of
Key Performance Indicators (KPIs)

20. For a SaaS product, new users is not enough, you need to pair
new users with churn.
Embrace Complexity
But Keep It Simple
In fact, it would be even better to distinguish a bit more and to measure on a
MoM basis: (a) new users, (b) churned users and (c) resurrected users, to be
MECE (mutually exclusive and collectively exhaustive).
click here to read the article!

21. In your dashboard, it is more useful to monitor retention rate than its contrary,
churned rate (1- churn rate= retention rate).
For the curious minds:
[users last period + new + resurrected – churn] = [users new period]
<=> churn = [user last period + new + resurrected] – [users new period]
Retained users = [users last period] – [churn new period]
<=> retained users = [users new period] – new – resurrected
Churn rate & Retention rate

23. Bottom line
We’ve seen that growth is key, yet growth forecasting is very hard.
We’ve seen the importance of choosing the right KPIs for growth,
even if it does not make it more predictable.
Yet, investing is not a sheer game of luck. Everything is about
assessing one’s potential and hoping for exogenous forces to evolve in
your favour (trends are a good indicator too).
interested in this? read the full explanation in our article to become a black belt

24. click here to read the article!
#4You Need to Lose
Money, But A Negative
Gross Margin Is A Really
Bad Idea

25. It’s easy to grow fast: just get a negative gross margin.
If you’re selling a $10 note for $1 you will have a ton of growth.
But nobody would do such a stupid thing, don’t you think?
Well, in fact Paypal did something very close to that.
At their early days, they gave $10 to every new user and an additional $10 everytime
they referred a friend. That gave them hundreds of thousands of new customers and
an exponential growth rate.
Of course, this customer acquisition strategy was unsustainable on its own — when
you pay people to be your customers, exponential growth means an exponentially
growing cost structure.
— Peter Thiel

26. Startups Still Have
Negative Gross Margin* Today
Negative gross margin might be voluntary: either you believe
the margin structure will evolve for your benefit (as explained
by Fred Wilson), or you believe the switch costs are high
enough and you want to lock as many users as possible.
* gross margin= revenue - cost of goods sold (COGS)

27. Negative Gross Margin
Is Not a Good Idea
Fernando Suarez & Gianvito Lanzolla showed, in their amazing
piece The Half Truth of the First Mover Advantage, it is very
difficult to really lock users in rough waters, where technology
and market structure are evolving at very fast paces.

28. Gross Margin => Growth
Growth margin represents the percentage of money a business
can invest into growth.

29. Bottom line
Some people argue that profit is just an opinion in the short
term: you can try to have a positive net income asap (like most
of traditional business) or just focus on growth, but cash
(revenue over all and gross margin especially) is a fact.
interested in this? read the full explanation in our article to become a black belt

30. click here to read the article!
#5How To Have Growth
AND Profits? Part 1

31. In transactional business models, user
growth is correlated with revenue growth*
As a rule of thumb, here is a good objective
MAU quick ratio** > 1.5
(good is > 2, great >4)
*all things being equal
** (new MAU + resurrected MAU)/churned MAU

32. Even better: grow your user AND the
average price paid per user
As a rule of thumb, here is a good objective
Revenue Quick ratio* > 4
* (new + expansion + resurrected) / (cancelled + contraction)

34. Growth and Profits:
some formulas & benchmark
Life Time Value > 3x CAC (and a payback period < 12 months)
(growth rate + profits rate) >= 40%
Looking for other formulas & benchmark? Read our article

35. How To Have Growth
AND Profits? Part 2
click here to read the article!
#6

36. In non-transactional business models,
user growth is not correlated
with revenue growth…
… so you need to find the right proxies* for growth and profits
click here to read the article!
*proxies are indicators that are not in themselves directly relevant, but
they are useful in place of an unobservable or immeasurable variable

37. Make your quick ratio* by replacing the
money by your proxy
For example, if you measure link sharing:
*quick ratio = (new + expansion + resurrected) / (cancelled + contraction))
new = you check new people sharing link
expansion = people sharing more links on average
resurrected = people sharing links that stopped sharing the previous month
cancelled = people that stopped sharing link
contraction = people sharing less links

38. Always favour engagement proxies
and go in depth
To study engagement distribution the best way is to use Cumulative Distribution Function

39. Bottom line
In the end, it is always a question of fundamental user needs
and the way startups tackle them. The moto should be: “build
the value, monetization will come eventually”
interested in this? read the full explanation in our article to become a black belt

40. click here to read the article!
#7What About Valuation
For Late Stage Startups?

41. Different investors, different approaches
Early stage investors are focusing a lot on the team, the product
and the total addressable market. The more you move into the
funding stages, the closer investors look at traction and
eventually at revenue.
The more predictable a business model can be, the more investors will focus on
future cash flows (and risks), like any traditional company.

42. Late stage startups valuation
The value of late stage startups should be approached very
similarly than other companies.
The methods are very well described in this guidelines from the IPEV (Price of
Recent Investment, Multiples, Benchmarks, Discounted Cash Flows, Net
Assets, etc.). Let’s explain the 3 main approaches (and the correction method):

43. 1. Recent Transactions
The easiest way to give a fair price is when the last investment
were very fresh (either a primary investment, such as a new
round table, or a secondary investment, such as when some of
the shareholders sell some shares).
If neither the market nor the company have tremendously changed, the last
transaction price is a good indicator of the valuation of the company.

44. 2. Probability-Weighted Expected Return Model
The idea of this approach is to compute the expected returns
using different exit scenarios (exit type, growth of revenue,
valuation, liquidation preferences) for the company.
One of the scenario for late stage startup valuation can also be liquidation
value: the valuation is then highly discounted, often as low as the price of
assets in the company such as their Intellectual Property.

45. 3. Market Comparables : benchmark & multiples
Mutual funds are also using more traditional approaches for late
stage startup valuation. They use valuation multiples. In theory,
several kind of multiples could be applied: sales, gross profit,
EBIDTA, revenue. The idea is to look at the company’s sales/gross
profit/EBIDTA/revenue and apply the valuation multiple of similar
public companies, taking into account the growth of the metric
considered.

46. Bottom line
Late stage startups valuation is based on different approaches,
taking into account growth AND revenue. They most often
use computing Probability-Weighted Expected Return Model
or market comparables, moderating them with premium and
discount.
interested in this? read the full explanation in our article to become a black belt

47. click here to read the article!
#8Fail Often, Fail Fast?
Investors Do Half of That.

48. The return of a typical VC portfolio
8 will returns no money or very little,
13 will returns only the money invested or much more,
3 will return a multiple > 3x,
1 will return a multiple > 10x.
which makes 21 fails over 25 investments (84%)…(returning
only the money invested 10 years before is not what we
should call a success.)

49. So after screening 2500+ startups, a professional teams of
investment still fail 84% of the time.
Let’s call that a false positive (if you consider the investment as a
diagnostic of a future financial success (positive)).
1. Failing due to False Positive

50. This trend will certainly be reinforced by the massive entry of new
players, who are less price-disciplined. These new actors step in
especially in early stage and late stage.
False Positive & New Players

51. In Early Stage
Source: 2015CF - The Crowdfunding Industry Report by Massolution - upfront ventures - daphni
Global equity crowdfunding amount (in $B)
1.1
0.4
2.6
2014 2015E2013

52. In Late Stage
Source: - CBInsights 1/1/09-4/20/15, VC backed US startups ex life sciences - upfront ventures - daphni
Medium size for mid- & late startup rounds by investor type
round sizes have exploded and are highly correlated with lack of price discipline
60
48
35
20
35
71
103
30
60
90
120
0
2012 2013 2014
Family office Hedge fund Mutual fund PE VCAsset mgmt

53. Unicorns hunting = bigger failures
This hunt for unicorns leading to many failures, since roughly 40% of these
unicorn IPOs are now flat or trading below their private market valuations.
source

54. VCs suffer also from lots of false negative: company that they thought
weren’t likely to become huge successes when they eventually did.
Legendary investors, such as Bessemer, missed a lot of great opportunities. They even built
what they called an “anti-portfolio”: the biggest company that they meet in their early time
and they chose not to invest in (or even to avoid meeting with the founders!).
2. Failing due to False Negative

55. Bottom line
There is a continual pendulum swing between high liquidity
and prices, and low liquidity and prices in the VC market,
shifting from too much confidence to too little. What is sure is
that funding black swans will have trouble becoming a science.
interested in this? read the full explanation in our article to become a black belt

56. about daphini & the author
@willybraun, co-founder of daphni
special thanks to my parter
@mathieudaix, for his feedbacks & inputs
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