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A Series of Small Things

Random Thoughts on Building Venture-Backed Companies in the Midwest

An ode to capital efficiency

8.19.10 by Dov

I came across this recent post from Jason Cohen (who writes a great blog from an entrepreneur’s perspective).  It includes a passionate discussion on the ways in which entrepreneurs’ and VCs’  interests can be out of alignment when it comes to “smaller” exits.

So, let me be the first (?) VC to say he’s absolutely right.  The traditional VC model requires homeruns and therefore creates large stretches of exit values where the entrepreneur would be happy exiting and the investors wouldn’t.

There are certainly lots of entrepreneurs who want to shoot for those huge exits, and therefore won’t have any issue with venture investment.  But it’s pretty hard to argue to an entrepreneur who sees a $25 million exit as a success that they should take venture money that they don’t need just to set themselves up for this conflict down the road.  If you can really build your company with $500,000 and sell it for $25 million to Google, that’s a pretty good path.

The ability to build companies for less capital than a decade ago is clearly one of the trends you can point to if you want to argue that the VC model is broken today.  $500 million funds can’t find enough entrepreneurs to take all that money and build billion dollar companies.

At the same time, it’s hard to dispute the value that professional investors can bring to an entrepreneur – even beyond what a sophisticated angel (or angel network) can bring: experience with numerous similar companies, networking for board members and management team members, and all from a group of people whose full-time job is to make your business succeed.

Now for the shameless plug: One of the reasons that our investors  and advisors liked the Allos model was they (mostly being former entrepreneurs themselves) saw the value that a smaller, early-stage fund could bring to entrepreneurs without creating the exit conflict that Jason rightfully points out.  Because we’re putting $2-3 million to work instead of $5-10, we are much better aligned with our partner companies and their management and founders.  We LOVE capital efficient businesses, because they can produce the returns our investors need at much lower exit valuations – perhaps not quite as low as $25 million, but certainly $40-50 million.

Does that mean we never want to see one of our partner companies become a multi-billion dollar success?  Of course not.  But we can have that discussion with the management team along the way, knowing that we’re all on the same side.

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We agree with IDC (or maybe vice versa)

8.12.10 by Dov

We love the SaaS (software-as-a-service) market.  While this breed of software company takes more capital to reach an exit, due to the fact that they essentially finance their customers, we think there are a lot of reasons for investors to like them.  Here are some off the top of my head –

1) Predictability – what investor doesn’t like predictability in a business?  (Well-managed) SaaS companies can predict revenues with startling accuracy as much as 6-12 months ahead.  And that’s something early-stage VCs don’t get to experience very often in other industries.

2) Steady growth – assuming you have a strong value proposition (and thus not much churn), every single sale increases your run-rate revenue.  That is, even if your bookings remain constant, your revenue will grow.  And if you books grow linearly, your revenue will grow exponentially.  How cool is that?  Compare that to a perpetual license software business, where you have to sell just as much as you did last year before you can even start to create growth.  So while is is more difficult to show rapid growth after the first few years, it’s still MUCH easier than having to rely on continually larger (or more) “elephants” to hunt.

3) Market dynamics – because there are so many reasons for customers to prefer SaaS, we believe that the shift from licensed software to hosted SaaS is just beginning and will affect numerous software markets – both consumer and enterprise.  And now, IDC agrees.

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