The 8 Things Everyone Should Know About Startup Funding

daphni

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#1Growth

is the only way

Growth could be the only metric

Why is growth that important? Two words: talent and money.

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.

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

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

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.

Bottom lineStartups 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.

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#2Growth Before Profits,

Sorry, No choice!

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

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.

Look at Amazon’s financial data:

Bottom lineif 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!

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

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#3If Growth Forecasting

Were Easy, There Would Be Only One VC fund: Nostradamus Partners

[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

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?

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)

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).

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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

Bottom lineWe’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

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#4You Need to Lose

Money, But A Negative Gross Margin Is A Really

Bad Idea

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

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)

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.

Gross Margin => Growth

Growth margin represents the percentage of money a business can invest into growth.

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

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#5How To Have Growth

AND Profits? Part 1

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

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)

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

How To Have Growth AND Profits? Part 2

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#6

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

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*proxies are indicators that are not in themselves directly relevant, but they are useful in place of an unobservable or immeasurable variable

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

Always favour engagement proxies and go in depth

To study engagement distribution the best way is to use Cumulative Distribution Function

Bottom lineIn 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

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#7What About Valuation

For Late Stage Startups?

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.

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):

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.

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.

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.

Bottom lineLate 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

click here to read the article!

#8Fail Often, Fail Fast?

Investors Do Half of That.

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.)

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

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

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

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

02012 2013 2014

Family office Hedge fund Mutual fund PE VCAsset mgmt

Unicorns hunting = bigger failuresThis 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

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

Bottom lineThere 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

about daphini & the author

@willybraun, co-founder of daphni

special thanks to my parter @mathieudaix, for his feedbacks & inputs

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