This post was originally published on LinkedIn on November 2, 2016
Early stage investing is cyclical. Periods of wild exuberance are followed by eras of uncertainty and then downright desperation. Over decades of evaluating new companies and emerging tech, we have seen many such swings of the pendulum.
Right now, we are in the midst of a modest downward trend. The macro environment is turbulent and full of variables in politics and world affairs as never seen before. The IPO market is constipated, but trying. Later stage investors are over committed to the many companies whose value they pumped up during the more recent boom times; as a result, Series A and B rounds are hard to get, and are coming with tough requirements and terms we haven't seen in a long time.
The good news is that tough times like these, historically, produce some of the best startups. In boom times, even weak leaders and iffy ideas can get funded. In downswings like now, lesser entrepreneurs may decide that a normal job isn't such a bad idea, and every new company concept gets severely tested from Day One. This Darwinian winnowing scrubs the hesitant from the field. In downward cycles like today, we may see fewer companies than in boom times, but their quality is higher.
Based on our long experience, and our overarching sensibility as pragmatic investors, here are the factors that we believe most directly drive value creation for startups today. These startup metrics absolutely drive our investment decisions.
Revenue rate. In the end, success is about revenue. Get it, you win. Don't, you lose. Even at moment-of-inception, we want to see companies that are thinking about how to get and maximize revenue. In most cases, we want to see at least preliminary explorations of revenue generation. Paid tests weigh much more heavily with us than freebie trials, for instance. We seek leaders who are always thinking about their markets and how to best extract income from them.
Revenue rise rate. Starting from zero, as all new companies do, the rate of revenue rise is critical. A slow revenue ramp leaves a small start-up exposed to competitive counter attacks. The time that transpires while revenue slowly builds could bring radical market shifts, rendering a strategy outmoded. Any wobble during a shallow revenue rise could require additional fund raising, which can be challenging for the company given the uncertainty of future conditions. Far better, needless to say, is a sprint to profitability. We study the revenue rise rate of startups closely. The question for entrepreneurs isn't only will you succeed, it is how fast will you succeed?
Unit economics. Under the hockey stick curves CEOs display in their decks, must lie strong and improving unit economics. So often, young entrepreneurs miss this or don't emphasize it enough. How much do you make on each unit you sell? Is your gross margin strong? Does it stay strong as you scale? Understanding unit economics for startup CEOs is like understanding the inner workings of an auto for a race car driver. Essential knowledge. We put more effort toward understanding unit economics than, perhaps, any other metric.
Are current customers increasing/renewing? Frequently, when we peel back financials, we find that growth is really just a reflection of motion, Wile E. Coyote style. Intense sales, the benefits of low hanging fruit opportunities, pump in new customers at so fast a rate that revenue grows even though current customers may be churning out or not spending more. What matters most, always, is getting more money from current customers. Your current customers are your best prospects. Companies that can't take advantage of that don't grow for the long term.
Does the business model show positive virality? While it can take time to perfect these models, we look for startups that have -- or at least have the potential to achieve -- positive virality. This means that each customer acquired attracts at least one other new customer. The net churn is positive, even if only slightly so. That small positive can compound hugely over time. By the same token, a small negative rate can wear down growth in the long run. Positive virality is the surest sign a company has something that its market really wants.
Is the customer base expanding? Are there more customers today than yesterday? Are more available to fuel growth tomorrow? It seems simple, but turning an addressable market into steady and predictable customer growth isn't easy. Startups can so quickly fall into the trap of over spending on marketing as soon as the easy, early customers have been obtained. If the cost of customer acquisition isn't flat or dropping, something is wrong.
Is burn holding? The one thing a startup CEO controls absolutely is spend. We like cheap bastards running our companies. Every dollar not spent today is in the bank to give the company more time. We always want to see plans that have burn growing far slower than revenue and performance that meets those targets.
Profitability vs. cash on hand and burn. At core, our question is always: Is this company survivable? Can this team, with this product and the cash currently being raised and on hand, achieve profitability? At minimum, can it achieve unit economics and operating performance so overwhelmingly positive that recalcitrant Series A investors will feel compelled to respond? Does the CEO know what the Series A investors will likely want to make an investment at that level of maturity for the company? Does she or he have an idea of which investors, based on their track records, they would target to lead the Series A?
What are the multiples of the raise vs. current revenue? We aren't in the profit business. We are in the value business. So we look hard at multiples on revenue in different market segments and for different business models. We have a strong preference for those with the highest multiples.
Do we believe this company can get public? We know that not all companies that could go public will go public. But we want to see the potential for a company to get that far. We want to back CEOs that believe achieving this much value is their mission.
Or, do we believe it can be acquired for high value? And, pragmatically, in times like this where the IPO market is constricted, we want a clear-eyed view about who might acquire each of our startups, why, and with what economics in play. We find that one of the biggest differences between entrepreneurs at the top of the heap and also-rans, is a steadfast focus on the end game.
Mike Edelhart is the managing partner of Social Starts, one of the most active moment-of-inception venture funds in the US. A pioneering media and Internet startup executive, Mike became widely known in tech circles as the original Executive Editor of PC Magazine. Find Mike on Twitter @MikeEdelhart.