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How much money should a startup raise? September 27, 2007

Posted by jeremyliew in start-up, startups, VC, Venture Capital.

Some startups that I’ve met are not sure how much money they want to raise. Some think about raising money to last a certain period of time, others look to benchmark themselves against other startups and want to raise similar amounts of money.

There are a few schools of thought as to how to arrive at a target amount of money for a startup to raise.

Marc Andreessen says:

In general, as much as you can.

Without giving away control of your company, and without being insane.

Entrepreneurs who try to play it too aggressive and hold back on raising money when they can because they think they can raise it later occasionally do very well, but are gambling their whole company on that strategy in addition to all the normal startup risks.

Suppose you raise a lot of money and you do really well. You’ll be really happy and make a lot of money, even if you don’t make quite as much money as if you had rolled the dice and raised less money up front.

Suppose you don’t raise a lot of money when you can and it backfires. You lose your company, and you’ll be really, really sad.

Dick Costelo of Feedburner/Google says:

First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say “raise just enough to get you to and then you will be able to do a B round at a bigger valuation”, etc., but you want to give yourself some reasonable stretch of time to be product and strategy focused after the A round before you have to hit the road again to raise more money. It’s no fun having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you always need more money than you think you need, especially if this is your first startup. You can have a nice detailed spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.

In general, I tend to agree with Dick. Marc’s advice is good but raising too much money raises the possibility of greater dilution than necessary, and it may not be practical advice to entrepreneurs with a less stellar track record than Marc’s (which is pretty much everybody!).

Here is how I would advise a startup to think about how much money to raise:

1. Figure out what you’ll want to have done before you want to raise the next round. This could mean revenue targets, usage targets, product development milestones or whatever, but focus on a set of tangible achievements that you think will make your next round of financing easy to raise. These achievements should demonstrate a reduction of one of the three types of risk that VCs worry about (i) technology risk (ii) market risk (iii) implementation risk.

2. Figure out how long it will take you to achieve these milestones.

3. Figure out how much cash you’ll burn in this time. Do this carefully. With costs, you should be able to be pretty precise in your projections. Costs are mostly within your control (e.g. hiring) or variable to your achievement targets (e.g. bandwidth costs). However, be conservative in your revenue projections. These are not entirely within your control, and many startups miss their initial revenue projections.

4. Add enough cash to sustain six months of burn with no revenue to that time period. This is partly as insurance in case your development timelines slip (that NEVER happens, right! ;-)) and partly because raising money takes time. You should budget between one and three months between starting the process and having cash hit your bank account, more if you’re raising money over a period like the holidays when it might be hard to set up all the meetings you want.

This should give you a reasonable estimate as to how much capital to raise in your current round.

Will email be dead in 5 years? September 17, 2007

Posted by jeremyliew in communication, Consumer internet, email, facebook, myspace, social networks, start-up, startups, VC, Venture Capital, virtual worlds.

I used to work with John McKinley at AOL where he was CTO and, later, President of Digital Services. I have enormous respect for him. In a recent blog post, he says that email in its current form is under attack and doesn’t have long to live:

We are in the midst of an important moment of truth – email as we know it is under attack, and the major firms are not moving fast enough to prevent it from becoming more of a niche form of communications in the next 5 years. The email experience of today is being threatened on multiple fronts by a variety of new forms of communication:

  • Twitter/short-form blogging
  • Asynchronous messaging in social networks (e.g., the Facebook Wall)
  • IM experiences now supporting queuing of messages to offline buddies
  • Away message/Status message utilization in instant messaging
  • SMS adoption (late to come to the US, but now pervasive)
  • Wikis and other new collaboration platforms
  • Comments (MySpace comments, Blog comments, et al)
  • Casual communication forms (the nudge, the wink)
  • New sharing experiences (Flickr, et al)
  • Email aggregators (e.g., I use Gmail to aggregate all of my AOL, Yahoo, and POP3 accounts. These other companies still bear all the cost of hosting my email accounts, but now get none of the pageviews.)
  • Email and IM integration into social networks (the new entrant risk).
  • People have more compelling, more contextual, more effective, and more convenient options to share and interact than ever before, and incumbent forms of communications will be the losers here.

    John hits on a very interesting broader point. Every few years a new form of communication arises and for some people this becomes their primary form of communication. Over time, earlier forms of communication lose overall share. This has happened to letter writing, telegraphs, talking on the phone, Usenet newsgroups, chat rooms, and message boards in the past. Email has displaced many of these prior forms of communication over the last 15 years, and is now under threat itself.

    I don’t think all of the communication forms John lists above are equally threatening to email. Some are just features, and others have communication as a secondary aspect to another purpose. But it is clear that SMS, IM and social network messaging have supplanted email use among teens. Kids and teens are also some of the earliest and most enthusiastic adopters of casual immersive worlds.

    As John points out:

    The risk is as follows: the major internet incumbents rely tremendously on having a robust base of consumer email account relationships to feed their ad/search businesses. Having that email inbox relationship can yield 2x the monthly page views, when compared with non-email-account consumers.

    The reason is simple – users are more likely to use their primary form of online communication as their homepage. This is why the social networks threaten portals. Being a homepage is an incredibly powerful position because as the first page a user sees, you have an ability to influence what other pages a user sees.

    The portals have long used webmail as the “milk at the back of the store” – a low margin product that keeps users coming back. But to get to the milk you have to walk past the high margin impulse purchase products in a supermarket – the candy and the cookies and the chips. Similarly, to get to your email you have to get past the editorial programming on the portals homepage. A few extra impulse clicks to which shows won at the Emmys or to read about the 700 foreclosure homes being auctioned in one city, and the portal generates some advertising revenue.

    This presents a real opportunity for startups. In the past, innovators that have driven mass adoption of new forms of communication have been bought by big portals well before they needed to show a revenue model, with ICQ and Hotmail being the two best examples. I’d be interested to hear what readers think are today’s most promising candidates for new forms of communication.

    Corporate invesments; the view from the entrepreneur’s side September 5, 2007

    Posted by jeremyliew in corporate investing, start-up, startups, strategic investment, VC, Venture Capital.

    Businessweek has an article about Google’s venture capital investments. It notes that corporate venture investing has been on the upswing recently, calling out Intel, Cisco and Motorola (in addition to Google) as other active corporate investors.

    Companies that aren’t full-time investors pumped $1.3 billion into 390 venture capital deals in the first half of 2007, up 30% from the $1 billion invested in about 350 deals a year earlier, according to an Aug. 30 report by PricewaterhouseCoopers and the National Venture Capital Assn. (NVCA), based on data from Thompson Financial (TOC). That’s the most invested since 2001, just before the bottom fell out of the tech industry.

    As Paid Content notes:

    Aside from increasing their presence in growing markets, corporate VC activity gives companies like Google another advantage: by funding early stage companies, corporate VCs tend to buy these companies outright for a cheaper price than they would otherwise pay regular VCs down the road.

    This is certainly consistent with my experience. When I was VP of Strategic Planning at IAC earlier this decade, when we invested in a startup we would always think about a “path to control”. We always asked for a call option to buy the rest of the company at a certain date and price in the future so that we knew that we could own the company outright in the future.

    An entrepreneur should bear in mind the implications of accepting an investment from a strategic investor, especially understanding the motivations as laid out above. A financial investor (whether angel or VC) is looking for a maximum return on their investment. A strategic investor may be looking for a way to buy companies for less than they otherwise would.

    Often strategic investments start out as business development discussions between the two companies. At some point, the big company (BigCo) says that by doing a biz dev deal with the startup(LittleCo), it will meaningfully increasing the value of LittleCo. BigCo would like to share in the value that it is helping to create. This is a perfectly reasonable position.

    For LittleCo, the key is to make sure that BigCo does not end up owning so much of LittleCo that it becomes the only logical acquirer. It’s hard to get full price at an auction if there is only one bidder.

    One way to think about BigCo’s ownership stake is as a discount if/when they want to acquire a LittleCo. Since BigCo already owns x% of LittleCo, BigCo will essentially be paying x% less than another acquirer (OtherCo) would have to pay.

    If x is large, then OtherCo may not bother bidding. OtherCo’s corporate development team is busy, and doesn’t have the time to waste on potential acquisitions that they are not going to win. OtherCo will realize that BigCo can outbid them because of the implicit discount that BigCo gets from already owning x% of LittleCo, so OtherCo doesn’t bid at all. This can lead to lower exit valuations for LittleCo*.

    The less that BigCo owns of LittleCo, the more likely OtherCo will be to bid. If OtherCo thinks that it can bring more synergy to LittleCo than BigCo can, and that LittleCo is more valuable to it than LittleCo is to BigCo, then OtherCo may still believe that they can win the auction, even with BigCo’s x% discount. In the extreme case, (x=0), all potential buyers line up at the table and all make their best bids, and exit valuations are maximized.

    The implication of all of this is that entrepreneurs should be careful. When they take strategic investments from corporate venture arms, they should not give up so much ownership that they discourage other potential acquirers from bidding in a future sale process. They should keep x small. Since early stage investors usually get more ownership than later stage investors, taking strategic investment tends to make more sense in a later round of funding.


    * As an aside, similar logic applies to giving anyone (whether a strategic investor or a biz dev partner) “right of first refusal” to a sale of your company. A potential bidder won’t want to do all the work to get to a deal, only to see it matched by the party with a right of first refusal. As a result, they often don’t bother bidding. With less bidders, once again, exit valuations are not maximized.

    Congratulations to Chamath and to Facebook July 10, 2007

    Posted by jeremyliew in facebook, VC, Venture Capital.

    As the WSJ announced today, Chamath Palihapitiya is leaving Mayfield to join Facebook as VP of Product Marketing and Operations.

    Lucky Facebook.

    I used to work with Chamath at AOL; he was GM of AIM and ICQ while I was GM of Netscape. Chamath is brilliant; visionary, thoughtful, charismatic, charming and very, very smart. At AOL he was a tireless advocate for the user experience. It is no accident that at the age of 30 he has achieved so much.

    While some who do not know him might question the hire, I have no doubt in my mind why Facebook would want Chamath on their team. He will add a great deal to the company, and Mark pursued him for some time.

    On a selfish note, I am also somewhat glad that Chamath is out of the Venture Capital business. I think that had he stayed, he would have been one of the best investors of this generation. Entrepreneurs that I have met hold him in high regard.

    Congratulations to Chamath and to Facebook.

    Asymmetric risk and the dangers of too high a valuation July 9, 2007

    Posted by jeremyliew in Entrepreneur, start-up, startups, VC, Venture Capital.

    I recently met a company that I really liked; an innovative online financial services product. It hit a lot of my criteria for investment; it had a working product, it paralleled existing offline behavior, and it had achieved some early success in gaining distribution. And it had done all this on just $1.5m of angel money.

    However, although I really liked the company, I didn’t seriously pursue an investment. The reason is that the $1.5m was raised at a $30m valuation. The company was still very early stage, with very limited usage and an unproven revenue model. Any sort of investment that we we would have made would have been at a much lower valuation than $30m.

    The company is still pursuing financing, but it is currently focusing its efforts on raising more angel money.

    This made me think about the asymmetric risk that an entrepreneur faces when pricing a round.

    An example of asymmetric risk is catching a plane. If you arrive early, you waste some time sitting in the airport. This is unfortunate, but it’s tolerable. If you arrive late, you miss the plane altogether. This can be expensive and very inconvenient.

    The same situation exists when an entrepreneur determines at what valuation she can raise money. So if she raises at a valuation that is too low, she suffers more dilution than she needed to. This is not desirable, but the negative consequences are linear in that they are roughly in proportion to the degree that the valuation was cheap. [Disclaimer: As a venture capitalist, I benefit from investing at lower valuations.]

    On the other hand, if she raises at a valuation that is too high, she runs the risk of a future “down round“, or even worse, being unable to raise more money at all. Valuation is always based on some combination of past performance and future potential. When valuations creep up and are based more on future potential than past performance, more pressure is put on the company to hit its potential and justify its valuation. If things don’t go to plan, when the company next needs to raise money it may not be able to justify its past valuation at all.

    The American Bar association has a good article describing some of the likely consequences of a down round. In this case, the negative consequences are not linear, but look more like a cliff. A downround can be highly disruptive and cause significant damage not just to ownership stakes, but to overall company morale and the relationship between investors and founders

    Marc Andreessen recently posted about fundraising for a startup and answered the question “So how much money should I raise?” as follows:

    In general, as much as you can.

    Without giving away control of your company, and without being insane.

    Entrepreneurs who try to play it too aggressive and hold back on raising money when they can because they think they can raise it later occasionally do very well, but are gambling their whole company on that strategy in addition to all the normal startup risks.

    Suppose you raise a lot of money and you do really well. You’ll be really happy and make a lot of money, even if you don’t make quite as much money as if you had rolled the dice and raised less money up front.

    Suppose you don’t raise a lot of money when you can and it backfires. You lose your company, and you’ll be really, really sad.

    His rationale is the same as the one for thinking about valuation – asymmetric risk.

    Today’s startup funding environment is buoyant, much like it was in the late ’90s. It’s a good time to be an entrepreneur. However, entrepreneurs should also be careful not to repeat some of the mistakes of the ’90s. Inc magazine has a case study of one company that raised money at too high a valuation that is worth reading as a lesson in the dangers of asymmetric risk.

    Slide Presentation at Web 2.0 Expo – “Show me the money”; business models for web 2.0 startups April 19, 2007

    Posted by jeremyliew in business models, Consumer internet, Ecommerce, media, start-up, startups, VC, Venture Capital, web 2.0.

    I spoke today at the Web2.0 expo on the topic of how this generation of internet companies can make money under both media and e-commerce models (Show me the money). This is an expansion of previous posts I have written on this topic.

    The short form of my presentation is as follows:

    1. Its easier than ever to start a consumer internet company
    > 1.1. Not too hard to get to cash flow breakeven

    2. For long term value creation, plan A can’t be “get bought by Google”
    3. Need to have a roadmap to be an independent public company

    > 3.1 Requires real scale
    > 3.2 Revenue sometimes lags costs when you are growing
    > 3.3 May need venture capital to bridge the gap

    I go into more detail on this and lay out the math as to how big you need to be to both breakeven and to be a public company under both business models.

    For those who are interested, slides are available here:

    Web 2.0 presentation – Show Me The Money

    Time Rich or Time Poor? March 19, 2007

    Posted by jeremyliew in Consumer internet, Ecommerce, Internet, Lead gen, Search, social networks, start-up, startups, user generated content, VC, Venture Capital, video, web 2.0.

    Broadly speaking, there are two types of internet users, Time Rich (more time than money) and Time Poor (more money than time). I’d speculate that many of the readers of this blog fall into the Time Poor category, but the vast majority of internet users fall into the Time Rich category. If you’re starting a new internet company, its important to know who your audience is, and to make sure that you don’t let your own experience and that of other Time Poor people guide you wrong.

    Time Poor

    Time Poor people use the internet to get things done. They are very task focused, and their favorite websites help them use their precious time more efficiently. Great examples of websites built for the Time Poor include search engines, first gen comparison shopping engines (trying to find the lowest price as quickly as possible), ecommerce and lead gen sites where the purchase is more functional than emotional, and many of the “social news” websites that filter the news for you.

    If you’re building a website for the Time Poor, your focus should be to minimize their time and pages on site. As a result, business models around e-commerce, CPC and lead generation are good matches for these sort of site – it aligns both user and site around getting to a transaction as quicly as possible. Depending on what you do, you may even be able to charge a subscription as well.

    Time Rich

    Time Rich people use the internet to kill some time. They are bored. They are willing to be diverted and entertained. Great examples of websites built for the Time Rich include broad based social networks, targeted social networks, picture sharing sites, anything celebrity related, anything sports related, social shopping sites (recreational shopping), social discovery websites that suggest new sites to you, all video websites and causal games websites.

    If you’re building a website for the Time Rich, your focus should be to give them options to explore. Links density is the name of the game – more links means more clicks. Suggest a next click at any natural pause point, and keep people clicking within your site. Stimulate communication and community – it keeps people engaged and coming back. Give people reasons to bookmark you and come back often with fresh content and evergreen favorites.

    You’ll likely monetize through advertising – sponsorship and CPM as well as CPC. Subscriptions may work for you too if you have certain features held back. If the products you sell are bought spontaneously, then ecommerce may also work for you. But don’t fall into the trap of creating extra pageviews for your own benefit and not that of your user (e.g. by splitting articles across multiple pages, or creating extra steps in a process to edit a profile page) as your users will wise up to your game soon enough. Time Rich does not mean unsophisticated. Your users spend enough time on the internet, and on your competitors sites, to know what are the best practices.

    Know your audience when you build your site, keep the target clear, and you’ll have a better chance of meeting their needs.

    UPDATE: New visitors, if you liked this post try the second most popular post, Three Ways to Build an Online Media Business to $50m in revenue

    Three ways to build an ecommerce business to $500m in revenues March 16, 2007

    Posted by jeremyliew in Consumer internet, Ecommerce, Internet, start-up, startups, VC, Venture Capital.

    Since my earlier post on “Three ways to build an online media business to $50m in revenues” was well received, I thought I’d examine the e-commerce industry as well.

    The margin structure in most (physical) ecommerce businesses is dramatically different from that of online media businesses. Whereas online media businesses can enjoy gross margins of upwards of 90%, and net margins (at scale) of 50% or higher, many ecommerce businesses have gross margins in the 20-40% range and net margins (at scale) in the 5-10% range. As a result, ecommerce companies have to grow to a much bigger top line to achieve the same value. We’ll target $500m in revenue to get to net income in the same range as a $50m revenue online media business.

    There are three ways that an ecommerce company can get to this scale:

    1. Build up $500m in sales in a single vertical. You’ll need to ensure that the vertical that you’re addressing is large enough in online sales to accommodate your size – books, music, consumer electronics, shoes and groceries are all good examples. You’ll likely need to be number one in your category, which implies industry leading cost structures. You’ll probably be holding inventory and operating multiple distribution centers, dealing with returns and generally operating a very large scale business that gives you certain margin advantages because you’re one of the largest retail channels for your suppliers.

    You’re probably able to spend on building a brand (vs performance based marketing only) and you likely think about customer lifetime value. Hence you may be willing to pay more to acquire a customer than you’ll realize from your first transaction since you sell a product that is bought frequently. As a result, you obsess over customer service because you need your customers to have a great experience and have confidence and recall to buy from you again in the future – ideally by typing your URL in directly into their browser.

    $500m in a single category is a lot. In 2005, according to Internet Retailer, only four pureplay ecommerce companies exceeded $500m in online revenues (Amazon, Newegg), Overstock and Netflix. The remaining 22 companies who had sales over $500m online were very large multi-channel retailers like Office Depot, Gap, Dell, Circuit City and Walmart.

    Other companies who likely have already reached this revenue level since then, or will soon, include companies like Zappos, Freshdirect, Drugstore.com and Buy.com

    2. Build up $50-100m in sales across each of 10-5 verticals. This could be by being a smaller player in a larger category (such as the verticals discussed above), but you’re likely number one in a smaller category. Say Ski gear, nutirtional supplements, autoparts or power tools; smaller categories than books or shoes, but still pretty big. (Note – the links are to examples of companies that are at or could get to $100m in sales, but they are not parts of companies with multiple verticals each doing $100m in sales).

    Since in many cases there are not that many synergies across categories (little or no ability to leverage supplier relationships for example) you may be a result of a rollup to get to critical scale. You may see some ability to leverage your distribution infrastructure, but in many cases the pick, pack and ship needs of different products are quite different and may not support shared infrastructure (small vials of pills looks very different from aftermarket auto parts). You likely hold inventory and operate your own distribution centers, but if you are in a category with large and unwieldy items that often get built to order, you may be able to dropship from your manufacturers.

    In 2005, according to Internet Retailer, only 155 companies exceeded $50m in online revenues, and only 45 were pure play etailers, including Blue Nile, Redenvelope.com, Shoebuy and Furniture.com. However, there are a number of companies who are taking this approach, including Musician’s Friend, Provide Commerce/ Liberty Media, and Blue Lava

    3. Build up less than $5m in sales in each of 100+ categories.
    According to Internet Retailer, there were 479 ecommerce companies with sales over $5m in 2005, including Batteries.com, Junonia (plus sized activewear for women), iGourmet, artbeads.com and thinkgeek.com. As you can see, even relatively small niches can sustain $5m in sales. You may be able to rely on your manufacturers to drop ship, and you may need lower levels of dedicated resources against each category with less depth of industry merchandising expertise.

    Rather than building a brand, you can rely more on performance based marketing, particularly paid and organic search and shopping engines. You may not even need to be number one in your verticals – if they are big enough you can still win some share of the market to get to $5m.

    What is hard is getting to this level of sales across so many verticals. To be able to do this you need a level of shared technology and processes that can be applied across many stores. Winning becomes less about any one store, and more about applying best practices across all the stores. The challenge is in being able to enter a category cost effectively, and to run a store against low volume in a very low cost way. Processes and cost control become paramount because any sub optimal practices get magnified across 100 stores. Although no one has hit $500m in revenues through this approach yet, there are a number of companies who are taking a shot at this approach, including Mercantila (a Lightspeed portfolio company)CSN Stores, Netshops, Niche Retail, and others.

    All these models are viable. As in most cases, the first $20m in revenues are the hardest! I’d love to hear from people on any of these paths.

    More on building an online media company to $50m in revenues March 14, 2007

    Posted by jeremyliew in advertising, Consumer internet, Internet, Lead gen, start-up, startups, VC, Venture Capital, web 2.0.

    As my previous post indicated, it is not easy to build an online media company to $50m in revenue. Depending on whether you’re broad reach, demographically focused, or can support endemic advertisers, you need to get to top 10, top 25 or top 125 levels of US website traffic.

    A couple of interesting studies have come out recently that underscore how difficult this can be.

    At the Online Publishers Association’s Forum on the Future earlier this month, Marketspace (a consulting firm associated with Monitor) announced the results of their research which showed that 92% of 2006 gross online ad spend in the US went to only four companies; Google, Yahoo, MSN and AOL. Although some portion of that ad spend was subsequently distributed to independent sites through ad networks (e.g. AOL’s Advertising.com, Google’s Adsense, Yahoo’s Publisher Network etc), that is a big proportion of the total. Furthermore, that is an INCREASE from the 88% that went to those four companies in 2005.

    Now According to the IAB and PwC, internet advertising revenues for 2006 were estimated to be $16.8 billion, a 34 percent increase over $12.5 billion in 2005. So doing the math, that suggests that the online advertising that didn’t go to the big four actually DECREASED from $1.5bn in 2005 to $1.34bn in 2006.

    For companies in the broad reach/$1 RPM bucket, this probably doesn’t matter much. Ad networks owned by the big four sell a lot of their advertising anyway. But for companies that target endemic advertisers, this is sobering information. To be able to realize RPMs in the $20 range, companies will need to have their own sales force. And if these numbers are to be believed, this sales force is actually competing for a share of a slightly shrinking pie.

    These numbers don’t quite match to the numbers in Avenue A/Razorfish’s 2007 Digital Outlook report, which is well summarized at Paidcontent, but they agree directionally. Avenue A says that portals have increased their share of online ad spend by 85% from 2005 to 2006, from 13% of overall ad spend to 24%. (This report breaks out search and ad networks separately – the big four would be a combination of these categories).

    It would appear that advertisers are seeking consolidation in their spending patterns.

    This isn’t entirely a doom and gloom story – online advertising revenue as a class is still growing at 34%, and $1.34bn of online ad spend among the independents is still plenty of revenue to go around. But it does underscore the need for websites to have a compelling story for advertisers, both about user targeting and about volume of traffic.

    Speaking at Web 2.0 Expo; April 15-18 in San Francisco March 13, 2007

    Posted by jeremyliew in start-up, startups, VC, Venture Capital, web 2.0.

    I’m speaking at the Web 2.0 Expo in April. Its a “how to” conference for people who are starting in or working at web 2.0 companies and companies that aspire to be “web 2.0”. The organizers have lined up a nice selection of workshops and speakers to cover seven tracks: Fundamentals, Services & platforms, Web Ops, Marketing and Community, Design & User Experience, Strategy & Business Models and Products and Services.

    My session is in the “Strategy & Business Models” track on Wednesday April 18th at 1pm, but I will be around most of the day Tuesday and Wednesday.

    Lightspeed blog readers who are attending can get $100 off their registration by using the discount code webex07mk3.

    Feel free to come say hello!