From time to time, we meet super ambitious teams with a unique insight around a big problem and a roadmap to take their solution to the market. In these cases, teams are complete, the early product is in production and there are signals of some product-market fit, represented by a few loyal, paying customers. They have done a remarkable job taking their idea to this stage and now need venture capital to accelerate their go-to-market. They also rightly expect to be rewarded for the good job they’ve done with a high pre-money valuation.
The scenario I describe above is ideal for us, as an early-stage VC with a fund size of $150m. It ticks many of the boxes we look for in our pipeline and typically we decide to extend a term sheet. However, frequently, the valuation we attach to the business is lower than the team’s expectations.
The primary reason for this is that at the stage we focus on, the ultimate success of these companies is dependent on multiple factors, all resulting in a positive outcome. Not only does the team have to continue to execute brilliantly, but their competition also has to execute more weakly and the regulators need to cooperate and the business cycle has to continue strongly and their market needs to grow as they predict, and so on and so on…
Their ultimate success is predicated on a long list of combined probabilities. Facing these types of “butterfly effect” business models, one needs to take into consideration the resulting long odds of success and price investments accordingly. Compounding probability is a notion that is not obvious to many founders.
Today UIPath announced its new round of funding taking the company to a post-money valuation of $1.1b (The news had leaked on Friday and Techcrunch had already run the story). I actually dislike the unicorn fetish and find the obsession with it meaningless, but I could not resist the headline of this blog post.
What is great about the story at UIPath is that it’s a validation of a key thesis of ours at the Earlybird Digital East Fund:
Innovation is not under the monopoly of Silicon Valley and bright engineers from underserved venture capital markets will continue to build great companies. There is an attractive VC opportunity in focusing on regions with a strong tech talent base.
Congratulations to everyone involved, starting with Daniel and Marius, my partner Dan Lupu, who was the first to spot the talent in the founding team, Ondrej, Reshma, and Luciana, who have been on this fantastic journey.
I am a product of a rationalist education. After my schooling, my career progressed in a way that made me more of a disciple of the rationalist cult. As a strategy consultant, we were brought in to be analytical, usually getting rewarded for overly complex models and frameworks that our clients used to make decisions (or, more often, validate decisions they would like to make).
My rational mind was also in the driver’s seat when I launched my first startup in 1999. It was the first time I was facing critical decisions about the strategy and tactics around a company, and I found it easy to build analytical frameworks for those decisions.
1999 was a horrible year to start a digital business. From the peak of the dot-com bubble, we hit the crash head-on. The next few years were full of anxiety, tough choices and blood, sweat & tears. It was then that I realized that in a lot of the decisions we were making as a team, my co-founders and I were also relying quite a bit on our intuitions.
Following my exit, I returned to my hometown of Istanbul and started to get to know the startup landscape there. I found myself falling back into my analytical habits. Perhaps, the lack of familiarity made me suspicious of my intuitions.
Now that it’s been 12 years since I have been back, I find that my intuition is playing a larger role in how I make decisions. As a VC, we spend a lot of effort looking at data and building frameworks around sectors, markets, and companies. However, I keep getting amazed how well my intuitions generally guide me. A lot of my regrets were results of me ignoring my intuitions. One of my 2018 resolutions is to focus more keenly on that inner voice.
This was inspired by a post on the great Farnam Street blog.
Since the dot-com boom in the late 90s, the venture capital industry has become a popular pop culture topic. The mythology around young executives getting to place bets on the future of technology with other people’s money has a certain appeal. Add to that the irrational exuberance of the 90s, the stories of overnight fortunes and the drama of the crash that followed, and the public interest in the industry was firmly cemented.
Since then, the fascination has only grown. We’ve had the Hollywood take on how tech innovation and VC works in The Social Network. VCs such as Peter Thiel, Jim Breyer, Fred Wilson, Marc Andreessen and Bill Gurley have become household names. Charismatic founders like Steve Jobs, Elon Musk, Mark Zuckerberg, Reed Hastings, Jeff Bezos, Travis Kalanick and Evan Spiegel are now celebrities.
The price our industry pays for this popularity is what we are now witnessing, with scandals like those at Rothenberg Ventures, Binary Capital and 500 Startups, and the fight on the board at Uber becoming front page news. This public drama has its toll on VC firms and startups involved.
I’ve been thinking that what we see in Trump’s White House must be making the writers’ job at House of Cards very difficult. Now I am thinking the same about the writers at Silicon Valley.
In the business of financing technology businesses, one of the most tricky areas is how you treat the forecasts in the pitch decks. Typically, you are taking a very limited, usually heavily biased, data set and using it to provide a baseline for forecasting a much longer trajectory. If you are familiar with probability, you’ll know that while this is possible, the result will have a very low confidence level. Therefore, you need to discount these forecast very, very heavily.
I was reminded of this when I read the Bloomberg New Energy Finance press release on Electric Vehicle sales forecasts. The headline is that Electric Vehicles will Accelerate to 54% of New Car Sales by 2040. I a sure there’s sound methodology behind this work, and the resulting graph looks great:
Now, please consider that Tesla Roadster, the first street-legal, serially produced EV with a viable range was introduced in 2008. When you are taking a 1% market share figure and growing it to 54% over 25 years, a tiny variance in that slope can end up with a vastly different figure.
As a VC, you come across enough forecasts to intuitively discount the out years. This is not really a science but more of a sense. However, it can make a massive difference in the eventual exit size and how much capital the business may end up consuming.
We have a love-hate relationship with online retail companies. My partner Evren is the founding investor at Trendyol, Turkey’s online fashion champion. We have backed Vivense, the leading online seller of furniture that is growing rapidly with healthy metrics. Trendyol is now one of the biggest Turkish tech success stories and Vivense has become the leader in its focus area of hard furniture.
Our experience, laced with blood, sweat, and tears, has shown us how difficult it is to build a sustainable and healthy online retail business, and we have also passed on a very large number of online retail startups.
Recently, I am sensing a change in how the world views online retail. In the recent months, we have seen some major moves in the sector:
- Emerging Markets conglomerates are investing into retail e-commerce.
- Amazon has made a rare market-entry driven acquisition in MENA.
- The leading local e-tailer in India, Flipcart, has raised a massive new round is rumored to be contemplating buying its largest local competitor, Snapdeal.
- Walmart paid $3b for Jet.com, which, at the time, was little more than a large repository of know-how and ambition.
- Unilever acquired DSC for $1b, showing the potential in smart vertical integration in certain e-commerce niches.
- It finally looks like Birchbox is profitable (read: perhaps sustainable), providing new hope for subscription models.
- Trendyol is now nicely profitable, without compromising from its rapid growth.
- Leaders like Amazon (generalist) and Zalando (fashion specialist) are trading at all-time highs.
I think these headlines are a sign that strong execution, operational excellence, and adequate funding are coming together in select pockets to show that retail e-commerce can work.
It is not sexy to write about the $40m acquisition of an 8-year old company with $4m EBITDA. The headline about Snap’s 60+ P/S ratio gets more attention.
The entrepreneurial mythology is full of epic stories, such as those of Apple, Google, Facebook and Amazon. Yet, the reality is much more boring, as represented in this chart. The selection bias around what you hear about is a trap in the entrepreneurial journey.
We frequently find ourselves in valuation discussions with founders where we think the asking price for the round is expensive. What keeps us grounded is the data represented in the chart above. Mind you that the exit sizes in Europe, and especially, Emerging Markets are lower than the global figures.
As an entrepreneur, you would be well-advised to keep in mind that your exit will likely be smaller than what you read about.