It’s widely known we VCs focus on just a couple of key dimensions when making our investment decisions: team, market, product / technology, and investment parameters or “deal”. While all of these parameters are loosely connected and there are many paths to “yes” at the end of the day market size is the prime reason VCs pass on otherwise credible opportunities.
It’s well known VC’s love markets that are huge in size, but what’s sufficiently big for a market to be attractive to VCs? It starts with an honest appraisal of TAM.
TAM = “Truly” Addressable Market –> Wikipedia would have you believe that TAM stands for total addressable market. But as a VC, I typically think of it as “truly” addressable. If market is the chief dimension on which VC’s pass, market size is the chief element of that. VCs invest in disruptive startups that have the potential to build large ($100M+ revenue, enterprise value of hundreds of millions to billions) and durable businesses. It’s hard for startups to capture more than a small fraction (10% or less) of a market, therefore a market must be measured in the billions for a VC to believe there’s a credible chance a startup can be a “venture scale” business.
But in the abstract, anyone can say that the market for X is some astronomically high number. What matters is the amount of money truly spent on a startup’s product or service. There’s $100B+ spent each year on plane flights, hotels, and rental cars in the US… but if you’re an upstart online travel service, you’re not competing for those dollars unless you actually own a fleet of planes, rental cars, and a bunch of hotels. You’re typically competing for the dollars spent by companies that own fleets of planes, rental cars, and hotels to promote their services to travelers. It turns out that itself is a pretty big market which is why many big businesses have been built there (Priceline, Kayak, TripAdvisor, Expedia, Hotwire, etc). But conflating the market for hotel rooms with the market for online promotion by companies that offer hotel rooms will hinder your chances of raising capital.
Understanding and pitching the market size which is truly addressable for your startup is critical, and VCs only love markets that are large in “truly” addressable size. A marketplace’s true revenue potential is the % of the total GMS (gross merchandise sales) they can charge (typically 5-10%), not the total GMS. A payments company’s true revenue potential is the % of the payment volume they can charge to process those transactions (typically 2-4% on a gross basis, <1% on a net basis), not the total payment volume. Conversely when a startup’s service truly is a substitute in a monstrously large market, these companies can be massively valuable (e.g. Uber, AirBnB).
VCs will not ignore adjacent markets or the possibility of expanding beyond a startup’s home country, but will tend to discount both in the short run. While it’s certainly possible for a startup to build new products to serve adjacent markets and it’s easier to expand internet & software businesses globally today than a decade ago, neither are easy to do in the first 0-5 years of a startup’s life. Some services, both consumer & B2B, face localization challenges or cultural differences in expanding or building a strong brand in one market segment may actually make it more challenging to expand into others. So highlighting adjacent or international markets can be useful examples of how a startup’s truly addressable market expands naturally over time, but typically VC’s will focus on the core/home market.
So think honestly and hard in defining your startup’s TAM. That which is truly addressable is what will increase the chances of getting to yes with VCs.
Most consumer web/mobile companies focus on user growth and usage early in the company’s lifecycle before shifting to monetization. This is a logical thing to do… when we started LinkedIn, my mentor Reid Hoffman instilled a mantra of Growth –> Usage –> Revenue which still holds for many consumer companies. This is especially true for those with a media / ad based business model (e.g. Facebook, Twitter, etc), where scale is a necessary condition for even the first dollar of revenue, in addition to maximizing long term enterprise value.
But B2B startups need to take a different tack. We invest in internet enabled companies at NextView and our portfolio is roughly equally split between consumer and B2B businesses. Business facing companies typically provide software or an online service for which their customers pay a fee.
Arguably revenue is the best signal of product-market fit for B2B startups. In the early days of a B2B startup’s product, all of the following will come into play:
- If a business customer is willing to pay something for your early product, even nominal or beta pricing, that’s a pretty healthy indicator the product has value in terms of features and functionality.
- Potential customers’ willingness to pay will help you segment your target market (by customer size, vertical, geography, etc) more effectively than simply “researching” your market in abstract.
- Some potential customers won’t take your product seriously unless you’re charging for it.
- You will be benchmarked on revenue and paying customers when you seek Series A funding… conceivably even at seed stage.
The early goal isn’t to maximize near term revenue… it’ll take time to fully understand your market and establish P-M fit, let alone optimizing the sales & marketing engine. And this is not to say that there’s no place for having an unpaid product. There’s a myriad of pricing and payment structures for B2B companies – subscription, transaction-based, term/perpetual licenses, OEM/embedded services, etc. If you’re collaborating very closely with alpha customers, you may give away the product during initial development phases. And even as they mature B2B companies may offer portions of their software for free either as a basic tier of service, or a free trial period, or lead-gen products that help fill the top of the funnel.
So if you’re in the early innings of building a B2B startup, embrace early revenue rather than putting monetization off until the distant future. FWIW this largely holds true of commerce and transaction based consumer startups too (think of the beginnings for Uber, Airbnb, et al).
Change Collective announced their seed round today, in conjunction with their broader launch of the company. I thought I’d share a little of what makes us enthusiastic to partner with Ben, Derek, and their team to help them as they build their business.
I first met Ben about 5-6 years ago. This was before we started NextView and at the time Ben was still building Zeo, the prior company he co-founded. It was great to get to know him and offer informal input, and though I wasn’t an investor in Zeo we stayed in pretty close contact over the years and then more recently in 2013 as he started to think about his next project. We signed a term sheet with Ben for Change Collective’s round shortly before the holidays and he did a great job bringing in our friends at Founder Collective as a co-lead and Eniac Ventures and a small set of angels in a short time.
1) Authentic & Experienced Team – Ben and Derek understand behavior change and personal improvement to their core. Zeo pioneered consumer sleep tracking in an era before anybody talked about “quantified self” and both of them have thought very deeply about the necessary ingredients for enabling consumers to effect real behavior change.
2) Self Learning Market is Enormous – We’re bullish on online learning generally, and the self learning market in particular. We’ve met with many startups working in this area over the last 2-3 years. Self-improvement content alone is a $10B+ market and self learning more broadly is a couple times that, so there’s ample space to build a very large, transformative company.
3) Mobile Is First Major Platform Shift for Self Learning/Improvement – Most of the consumer-facing companies we’ve been investing in are “mobile first” and we’ve been talking about ubiquitous computing for several years. It’s easy for a startup to pitch itself as “mobile first” just as entrepreneurs pitched “cloud” a few years ago and “web” more than a decade ago.
But Change Collective’s founders didn’t use this as a catchphrase… they understand that mobile platforms’ very nature transforms how consumers experience self improvement content. This was historically static content delivered via books, DVDs, podcasts, blogs, etc. Software makes static content interactive, the social layer makes consumers accountable, and mobile’s real-time/ubiquity helps the experts with whom Change Collective collaborates reach users in a radically more scalable and continuous fashion than before.
We’re thrilled to help Ben, Derek, and the rest of the Change Collective team as the continue to build the company and help millions of consumers create a better self through real, lasting behavior change. This is NextView’s first investment of 2014, and we’ve got two more lined up that will be closing soon. We’ve got a lot of things cooking for 2014 and glad we can start it off with Change Collective.
I was recently talking with another member of LinkedIn’s founding team. It’s been awhile since we worked together on a daily basis so a lot was just general catch up, but one of the primary reasons for our chat was that this person was starting to become a more active angel investor and was just looking for feedback. I’ve had similar conversations in the last year or so with other folks looking to begin, or ramp up, their activity as angel investors.
I think the most important thing any new angel investor can do is to candidly assess their motivations for making startup investments. Angel investing, particularly for entrepreneurs and others who’ve chosen a startup career path, can be rewarding in many different ways. But really understanding yourself and what you’re hoping to get out of angel investing is critical… without candidly defining what “success” is, you’re unlikely to reach your goals.
There are broadly 5 reasons for individuals to invest in tech startups:
1) Pure ROI & Asset Allocation - Very successful angel investors can generate substantially better returns with their startup investments than most other asset classes. For some angels, this pure return on investment and the diversification it can bring to an overall asset allocation is the main motivation. But the reality is that on average, most angel investors are not highly successful in terms of their angel investment returns. In addition, investing in startup tech companies turns out to provide only a modest level of diversification… angel investments tend to form a high beta portfolio, with reasonably close correlations to public equity markets.
If ROI and asset allocation are the sole objective for an angel investor, then they may be best served investing in late stage startups via secondary markets or investing in a VC fund (if they have access to high quality funds) rather than trying to find and pick a bunch of early-stage startups to invest in. That’s not to say that angels primarily focused on ROI can’t do great on their own… many have, but again a large number do not and a would-be angel just starting to invest in startups would do well to ask themselves if they have an unfair advantage in finding and selecting great startup investments (topic for another post sometime).
2) Gain Market Insight – Another reason to invest in early stage tech startups is to gain additional market insight and connections to the entrepreneurial community. This can include learning more about technologies, markets, and people that may be impactful to the angel’s other endeavors. As a VC investing not only personal capital, but on behalf of limited partners, one can’t take this strategy. My NextView partners & I have a fiduciary responsibility to invest and manage our LPs money… we cannot look them in the face and tell them “We lost a ton of dough on a bunch of companies, but man… we learned a bunch along the way.”
But as an angel one can overweight this factor. Such insight tends to be most useful to entrepreneurs and startup types, since keeping up on new innovations and staying plugged in to new generations of founders can help them bring greater perspective to their own startup (or a future startup). But I know a handful of angels who focus mainly on public market investing (either as part of a hedge fund or institution, or for their own account) who feel that learning about early-stage companies and trends as angels makes them better public investors.
While I believe that you can learn something from failure, I fall squarely in the camp of those who feel that startup successes teach you a hell of a lot more about generating future success. So to the extent you invest in some great companies, you’ll probably be more successful in achieving your goal of gaining insights or connecting with great entrepreneurs that help you with your own startup. But for angels primarily focused on insight, the scale of their investments matter less than having a more diversified portfolio and taking the time to connect with the startups they invest in (e.g. totally passive strategy won’t teach you much).
3) Pathway to VC Role - Many former entrepreneurs who ultimately become VCs had at least some experience as angels prior to joining a VC firm or starting their own firm. If a path to a VC career is a primary motivator, then of course generating good returns is part of this. But in this case an angel probably needs to focus on who the syndicate partners are in a particular investment, and also be sure to be an angel in large venture scale companies… even if they’re investing in a Ser B or Ser C round instead of a seed round.
4) Help Friends / Community - For angels who are successful entrepreneurs themselves, supporting former colleagues and/or the broader startup community can be a motivation for angel investing. Most folks in this camp don’t think of this as “charity”… they’re not looking to lose money on their startup investments. But if “paying it forward” or helping people who helped them build their own companies is a factor, then success may hinge more on impact on funding would-be companies than on pure ROI.
5) Something Interesting to Do - Finding an intellectually stimulating way to spend time is a perfectly legitimate reason to angel invest. For some this is as good a way of “spending” money as doing anything else, and for these folks the best approach is simply to find businesses that appeal to them to invest in.
The reality is that none of these is really mutually exclusive, and most angels are motivated by some combination of them. The primary motivation can inform the optimal strategy to some extent. But the most important thing is to ask the question of what motivates you as an angel, because this will ultimately help you both define and maximize the chances of success. Once you’ve done that, the next thing to do is to figure out what your angel “superpower” or unfair advantage is and how to put that to work (topic for another day).
As many of you know, in the past I’ve done a series of posts deconstructing the S-1s of VC-backed internet startups going public. A few years ago this was sort of a novelty… not that many startups were going public and not that many bloggers or mainstream journalists took the time or had familiarity with combing these SEC filings. But now there’s a lot of info reported and a number of good, thorough analyses of S-1s as we enjoy a quiet but very real “boom” in the tech economy.
Twitter’s IPO has garnered a ton of attention in the tech and popular press. So their revenue figures, pre IPO financing and ownership, and other info is all widely available. I thought I’d provide a little analysis of Twitter based on their S-1, but also strive to put it in a broader context of other consumer internet businesses and where we are in the current tech cycle.
Three Ways to Make Money On the Consumer Internet
I authored a post seven years ago (geez… time flies!) on the three ways to make money on the consumer internet. The emergence of mobile platforms has broadened the array of internet-enabled businesses somewhat, and overall it obviously marks a massive shift in computing platforms. But at its base level, ubiquitous computing or “mobile” hasn’t actually changed that much from the desktop web when it comes to fundamental business models.
Again there’s three fundamental ways to make money in consumer-facing internet businesses: you can sell people stuff in a physical realm (e-commerce), you can indirectly monetize consumer attention (media or ad-based), or you can provide online software & services that consumers pay for (premium services). There’s different flavors or derivations of these… e-tailers and marketplaces are both e-commerce businesses but differ in operational model, growth patterns, and profit margins. Games monetized via in-app purchases are a premium service. But at the end of the day I’m a simple guy and subscribe to Occam’s razor… all else being equal, the simpler explanation of something is generally better.
Twitter Is A Media Business
Despite it’s long-standing protestations, Twitter is indeed a media company. If this were a math class, I’d just say the proof is evident but if you want some data on Twitter’s 2013 YTD revenue here you go.
So Twitter is a media business given nearly 90% of their revenue is advertising and the company expects “data licensing revenue to decrease as a percentage of our total revenue over time”. Facebook is a media business. In an unconventional way, Google is also media business, though their consumer “attention” is intent-based rather than time-based. TripAdvisor and Yelp don’t get as much hype as Twitter or Facebook, but they too have built very large audience/media businesses.
If Pinterest and SnapChat turn out to be big businesses, they’ll be media-based businesses. That’s why some smart investors believe they’re worth $3-4B each despite being pre-revenue. Instagram hadn’t built a true business (e.g. revenues –> profits –> cash flows) yet when they were acquired, but they had built a very successful product with great potential to build a business.
Value of Media vs E-Commerce vs Premium Services
Tomorrow we’ll know Twitter’s market cap definitively, at least near term. Since they upped their IPO pricing range to $23-25/share the offering will imply a market cap of $12-14B, but where it will stand after the first day of trading is anyone’s guess and most of the guesses are $15-20B+.
Why are media businesses so valuable? Well it’s not clear that media businesses, in aggregate, are inherently more valuable than e-commerce or premium services companies in aggregate [see Note 1 below regarding categorization]. In the consumer realm, there are more e-commerce companies that will go public this year than media-based startups. For e-commerce you have RetailMeNot (not a traditional e-tailer but still e-commerce nonetheless), Zulilly (great analysis here by Greg Bettinelli), and of course Alibaba on the horizon. There are also a bunch of other e-commerce companies which may have the potential to go public in the not too distant future like Wayfair, Fab, One Kings Lane, and others. But with the exception of Alibaba none of these will businesses worth $10B+ (I plan to do a detailed analysis of Alibaba when they file).
There haven’t been any consumer internet companies with premium service business model to go public in 2013 here. The last one to do so was arguably Zynga, as gaming is a category consumers have clear willingness to pay for, and Supercell had an M&A exit which valued the whole company at around $3B. But there are several premium services business waiting in the wings with potential to be standalone public companies like Dropbox, Evernote, Spotify, and others. And of course Netflix has been public for years but has enjoyed stupendous momentum as a public company in the past 12-18 months.
So there’s arguably more e-commerce and premium services companies that have gone public in the last 1-2 years than media/audience businesses. But with media-based businesses, the distribution of outcomes is markedly different in part because the value capture by new disruptive startups is different. Google, Facebook, and Twitter have each created a new audience-based paradigm and thus have created and dominated a new segment of advertising. Prior generations of media companies typically get little or no share of the new ad markets that are created, meaning the lion’s share of value flows to these new innovative platforms making them exceedingly valuable businesses.
While there are many new standalone companies that are built in the e-commerce and digital premium services segments, a lot of value is also captured by legacy players in each category. Amazon dominates e-commerce, but Nordstrom, Wal-Mart, et al have non-trivial e-commerce businesses of their own. Similarly for every Supercell and Zynga, there’s also big mobile gaming franchises built by legacy publishers like EA.
Growth IPOs Are Back
One other way to put Twitter’s IPO, and other consumer & B2B IPOs recently, in context is the broader macroeconomy and investing environment. A couple things factor into this.
1) Skepticism of Startup IPOs is Behind Us – A few years ago there was exceptional dubiousness of new technology companies, which along with the tech crash of ’01-02 and recession of ’08-09 strongly contributed to the IPO drought from 2003-2010. Yes there’ve been high profile missteps for Facebook’s IPO and companies which have underwhelmed like Zynga and Groupon. But the broad success of both consumer and business facing companies new to the public has meant the prevailing bias against tech IPOs has been replaced with a healthy balance between enthusiasm and skepticism. Investors can debate valuation, but it’s patently obvious that Facebook, LinkedIn, Workday, TripAdvisor, and many other startup IPOs of the last 1-2 years are great businesses.
2) Growth is Prized – We live in an unusual time where the confluence of near zero yields, QE, underlying technology innovation, low macro growth, and worldwide demographic shifts have produced an environment where growth potential is especially prized by equity investors. The tables below show year over year growth rates based on last quarter’s reported results followed by stock price over the last 12 months for a group of companies all of which have seen 100%+ rises in share price. To be fair the broad equity markets are up strongly over this time period, but clearly growth has been strongly favored. And for what it’s worth, a lack of growth or the departure of former growth has been penalized by the market as well (just look at Zynga).
So viewed through this lens, it’s pretty clear why Twitter will be valued highly tomorrow… it’s a media-based success in an environment ripe for high growth consumer internet businesses. I wish all of those involved with Twitter very well.
Note 1: Most consumer internet businesses can be put into one of the three buckets pretty easily. LinkedIn is a little unusual in that it’s essentially a B2B SaaS business, a consumer premium services business, and a media business all wrapped together. One could argue Groupon is a “media” business in that they “sell” the attention of their consumers to small businesses, but I think of Groupon really more like an e-commerce business… they directly facilitate transactions and their gross margins work like a commerce rather than a media company.