An Open Letter to Other VCs

8th April, 2016 No Comments Blog

To Whom It May Concern,

As may already have happened, my firm, CoVenture, will occasionally send you investment opportunities.  When these companies are from our portfolio, we obviously know them well and are sending them to you because we feel they are, in some sense, ready for additional capital and the next phase of development.  In this letter, I will outline what we look for when we assess this readiness.

I’m writing this letter now because we believe that, over the last four or five years, the venture capital landscape has undergone a change; the labels and parameters that apply to each stage of funding have shifted.  As a result of this shift, there is frequent miscommunication among investors and entrepreneurs.  I hope to provide here a clear articulation of our view of the various funding stages for venture-backed companies.

We at CoVenture usually invest at what has come to be called the Pre-Seed stage.  We help each company build an initial version of its product, enabling the founding team to test its “Value Hypothesis:”  basically, they try to get customers to use that first product.  In order to validate their value hypothesis, we feel our companies must determine whether or not their products provide value, and if so, how much value.  Without knowing how much value is being created, a company cannot determine its growth strategy.  A product priced at $10,000 can be marketed and sold differently than one sold at $50.  Proving growth before proving value therefore rarely makes sense.  We try to ensure that each company has sufficient capital (usually $100,000-1,000,000) to develop and test the product in this way.  If they are successful in attracting initial users – validating the Value Hypothesis – we deem them ready to raise additional capital (a Seed financing) to pursue the next milestone (developing a “Growth Hyphothesis”).

We don’t lead Seed financings, so will at that point reach out to our friends at Seed firms about getting involved.  As the previous paragraph indicates, we’ll try to highlight what the company has done to validate its Value Hypothesis, describing the early usage the initial product has received.  Most likely, the company will have little revenue and the founders will not have a clear sense of how they will find and attract more customers, but may have a few ideas about how to do so.  We believe that is the goal of the Seed round (usually $1-3 million):  to test a variety of approaches to marketing the product until the management team has a clear view, based on numerous attempts at actual sales, about how to pursue growth given additional capital to do so.  This is the process of developing the Growth Hypothesis – determining the cost of acquiring a customer (CAC) in each potential channel (depending on the target customer, these might include outside sales, inside sales, SEO, SEM, e-mail, direct mail, online ad buys, OOH, etc.) as well as an estimated Lifetime Value (LTV) of the customer (or at least Annual Revenue per Customer, ARPU).  These efforts should ultimately produce revenue at this stage, though it may not be a smooth “hockey stick” progression just yet.  But when a management team can explain how and why they would spend their next marketing dollar in a sufficiently profitable way, it’s time to raise more capital.

We encourage companies to pursue a Series A financing (generally of more than $3 million) when they have (i) a growing list of happy customers showing good unit economics and (ii) a fact-based argument for how they would go get more of them (a Growth Hypothesis).  We will therefore introduce portfolio companies to Series A investors when the company can describe the unit economics across its various marketing channels and explain why one or more of them represents an attractive potential growth driver.  The purpose of the Series A is to provide capital to test the Growth Hypothesis.  Just because a company figured out with Seed capital how to attract, say, 1,000 users does not mean it can attract 100,000 in the same way.  If it does so, or finds another marketing approach that clearly leads to significant growth, it has validated its Growth Hypothesis.

Unless or until the market changes in some way, or some other unexpected event befalls a company at this stage (which is all too common), additional financings are generally to provide additional capital to fuel growth.  Companies at this stage of maturity should be more or less like money machines; an additional $X spent on marketing will be known to yield more or less $Y in revenue over Z months.

Not all investors look for the same things at each stage.  We understand and respect that you have your own thesis(es), whether sector, geography, or other theme.   And of course we expect you to invest in the best available opportunities (e.g. if a company manages to validate its Growth Hypothesis at the Seed Stage, it will be more attractive than most companies to a Series A investor).

That said, we have also noticed a tendency on the part of some investors, particularly at the Series A stage, to filter investment opportunities based on a minimum amount of recurring revenue or number of users.  We believe these absolute metrics are often beside the point at this stage; a company with <$1 million in revenue that can demonstrate beyond a reasonable doubt a likely rapid path to, say, $5 million ARR with profitable unit economics should probably be attractive to a Series A investor.  In other words, it isn’t so much the absolute metric (like revenue) as it is other “relative” or unit-level metrics (such as CAC, estimated ARPU and LTV) that we think are the yardstick of success at this point.

I hope I’ve been able to clearly lay out in this letter our expectations for our own companies as they deploy capital.  I hope you’ll share your questions and/or thoughts, either directly or in a public forum, in response.  The more we can be on the same page as an investment community, the more efficient our private capital market will be.

As you may have gathered, this letter borrows liberally from Eric Ries’s Lean Startup and Steve Blank’s writings.  It’s also a close cousin of my last blog post, What is Pre-Seed?

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