The holodecks of the Star Trek universe once captivated millions of people’s imaginations. For the unfamiliar, holodecks were rooms that became any setting you wanted, from a dojo to a sprawling valley in Austria. While today’s reality bending technologies don’t quite reach the same level on integration, advances in the industry are shaking things up. Google’s Tilt Brush turns your room into a personal graffiti studio while esi-group is building a tool for industrial product pitches. The virtualization of fabricated reality with digital tools isn’t anything new. Nissan’s Gran Turismo Academy trains pro gamers to be pro drivers using the realistic racing game Gran Turismo. This year, the advantages of virtual reality training has landed the programs alumni a ban from Britain’s premier racing tournament. NASA started using early virtual reality with flight simulators in 1959. The turning point bringing this technology to the masses has been the analogous VR/AR headwear.

The initial push into consumers lives were Google Glass and the Occulus Rift headset, but the move has slowed down since the HTC Vive. Everyone from Samsung to Dell has some version of the VR headset. As the race for smaller and smaller transistors heats up, we’re likely to see the landscape change. Google Glass was premature to market, lacked positive consumer sentiment and because of ithat ultimately failed as a flagship of the augmented reality sector. However as our smartphones become more powerful and various wireless technologies come into greater maturity, we are likely to see new attempts at the eye wear of the future.

As with last month’s outlook on nanotechnologies and advanced materials, which have some heavy implications for the VR/AR industry, VCA team member Ethan Harden has prepared an outlook on the future of augmented and virtual reality. His report goes in depth about the future of these technologies, their mediums, and the mix of revenue streams projected to grow in this industry. You can download the outlook here.


Ethan is a Sr. Financial Analyst at Stantec, a Top 10 design firm awarded by Engineering News Record. He works as a financial consultant primarily serving water and wastewater municipalities across the country. His focus is to provide value to his clients through technical financial planning, cost-of-service, plant-investment fee and affordability financial modeling.

Ethan’s enthusiasm to work in a fast-paced, volatile and varying environment has led him to venture capital to employ the full business acumen he has developed. He is looking to immerse himself in venture capital to gain the knowledge and understanding of the fundraising process in order to be prepared for his next opportunity.

He holds a degree in Finance, Marketing and a Masters in Business Administration from the Daniels College of Business at the University of Denver.

Hello RVC members, my name is Justin and I am a summer intern for RVC. One of our primary objectives for this summer is to provide an update on RVC portfolio companies for members. This week, I’m bringing you an update on Silvernest. Finding a roommate is important, but it is never an easy task, even for open-minded college students with low standards.  As a typical cash-strapped CU Boulder student, I can rant about how expensive rent is and how difficult it is to find a good roommate all day long. The roommate situation and process are more challenging for the community age 50 or above. As people get older, they seek out supplemental income and companionship, and the housing situation for empty-nesters and baby boomers is currently a national concern. Nearly half of adults in U.S age 65 and older live in poverty and cannot afford to live in the nursing home. Public housing is not a viable solution either, as the average wait time exceeds a year. For example, the average wait time is more than four years for public housing in New York. Wendi Burkhardt understood that this is a critical issue that the government won’t be able to solve, which inspired her to co-found Silvernest to tackle this problem. Before starting Silvernest, Wendi held multiple executive positions in the tech industry and has years of experience in marketing and sales. Silvernest is the only roommate matching and home-sharing service designed specifically for the community over 50. It is a brilliant service to lighten the financial burden and to find trustworthy companions for the aging community. For a small fee, homeowners have access to 60 days of unlimited communication, matching and background screening for their potential roommate.

 

Silvernest hasn’t always sailed on smooth waters. Wendi and her team have faced numerous challenges and hurdles since the formation of the company. According to Wendi, it is very difficult to be a female founder in the startup world, since it is tough to raise capital as a female founder in a industry that is primarily dominated by men. This is a truth we see resoundingly supported by data, with female founders receiving just 2% of venture  dollars in in 2017. Wendi was able to secure funding through grit, perseverance, and tenacity, along with the help of her wonderful team. Another challenging process for Silvernest was building partnerships with non-profit organizations (NPO). Silvernest currently partners with multiple organization including Village to Village Network, an NGO that helps communities establish and manage their own aging in place initiatives called Villages. This is a great achievement for Silvernest, given that most NPOs tend to be  hesitant to partner with for-profit organizations status.

 

Silvernest received national recognition after their RVC Angel round in 2017. It now operates in all 50 states but markets actively in Colorado and California. Silvernest has been expanding rapidly and successfully raised more funding after the RVC angel round. It raised $1.3M back in 2017 and is currently close to finalizing an additional round of funding. Despite recent success, Wendi was very humble throughout the interview. She stated that the primary objective remains helping the boomer generation and that Silvernest will not deviate from its mission. Although Silvernest became very popular in the general roommate matching market, 90% of Silvernest’s subscribers are over the age of 50 with the average age of the renter being 40. Wendi also mentioned to me that the proudest moment for her was when Silvernest was one of 46 companies selected out of 1,000 by 500 Startups.

 

Silvernest is an amazing company with enormous potential. It is certainly a great way to find affordable housing and has an enormous social impact. Some of the houses listed on there make my Boulder apartment looks like a flaming trash heap, and yet they are in a similar price range. I am already better situated than most other Boulder students, as I am not paying $800 to live in a closet without AC along with five other roommates, and maybe three raccoons. However, we should never let good get in the way of being great, and based on what I saw at Silvernest, we can all live a great life. That is all for today, have an amazing day and enjoy the air conditioning in this hot weather! Most Boulder kids don’t have AC at their home, including myself, so crank up the AC for me!

Tic… Toc… Tic… Toc…

RT Custer and Tyler Wolfe had lost count of the tics and the tocs a long time ago. Three years and about 25 iterations later, the partners had created a fully adjustable assembly that allowed them to transform antique pocket watches into a unique wrist watches, bristling with authenticity and character. This was the genesis of Vortic Watch Company, the only company that manufactures watches, 100% made in the U.S.A.

Vortic’s technology is ingenious.  By altering the actuator, the setting and winding system of the watch, Vortic has the ability to provide custom watch manufacturing and vintage watch restoration to those seeking a timeless style. Using this new technology, RT and Tyler conceived Vortic’s first line of rustic watches: the American Artisan Series.

As a sucker for branding, Vortic struck me while researching RVC Portfolio Companies during my first couple days as an RVC intern. I thought about the saturation in luxury watches with big players like the Swatch Group, Tudor, and Rolex. With this market dominated by Swiss manufacturers, these companies have established an international reputation for quality. The handcrafted designs are so immaculate that they can be seen on the wrists of professional athletes, cinematic idols, and world leaders alike.

So how can these guys, based in Colorado, compete with the foreign goliaths?

In an interview, I asked cofounder and CEO of Vortic, RT Custer, how the company plans to break into an industry already saturated with brands that are synonymous with luxury and success. Without missing a tic, RT explained, “The biggest thing that you see working for all watch companies right now is limited editions, which creates urgency for the customer and scarcity for the product,” which Vortic specializes in because every watch is different. The vintage look of each watch encompasses America’s rich history in manufacturing, when we built this country from the ground up. Each watch tells a different story because Vortic creates every one of their pieces as a “limited edition of one.”

It was this brand’s scarcity that attracted investors in the first place. The guys from Vortic originally were referred to Rockies Venture Club through an RVC member attending a 1 Million Cups pitch event. At the time, Vortic had what they called a “Version 1” of the product, and they were not quite ready for venture capital. Nonetheless, an introduction was made with RVC’s Director of Operations, Dave Harris. Later, RT attended an RVC “Mastermind” strategy group and the group unanimously recommended that RT put his venture capital funding ambitions on hold and pursue an SBA loan with RVC partner, Colorado Lending Source.  After 2½ years’ worth of tics and tocs funded by the SBA, Vortic was ready to get venture capital funding. They applied through RVC and ended up receiving necessary capital a few months later.

It is not out of the question that the luxury watch industry could be in danger with the rise of smart watches, but RT does not worry about that either. In fact, he believes that Apple may have just done them a huge favor by releasing the Series 3 model that costs up to $1,399. With these increasing prices for smart watches, Apple, in a way, is conditioning millennials to understand the cost of quality wrist wear. As these smartwatches become more and more like cell phones, they begin to compete against technology, rather than these luxury watches. RT actually sees a trend of smart watches becoming more and more like cell phones. In the near future, wearable cell phones could replace current cellular devices entirely, similar to 80 years ago, when wrist watches overtook pocket watches, but only time will tell.

The finance world lives on the mantra of “cash is king”. Why, you ask? Well, it’s because it’s a company’s cold, hard cash, not its reported profit, that determines the value of a business.

Profit is merely an accounting mechanism. Future cash flows actually pay the bills. And the investors. And, most importantly, the investors’ investors.

But, how does one going about creating this tsunami of future cash? You best believe it’s by buying your customers’ delight and loyalty, which manifests in continued purchasing and future cash flows.

After all, it’s their cash that is ultimately all of our king and your ticket to success.

Here’s a crazy statement…“customer-focused companies are 60% more profitable.” Ok, we’re talking about cash not profit, but you get the point.

Bottom line, focusing on your customers’ happiness is important to ensure steady cash flow.

Click To Tweet

Here are 4 steps to generating future cash from customers:

Step 1: Get Customers

This is so obvious that it’s almost painful to type, but let’s be clear here: without customers, you have no one to buy your products. This likely means you have no sales and no customer-generated cash. This, in turn, means you’re beholden to other people (i.e., capital providers) who can provide you with cash. Problem is, these people like customers’ cash too, so the fact that you have none will turn them off. No accounting shenanigans, beautiful decks, or even talent will overcome this on an ongoing basis.

Step 2: Keep Their Business

Acquiring a new customer costs five times as much as keeping an existing customer. So, you better make the customers you’ve already gotten happy; else, you’ll spend more of their cash replacing them with new customers you have to keep happy. This is one reason churn is so painful. Another reason is the extremely dilutive impact it has on your company valuation as you miss out on the compounding magic of compounding recurring revenue growth and its contribution to your future cash flows.

Here’s a simple model we’ve built we’ve built to play with your bookings and churn rates and see the impact on your potential valuation.

Churn's Impact on Future Cash Flow

Step 3: Make Them Mouthpieces

80% of customer service related tweets are negative and critical. That’s a crazy stat. How are we that bad at servicing our customers? It’s probably because we think we’ve done the hard work by getting them to actually pay us. Our onboarding and activation flows are so dialed, they can take care of themselves. Troops, we must find more customers!

I think we all fall victim to this top of funnel mindset. I think we’re suffering from it. We’re missing out on the engagement opportunity to build the relationships that make our customers comfortable to say, “You’ve got to give [your_company_name] a try. They’re amazing!” Which leads us to…

Step 4: WOW THEM

Answer their chats with empathy. Take their calls and listen to learn. Don’t direct them to your FAQ. Don’t point them to obscure features that might kind of solve their problem. Make them want to reach out to you, both because you solve their problems and your enjoyable to interact with.

There’s your funnel humanized. Next, we’ll delve into how to delight the customers who have chosen to give you their cash.


This article was originally published by our friends over at Bigfoot Capital on their blogBigfoot Capital provides growth capital for SaaS businesses that have achieved initial revenue scale ($30K-$150K MRR) by selling to SMBs. Our ongoing capital investments range from $150k-$750k to support efficient growth and help Founders retain the lion’s share of their equity and upside. Beyond capital, we have built relationships with specialized services firms across sales and marketing, product development, and operations to help you scale beyond your current human resources. Want to learn more? Visit www.bigfootcap.com or schedule a time to chat.

If you ask an engineer what stands between them and their dream, they’ll probably make a joke about debt. If you throw a pile of cash at an engineer and ask them again, the problem may be solved, or they may tell you, “It’s just not possible yet”. New materials have been at the forefront of every technological or industrial revolution in history. We title eras of history by the materials that defined them, from bronze to steel, leading up to today’s so called ‘Silicon Age’. Electricity and fertilizers shaped the 20th century’s population boom, and progressively lighter, stronger steel gave it further form. As we begin to outstrip the capabilities of the materials that made our achievements possible in the past, materials engineers are rapidly pursuing new, novel materials to drive our advancing needs. Case in point, 2017 was the year of graphene with its promise to reshape how we do everything from computing to water filtration. 2018 is shaping up to be a year of silicon, lithium, and cobalt as we sprint towards newer, better batteries; bioconcretes are looking to be the future of roads and construction. Questions then arise. What technologies will drive the next wave of growth? What are engineers building now that will shape our next major wave of new inventions? What will those markets look like in 5 years? Ethan Harden, an analyst on the VCA team at RVC, has created an Industry Outlook about nanotechnologies and the advanced materials they’re driving. You can read it here.

It’s that time of year again! RVC’s HyperAccelerator is back for a fresh, new, June 18th installment focusing on Impact Ventures. This is our sixth run of the gamut, this time with the support BSW Wealth Partners and the Colorado Office of Economic Development and International Trade.Take a look at these companies and see if you think they are all “impact” – doing good through social, environmental and economic development. We’ve spent a lot of time thinking about impact and what makes for a good impact investment, so we’re excited to work closely with this cohort of impact companies to push their programs forward with strategy and venture capital funding readiness. You can learn more about how we think about impact investing here. Join us at the Soda Pop Garage (2150 Market) on Monday, June 25th at 2pm for our Demo Day, where our freshly (hyper)accelerated ventures will pitch for you, the public. Register today!

 

Achroma plans to develop a blockchain powered loan platform to help remove underlying bias in the loan system. Using a blend of anonymity and data analytics, this FinTech/blockchain hybrid is hoping to help loan seekers feel sure that the system is working for them.

 

Brainitz is an EdTech company building a platform for teachers to create interactive videos. CEO Clint Knox is a teacher by trade and set out with the goal of streamlining the teaching process by giving students the teacher tools to help them teach outside of the classroom. Brainitz achieves this by integrating questions directly into video lectures.

 

 

EnVision Meditation uses scientifically backed techniques in order to guide users through daily 10 minute visualizations meant to provide empowerment and self improvement. The benefits are meant to reduce stress, fear, worry, and doubt, and increase confidence, motivation, focus and awareness. The company reaches users through its app of the same name.

MFB Fertility creates affordable medical devices and digital health solutions to help women better monitor their own hormonal cycles. The Ovulation Double Check is the FDA compliant, flagship product the company produces to help women understand when they are hormonally prime for pregnancy. MFB is now producing a take home device and an app that will help women monitor their hormones for purposes beyond fertility, such as detecting early stages of menopause. MFB Fertility is a recipient of the OEDIT Advanced Industries grant.

Starfire Energy utilizes clean energy sources to in order to produce ammonia. Using proprietary technology, Starfire makes this process easier to descale and ramp. The company hopes that it can produce nitrate to help power companies generate clean power storage and fuel.

 

Storion Energy. is developing and commercializing advanced batteries for the large-scale storage and delivery of renewable energy. Storion’s redox flow battery provides a blend of economy, performance, and reliability. Storion continues development of next-generation technologies to increase performance and drive down costs. Storion hopes to drive a shift in the energy industry by solving the long known ‘peak hours’ problems of renewable energy.

Synthio Chemicals is a developer and contract manufacturer of fine and specialty chemicals. The company uses novel continuous manufacturing techniques to produce specialty chemicals on a continuous rather than batch basis. Synthio is able to produce chemicals at a price and purity ratio drastically superior to competitors using proprietary tools and techniques. Synthio has broken into the pharmaceutical industry with intermediaries as their opening move. Synthio Chemicals is a recipient of the OEDIT Advanced Industries grant.

 

Convertible debt is commonly used in seed stage transactions, and for anything but friends and family, or a true 90 day or less bridge, I cannot understand why anyone would use these to fund a company, regardless of whether you’re an investor or founder – it’s equally bad for both.

Fallacies about convertible debt - peter adams

There are a lot of otherwise smart people out there who continue to support fallacies about the

 benefits of convertible notes.  I’ll walk you through the claims and show you how they are not only wrong, but are the exact opposite of many people’s beliefs.

 

Fallacy #1:  Convertible Notes are Cheaper than Preferred Equity Deals.

This belief comes from a shallow idea of the cost of a note.  While it’s true that the legal costs for doing a note are $2500-$5000 in many markets and the cost for doing a preferred equity round can be as much as $10,000 to $20,000, there are other costs to consider.

If the note is for two years, for $1 million at 8% interest, then the entrepreneur is going to have to pay $166,400 in interest.  Some will argue that this is rarely paid in cash, but it is still a huge amount of dilution for the company and represents a real cost to them.  So, when does it make sense to “save” $15,000 when it costs $166,400 to do so?

The other part of the fallacy of this thinking is that the note cost is the only legal cost.  In fact, the entire premise of the note is that it will convert into equity when the company has a priced round, usually of $1 million or more.  At that time, the company will still have to pay the $10,000-$20,000 PLUS the original $2500-$5000 that they paid for the note originally, That’s right – the founder is really going to have to pay for both, resulting in 25% HIGHER legal costs than just doing an equity round in the first place.

 

Fallacy #2: Convertible Notes are Easier than Preferred Equity

It’s true that a note is only a few pages and very few terms to negotiate and Preferred Equity requires changes to multiple documents; the term sheet, subscription agreement, changes to the articles of incorporation, etc., but in the long run, convertible notes can end up being much more complicated and require a lot of legal time to figure out the ambiguous outcomes.

 

Let me start by saying that “simple” does not mean “best”.  Leaving major terms and issues undecided and unaddressed helps neither the founder nor the investor.  I recently had a portfolio company that almost went out of business for no other reason than that they had used convertible notes injudiciously and they found themselves in default on multiple notes simultaneously.

 

Let’s just consider a simple case of convertible debt vs. preferred equity in two rounds.  Let’s ask ourselves, how many shares does each round of investors get and how many does the founder get?  (Note that this conversation doesn’t occur until conversion, so many founders, attorneys and investors don’t think about these until it’s too late.)

How Many Shares do the founders have after these three rounds?

How many shares do Round 1 investors have?

How many shares do Round 2 Investors have?

How many shares do Round 3 Investors have?

 

Convertible Note

10 million shares authorized and 1 million shares issued to founders at start.

Preferred Equity

10 million shares authorized and 1 million shares issued to founders at start.

Round 1:  $1 million convertible note, 8% interest, 20% discount, $4 million valuation cap.

Round 2: $2 million convertible note, 8% interest, 20% discount, $6 million valuation cap.

Series A Conversion with Priced Round: $5 million Preferred Equity with $10 million pre-money valuation

Round 1: $1 million preferred equity with $4 million pre-money valuation.

Round 2: $2 million preferred equity with $6 million pre-money valuation

Round 3: $5 million Preferred Equity with $10 million pre-money valuation

Round 1: Founders 1 million/ Investors 0

Round 2: Founders 1 million/ Round 1 Investors 0, Round 2 Investors 0

Round 3:  Founders 1 million shares

Round 1 Note holders convert at the better of 20% discount from the priced round or the valuation cap.  Since 20% discount from $10 million would be $8 million, they will take the valuation cap at $4 million.

But wait – we have to calculate Round 2 simultaneously.  They would also take the valuation cap at $6 million, since that’s less than the 20% discount at $8 million.

Now, the Series A investors get 33% for their $5 million on $15 million post-money, right?

Or, since the first two notes are now converting, this round is actually $1 million from Round 1 plus $2 million from Round 2 plus $5 million from Round 3, so the total is $8 million on $10 million pre-money.

So, how many shares do each of the investors get?

Round 1 is $1 million on $4 million cap, so they get 20%

Round 2 is $2 million on $6 million cap, so they get 25%

Round 3 is $5 million on $18 million post-money, so they get 27.8% of the company.

The Founders get what’s left – 27.2% (1-.333-.25-.2)

That works out great, unless the Series A investor has negotiated $5 million on $10 million pre-money for 33.3% of the company.  That’s not technically how it should work since the post-money valuation is $18 million, not $15 million. The Series A investor might want to come in as if the first two rounds were equity and theirs would be the only new money coming in.  This is called “The Golden Rule” – he who has the gold makes the rules. In that case, what does Round 1 get? They should still get their 20% since that’s what they negotiated, and Round 2 should get their 25%. So, here’s how the percentages should work out in this scenario:

Founders 21.7% (1-.3333-.25-.20)

Round 1 20%

Round 2 25%

Series A 33.33%

Alternatively, the Series A investor might require that the investors in the first two convertible notes take the dilution hit instead of the founders.  Or they may figure out a way to share the dilution between early investors and founders. In these scenarios, the people who took the greatest amount of risk can be unfairly treated by later round investors who come in after the deal has been de-risked.

Believe it or not, there are still other ways that this scenario can be calculated and it gets even trickier if there is a carve-out for an employee option pool.   But the point is that there is a lot of ambiguity and this can result in higher legal costs and difficult negotiation after the fact.

Ok, so now we have to turn these percentages into shares.  For the first scenario, the only party to the transaction that we know how many shares they have is the founders at 1 million.  We know that they will own 27.2% of the company, so we need to find the number that 1 million is 27.2% of which will be the total number of issued shares after Series A.  Then we can just apply the percentages to see how many shares each party gets.

So, 1,000,000 divided by .272 gives us a total of 3,676,471 and the shares would be distributed as follows:

Founders = 1,000,000

Round 1 = 735,294

Round 2 = 919,118

Series A = 1,022,059

Round 1: Founders 1 million, Investors 250,000 (Note – investors own 20%, having invested $1 million with $4 million pre-money/$5 million post-money.

Round 2: Founders 1 million, Round 1 Investors 250,000, Round 2 investors 416,667 (Note – Round 2 investors own 25% having invested $2 million with $8 million post-money and 416,667 equals 25% of the total shares outstanding)

Round 3: Founders 1 million, Round 1 investors still have 250,000, Round 2 Investors have 416,667 and Round 3 Investors get 835,836 (again, 835,836  is 33% of the company since Round 3 Investors put in $5 million with $15 million post-money, so the calculation is easy)

 

So, between figuring out the math and negotiating all the ambiguities between the parties, doing the conversion on a convertible note is much more complex and challenging than just going through a vanilla Series Seed term sheet for Preferred Equity.  Anyone can read Venture Deals to learn about the terms and then work with their attorney to come up with a reasonably negotiated term sheet. That’s a lot easier than going through all the headache and ambiguity of converting complex convertible notes.

 

* BlockChain ICO Note:  one more complexity that is becoming more common is that companies are choosing to do an Initial Coin Offering (ICO) rather than going to Series A.  This can mean that the note never converts because there is no priced round to drive the conversion. Again – the complexity is much greater on convertible notes!

 

Fallacy #3 You can Avoid Valuation by Using Convertible Debt

 

Many people falsely believe that they can “kick the can down the road” on valuation by using convertible debt and then letting the Series A investors set the price and terms.  While this may make sense when friends and family are investing, angel investors who are investing for profit rather than family or friendship are going to need to have a valuation cap if they use a convertible note.  You may recall that in the examples above, the cap was always lower than the discount, so if investors had used an “uncapped note” without a valuation cap, they would have overpaid for their investment by millions of dollars!  For that reason, virtually none of the notes done today are done without a valuation cap, so there is still valuation work to be done to calculate what the cap should be.

 

While many recognize the need for a valuation cap on the note, many people do not understand how to calculate the valuation cap.  The formula for calculating the cap is easy:

Valuation Cap = Equity Valuation

 

That is to say, the valuation cap is calculated in exactly the same way that we calculate the equity valuation for a company when we do a preferred equity round.  

 

Venture backed companies grow as much as 2X in value every year – it would be injudicious for anyone to put their capital at risk to invest in a convertible note with a return of only 20%.  At that rate, the angel investing community would pack up their bags and go home when calculating the cumulative losses in their portfolios and lack of tax benefits.

 

I have heard no argument for why the valuation cap should be anything more than what the valuation would have been if it were an equity round.  If anything, it should be lower because of the lack of tax advantages for gains or losses to investors which can cost 20% difference in terms of after tax cash in the bank because of penalties for using convertible notes vs. equity.  (See Section 1202, Section 1244 and Section 1042 of the IRS code to understand the benefits to investors investing in preferred equity deals that are not available to convertible note investors.)

 

Valuation is a function of risk.  It makes sense that the value an investor pays should be tied to the risk AT THE TIME OF INVESTMENT.  Some get confused by thinking that the value should be set at the time of conversion, once the investor’s capital has been put at extreme risk in order to reduce risk for future investors and to increase value for the founders.  There is simply no rationale that says that value should be set at a future date when risk is lower and even less rationale to argue that a 20% discount off the de-risked value would be appropriate.

 

Conclusions

While I’ll grant that there are a few narrow uses for convertible debt today, the widespread use of them in the startup and seed stage investing community is dangerous and unjustified for both founders and early stage investors.  Attorneys should understand these fallacies and lead their clients to preferred equity deals that will better serve the needs of startup founders and investors.

 

In light of the recent SCOTUS ruling, we thought we would talk about an economic model that helps us understand discrimination and voting with your dollar. How your preferences affect the price you’re willing to pay for a product or service directly correlates to a business’s ability to stay open. You wouldn’t go to a burger joint that was dirty or had terrible service if the burger place a block away had the same prices and was clean or had better service, and we can explain it with economics.

Bakers Green and Blue

Anyone who has sat through Economics 101 knows this graph. It’s a basic supply and demand chart with two bakeries and the market of buyers. Bakery Green is charging Y more than Blue Bakery for reason A. In a normal scenario, Green must lower their price or go out of business as Blue takes all the business they can handle (Blue could, in theory, raise prices to match Green, but that model gets complicated as we factor in behavioral economics and the price elasticity of demand.). In the traditional, basic model, Green just has higher costs. Maybe the owner wants a higher salary, maybe the business had to take out loans at a higher rate, with the result being costs that are higher. If that price is as low as Green can charge, then Green will eventually go out of business.

Now let’s abstract a little. What if reason the price is difference, Y, is not a dollar amount? Common examples of this would be that Green is further from town than Blue, or perhaps Blue is able to keep the line short while Green has a 30 minute wait. In this case, we’ll say that Y is difference in beliefs between you and Green Bakery’s management. In some cases business will fail slowly as a result of this type of disagreement as social norms shift, while in some cases firms go out of business rather quickly. For some customers, Green will not have this additional cost Y and will cost the same as Blue. For some customers, Green’s preferences could even align with theirs, adding to business, but so long as a critical mass of Green’s existing customers have beliefs and a demand function like the gray one above, Green will lose business to Blue and be forced to shutter their doors. In this case, hinging on the critical mass of disagreement, the free market at work will reduce business for Green until the day they no longer breakeven.

We see a similar story in the allocation of venture capital. Plenty of research has shown that women executives and female CEOs outperform the indexes of male dominated companies. Women are managing to be a better bet than men by as much as a factor of three, and yet they only make up about 6.5% of Fortune 500 CEOs and only 20% of VC deals, or 2% of all venture capital. They drive additional value, outgrowing their male counterparts by 63% in the case of First Round Capital. In other words, women founders cost VCs less, earn them more, and yet, they still don’t receive equal funding. This is a lot like our bakers Blue and Green. Blue is the VC funds putting capital towards women founders and seeing results. Green is the funds that follow the industry standards and miss out on the returns of investing in female founders. Angels and venture capitalists are suffering a huge opportunity cost in not servicing the demands of female founders.

Various reports of discrimination in the community help to explain some of this. In some benevolent cases, discrimination occurs as an accident, as Katrina Lake outlines in conversation with NPR, pointing out that many VCs have pitch requirements that could exclude the growing industry of so-called mompreneurs. The offices are highly male dominated, with only 6% of VCs being women as recently as 2016.

Compare these averages to the Rockies Venture Club. Of our 31 portfolio companies, over half star female founders running companies ranging from tech solutions for kitchens to FinTech answers for any early stage startup. Enter RVC’s Women’s Investor Network, or WIN for short. Headed up by Director Barbara Bauer, WIN was founded to increase the number of active female Angel’s working with RVC. Something Barbara has identified, and highlights regularly at RVC events and talks, is the need to fund female entrepreneurs to make sure that women have the capital and the experience to be informed Angels. As an experienced entrepreneur with a background and education in science and engineering, Barbara represents the best of the best to lead RVC and the venture and Angel communities as a whole towards a better, more diverse future.

Know someone interested in working with Barbara as a WINtern? Have them send a resume to info@rockiesventureclub.org!

Most interns don’t expect to learn from the Executive Director or their CEO. Fewer get to. Fewer yet get to sit through a five hour seminar on financial strategy with said executive. This is what the analysts at RVC got on Tuesday as Executive Director Peter Adams walked a group of entrepreneurs and investors through a CFO’s role in acquiring funding. From how to build adequate proformas to when to schedule your raises, the RVC Financial Class Cluster threw us into the fire of financial strategy. Sitting in with a group of investors and entrepreneurs alike, here’s a look at what we covered.

Financial Strategy

Diligence is the name of the game at RVC, with every prospective deal getting a full diligence report drafted up for RVC members. For Peter, this means believability and accuracy in the numbers. In the case of financial strategy, this means clearly defining your major milestones, your key hires, when (roughly) you’re going to raise capital, how you’re going to raise it, and the nitty gritty of each of those things. Peter’s philosophy outlines all of these alongside clear exit modeling as fundamental to a success for prospective founders. What stood out in this densely packed granola bar of venture capital knowledge? The paradox of uncertainty.

Peter made clear that a company and its founders won’t have a clear date on which they will need to raise the next round, hire that new sales star, or sit down with their dream acquirer. Peter also made clear that a company needs to have an idea of what those events look like, and while precision is not present, they key came down to milestones. Bringing on new team members shortly after key product launches, identifying the scalability inflection point, and raising enough money to pave a long enough runway are his tips for a successful financial plan.

Valuations

Part of diligence is accuracy and reasonable goals, which for valuations means a lot things. One of Peter’s highlights is that while Angels would absolutely love it if their firms all became unicorns, unless that conversion happens in a fairly tight window, doing so isn’t best for the Angel. Rather than lofty goals that may provide a bigger sum after a decade, Peter instead argues for reasonable exit strategies. Acquisition by key distributors or large firms with histories of choosing the buy side of the buy-or-build dilemma, Peter argues, can result in faster turnarounds and safer strategies for both Angels and entrepreneurs.He defines clear ranges with key milestones for reasonable early valuations, and outlined a number of models used at RVC to determine those early valuations.

Peter also faced the audience with a thought challenge. Imagine an entrepreneur trying to raise their first seed round. As the omnipotent spectator, we know this company to have a specific valuation. The question at hand? Is it better for the entrepreneur if the company gets valued at double that valuation, or 10% less than its true value? While the company would be able to raise more money at the double valuation, the answer would be the 10% reduction. Less dilution and a slower, more controlled value inflation would prove advantageous for the entrepreneur.

Proformas

Proformas are integral to the other parts of this class. They are the bridge between your vision as an entrepreneur and the funding to get you there. It is the blueprint of your business and your plans, the pictogram by which you assemble a successful company. This means years of financials, forecasts, milestones and targets, key hires, and more. Good proformas are believable proformas, argues Peter, utilizing reasonable projections and honest numbers to justify their claims and valuation. He argues that VCs and Angels alike would rather see that entrepreneurs have reasonable expectations and goals they know they can reach. In other words, be honest. If your burn is running $15k a month, don’t try to hide it. Instead, highlight where that burn is resulting in growth and is driving value. Show how you can scale back to balance if you need to slow down while seeking funding. Tell prospective investors honestly whether or not you have plans for future rounds. What milestones lead up to it? There are no ruby red slippers to take you back to the quiet farm in Kansas, so build the yellow brick road that takes you to Emerald City of successful exit, no matter how treacherous it may be.

In a panel on angel return data at the Angel Capital Association Summit recently the speaker went back and forth between data using ROI (multiples of the original investment) and IRR (internal rate of return).  These metrics are very different and it is important for angels to have a good understanding of how using each of these will impact their investment strategy – in many cases for the worse!

Why Hunting for Unicorns May not be a Good Strategy for Angel Investors

Angel Investing Unicorn

 

There is a mythology among angel investors about going for “unicorns” (private companies with a valuation of $1 billion or more) in their portfolios.  In many cases, real returns from unicorns may be less than hitting solid singles and doubles that exit at under $100 million. Here’s why:

 

While unicorns may appear to give great returns, our speaker gave an example.  He had invested in DocuSign which is now readying itself for an IPO.  (Initial Public Offering)  After multiple follow-on rounds after his angel investment, his percentage ownership had been significantly diluted, but even worse – it took twelve years for DocuSign to get to exit from the time of his investment.  While he expects to receive an investment ROI multiple of 4.8 times his original investment, that comes out to only a 15.3% IRR. Getting $480,000 back on a $100,000 investment sounds good initially. When the amount of time that the investment takes comes into the calculation, the unicorn doesn’t look as good as some of the same investor’s exits that came along in five or fewer years and yielded $100 million or less.  In fact, his average IRR over his portfolio was 27%, so this unicorn was bringing his average down!

 

Angel Investors should think about their investments from a portfolio strategy viewpoint.  

Smart angels will target 10X their investment back within five years or less – that’s a 58.5% IRR.  After calculating winners and losers over time, angels who invest through angel groups will typically see a portfolio return in the 23-37% range, or about 2.5X.  Getting 4.8X your money back sounds good, until you think about what you could have done with that money if you could have reinvested it after five years.  

 

What if the investor had taken his $100,000 and NOT invested in DocuSign, but rather invested in ten deals at $10,000 each with half of them returning nothing and the returns from the others averaging 2.5X return over five years?  And what if he had reinvested the returns from those investments? At that rate, including winners and losers, he would have received $850,000 at the end of twelve years for an 8.5X return or 27% IRR. Clearly, taking time into account, but also taking the opportunity to recycle exits into the next deal increases profits.  

 

The likelihood of any one investment being a unicorn is something like 1,800 to 1, but the most prolific angel investors I know have portfolios of maybe 100-150 deals.  On the other hand, getting a 2.5X in five years on a ten company portfolio is fairly common among angels. Unicorn hunting, even when successful returned almost half the cash that the diversified angel did.  Using IRR instead of ROI helps angels to understand the best way to think of their strategy.

How do Venture Capitalists Differ from Angels?

Venture Capital funds often talk about how they need to go for the big multiples “because they need to return large amounts to their Limited Partners.”  This is partly true, but not for the reasons they would have you think. Angels have the same return targets as VCs, and, when they invest in groups, they tend to outperform Venture Capital funds by a good margin.  Over the past fifteen years VCs have been hunting for unicorns and missing out on the singles,doubles and triples that angels enjoy, but their returns averaged 9.98% – less than half of what angels have earned during the same period.

 

VCs are limited by time in their investments.  The average VC fund lasts for ten years, and many funds have a policy of not “recycling” their returns into new investments, so they are motivated to get large multiples of ROI rather than focusing on quick returns with high IRR.  It’s better if a fund can recycle its returns into new investments, with the caveat that they must return all capital to Limited Partners within ten years.

 

VCs also shy from using IRR to measure their fund’s performance because of the “J Curve” which refers to the shorter period between investment and failure compared to the longer period between investment and large-multiple success.  Using IRR can make the fund’s performance look sub-par early in the fund’s lifecycle.

 

Finally, the institutional investors that are the VC’s Limited Partners often earmark their funds for long investment periods and the last thing they want is to get a 30% IRR on an investment that comes back in the first year.  They would rather deploy the capital for longer periods for larger returns. Because institutional investors have a high cost of analyzing investment opportunities, it’s not as easy for them to re-deploy as it might be for angels.

 

So, angel investors differ from VCs in investment strategy, and if they invest in groups and pay attention to using IRR as their performance metric, they can outperform VCs and create significant returns for their own portfolios.