Chat with any venture capitalist about the current down market and their talking point is always the same — great companies get funded during downturns.
But is that really true?
It does seem odd that when the economy slows and VCs pull back on their checkbooks, they all of the sudden are able to sort the wheat from the chaff. However, the theory is that during tough times, great companies will rise to the top and investors will do more due diligence and leg work to find them.
That sounds good and makes a certain amount of sense, but does it actually play out? Did great companies get the biggest fundings when the market tanked during the global crisis of 2008-09? Or did VCs actually back their fair share of washouts just like any other time?
Running a quick search of Crunchabse’s data for the largest rounds raised by U.S.-based startups between mid-2007 and mid-2009 gives us a glimpse at all the “great” startups that got funded during the previous downturn.
The top 10 rounds from the last downturn
Here is a quick rundown of the 10 biggest rounds from that era:
The two biggest rounds in that 24-month period were two $300 million Series Ds — one to gaming studio ZeniMax and the other to solar power startup Nanosolar.
Those two companies’ stories turned out about as differently as one can imagine.
Media company ZeniMax is best known as the publisher of the Fallout gaming series and many others games — and for winning a lawsuit against Oculus for copyright and trademark violations. Less than three years ago, Microsoft announced it would acquire ZeniMax and all its subsidiaries for $7.5 billion.
Nanosolar’s story turned out very different — as did the tales of most solar companies from that time (which we’ll get further into). The San Jose, California-based startup developed a low-cost printable solar cell manufacturing process. But, after the financial crisis, prices for solar panels made of crystalline silicon plummeted. By 2013, Nanosolar’s competitive advantage evaporated and it had laid off most of its workforce and was soon gone.
Austin, Texas-based HomeAway comes up next with the third-largest round during that time — a $250 million Series D. The startup was a pioneer in the vacation rental marketplace. It actually went public just after the downturn, and was later bought for $3.9 billion in cash and stock by Expedia. HomeAway also made several acquisitions, with its best known likely Vrbo.
Inside Melbourne’s high-rise towers, small offices, and co-working spaces, and behind historic building facades, a digital revolution is taking place. Over the past few years, the city’s burgeoning technology industry has placed the city well and truly on the map as a destination for global innovation, and has earned it the title of Australia’s tech capital.
It is now home to more than half of Australia’s top 20 technology companies. With more than 8,000 technology businesses operating in Victoria, the industry generates $34 billion in revenue each year, employs about 90,000 people, and accounts for approximately 31% of Australia’s entire ICT workforce, according to InvestVic.
Melbourne is a city that produces more IT graduates than any other Australian city, and is ripe with opportunity to nurture, grow and attract global talent, and will continue its rise as a true hub for technology and innovation.
The future of technology in Australia is exciting, and that future is coming from Melbourne.
So, what’s “Organic Growth”; Organic growth is the gradual growth in a company’s revenue through the slow and steady acquisition of new customers with a limited budget.
This slow and steady approach is common in old school businesses that lack the knowledge and capital to grow rapidly. I know I founded my first business this way decades ago, and it was a damn hard struggle trying to drive growth using small increases in revenue to fund sales and marketing.
It’s common to see businesses like these with limited funds to spend on the important areas that drive revenue, areas like sales, marketing and product development; this typifies organic growth.
These businesses are in effect capital constrained which is the main cause of organic growth, the investment community sometimes refers to this as being “under capitalised”. Which leaves few alternatives other than raising capital.
Now if you had capital in your company and could spend an extra million dollars on sales, marketing and advancing your product I’m sure you would be achieving more rapid growth maybe even 20% a month.
Wouldn’t that be a significantly better outcome?
The other reason why you might need to raise capital is you might be in an industry or a sector where you have competition that is rapidly coming up behind. You don’t want to be overtaken by your competition, which means you need to grow quicker than your competition and to do that you need capital. Organic growth is probably going to see you wiped out by your competition.
Let’s look at two examples.
Company X is a 3 year old small business with 100 customers, X is consistently picking up one new customer a month with a small budget for sales and marketing based on existing revenue. So each year Company X adds 12 customers which is a 12% annual growth rate. Now this is okay for a lifestyle business and organic growth but bad for a business or Startup if you want to exit for millions.
Company Y is a 2 year old Startup with 50 customers, X is consistently picking up five customers a month with a $800k budget for sales and marketing funded by a Series A investment. So, each year Company Y adds 60 customers which is a 120% annual growth rate.
Company Y will overtake Company X in its third year.
So organic growth is a mugs game because your limiting your growth and therefore you need to raise capital.
Furthermore, if your product is online, cloud, software as a service or in a high technology sector, your market is advancing, innovating and growing at higher than average rate
The days of slow organic growth are over, rapid advances in technology are enabling companies to quickly grow and service more customers with less effort. Artificial Intelligence is a prime example of this, if you haven’t heard, it’s going to impact every industry in the coming decade. This is not a bad thing, you can use it to your advantage by developing a smarter sales and marketing strategy using technology.
Bottom line those raising capital have more money to spend than those that do not. Which means you have little choice but to raise capital to not only secure your market but to grow your revenue before your competitive advantage evaporates and your competition overruns your market position.
Don’t even think about organic growth, it’s a mugs game.
Take the smarter path to success and start planning your capital raise now.
Capital raise dilution and founder equity is commonly misunderstood, getting it wrong can kill investment, restrict your growth and get you kicked out of your own company. It’s where you as a founder exchange equity in your company for cash that you can invest in the business.
You’re going to get diluted the only real question is by how much, which is completely dependent on the amount you are raising and your ability to justify your “perceived valuation”, and the “real valuation” accepted by an investor. For first-time founders this is a new hurdle that requires understanding and planning.
A common problem is founders trying to maintain the maximum amount of equity, this is an incorrect approach because cash is the most valuable resource a startup company can have. Usually this is due to a lack of understanding that all shareholders dilute in all rounds besides the first round. Equity is from the company as a whole not the founders equity position.
In Venture Capital rounds this may not be the case but for this explanation we are taking a simple view.
You must be prepared to exchange equity for cash. Now when I say this I say this within limits, you don’t want to be handing over more than 35% of your company in any round other than an IPO.
Unlike “Dragons Den” and “Shark Tank”, do not give away half of your company right from the outset! Unless of course you’re sharing half of your company with a co-founder, or you have nothing but an idea, then it’s a different scenario.
So let’s assume you’re the sole founder in the company and you need to raise capital, so what’s going to be a reasonable amount of equity dilution?
In my experience it’s reasonable to be handing over anything from 10% to 25% per investment round, in an IPO it can be 30% to 50%.
As long as it’s less than 25% in each capital raise round you should not be too concerned.
Now consider that prior investors are also diluting and your value is increasing in each round, so you’re not giving up as much as you might think.
This is where most founders get it wrong, its the dilution maths, so here’s the common miscalculation.
The company exchanges 25% company equity in three separate rounds of capital raising, then I’m only left with 25% of my company.
Incorrect, you actually have 42.19% equity remaining after three rounds.
Why, because 25% is not from your equity, its from the company as a whole and all prior investors dilute which means you dilute less in each subsequent round.
Pre Money Value
Post Money Value
Now let’s look at another example.
Company “XYZ” has an online platform with software development six months from completion, they need cash to stay on track and avert a disaster.
So the valuation has to be realistic, otherwise it’s going be a really hard sell, investors hate overvalued companies and will deeply questioning your financials.
At this point it’s important you consider the end game which is your final equity position and exit value.
So there are two choices: more capital raises in smaller steps “Staggering” or raise more in less rounds. Each has it’s advantages and disadvantages, and every situation is different, but a staggered capital raise strategy give you more room for mistakes and get you investment more quickly.
In this example we are assuming a staggered capital raise as the company is early phase and has suffered a few setbacks so better to play it safe. There’s nothing stopping the company from adapting its capital raise strategy later.
You can change “Capital Raise” amount and “Pre Money Value” to suit your own circumstances.
In the chart view, its easier to see the decreasing Founder dilution and increasing value.
NOTE: After the IPO round Founders @ 21.5% and $21,504,000 In fact in the last round although the company as a whole diluted 30% the founder only diluted 9% That’s the impact of equal equity dilution across all shareholders
I always try and make sure my equity dilution on each round is in a target range of 15% to 20%, with a final exit range of 15%-25%.
So diluting your equity position when capital raising is a completely normal thing.
Again it’s important to understand your looking at the endgame here, focus on your final equity position and exit value. That end game when the company valuation is enormous is where you’re actually going to make your money.
Your better to hold 20% of a successful $100 Million company, than 50% of a $20 Million company that was under capitalised with strangled revenue growth.
Remember have the end game in sight, don’t get greedy and don’t be afraid to give up equity, you’re going to have to do it to raise capital for company growth.
If your early round values are low consider a staggered capital raise
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June 6, 2018 By Katie Abouzahr, Frances Brooks Taplett, Matt Krentz & John Harthorne. The gender pay gap is well documented: women make about 80 cents for every dollar that a man earns. Less well known: the gender investment gap. According to our research, when women business owners pitch their ideas to investors for early-stage capital, they receive significantly less—a disparity that averages more than $1 million—than men. Yet businesses founded by women ultimately deliver higher revenue—more than twice as much per dollar invested—than those founded by men, making women-owned companies better investments for financial backers.
Businesses founded by women ultimately deliver higher revenue
BCG recently partnered with MassChallenge, a US-based global network of accelerators that offers startup businesses access to mentors, industry experts, and other resources. Since its founding in 2010, MassChallenge has backed more than 1,500 businesses, which have raised more than $3 billion in funding and created more than 80,000 jobs. MassChallenge, which neither provides financial support nor takes equity in the businesses it works with, puts significant effort into supporting women entrepreneurs.
Our objective was to see how companies founded by women differ from those founded by men. Our data shows a clear gender gap in new-business funding. We also spoke with investors and women business owners to get a sense of how they perceive the funding status quo. Our findings have clear implications for investors, startup accelerators, and women entrepreneurs seeking backers.
One might think that gender plays no role in the realm of investing in early-stage companies. Investors make calculated decisions that are—or should be—based on business plans and projections. Moreover, a growing body of evidence shows that organizations with a higher percentage of women in leadership roles outperform male-dominated companies. (See “How Diverse Leadership Teams Boost Innovation,” BCG article, January 2018.) Unfortunately, however, women-owned companies don’t get the same level of financial backing as those founded by men. To determine the scope of the funding gap, BCG turned to the detailed data MassChallenge has collected on the startup organizations it has worked with. About 42% of all MassChallenge-accelerated businesses—of all types and in all locations—have had at least one female founder. Aiming to build on the growing proportion of women entrepreneurs, the availability of education and support for them, and the sizable community of women who are business experts, MassChallenge determined that it needed to learn more about how its women entrepreneurs were faring and how the program could better prepare them for future success.
In a review of five years of investment and revenue data, the gender-focused analysis showed a clear funding gap (see the exhibit).
Investments in companies founded or cofounded by women averaged $935,000, which is less than half the average $2.1 million invested in companies founded by male entrepreneurs.
Despite this disparity, startups founded and cofounded by women actually performed better over time, generating 10% more in cumulative revenue over a five-year period: $730,000 compared with $662,000.
In terms of how effectively companies turn a dollar of investment into a dollar of revenue, startups founded and cofounded by women are significantly better financial investments. For every dollar of funding, these startups generated 78 cents, while male-founded startups generated less than half that—just 31 cents.
The findings are statistically significant, and we ruled out factors that could have affected investment amounts, such as education levels of the entrepreneurs and the quality of their pitches. (See the sidebar, “A Closer Look at the Data.”)
A closer look at the data
The results, although disappointing, are not surprising. According to PitchBook Data, since the beginning of 2016, companies with women founders have received only 4.4% of venture capital (VC) deals, and those companies have garnered only about 2% of all capital invested.
Why the disparity?
To dig deeper, we spoke to women founders, business mentors, and investors, some of whom were not affiliated with MassChallenge. From those conversations, three explanations emerged. One, more than men, women founders and their presentations are subject to challenges and pushback. For example, more women report being asked during their presentations to establish that they understand basic technical knowledge. And often, investors simply presume that the women founders don’t have that knowledge. One woman who cofounded a business with a male partner told us, “When I pitch with him, they always assume he knows the technology, so they ask him all the technical questions.” We heard that when they are making their pitches, women founders also hesitate to respond directly to criticism. If a potential funder makes negative comments about aspects of a woman’s pitch, rather than disagree with the investor and argue her case, she is more likely than a man to accept it as legitimate feedback. “Most guys will come back at you in those situations,” an investor said. “They’ll say, ‘You’re wrong and here’s why.’” Two, male founders are more likely to make bold projections and assumptions in their pitches. One investor told us, “Men often overpitch and oversell.” Women, by contrast, are generally more conservative in their projections and may simply be asking for less than men. Three, many male investors have little familiarity with the products and services that women-founded businesses market to other women. According to Crunchbase, which tracks VC funding, 92% of partners at the biggest VC firms in the US are men. “In general, women often come up with ideas that they have experience with,” one investor said. “That’s less true with men.” Many of the female interviewees told us that their offerings—in categories such as childcare or beauty—had been created on the basis of personal experience and that they had struggled to get male investors to understand the need or see the potential value of their ideas. One founder told us that this lack of understanding shows up also in terms of social class when entrepreneurs pitch products for people at socioeconomic levels significantly lower than that of the typical angel or VC investor.