Part I: Why we want to build a systematic investing strategy
Part II: The operational hurdle of valuing companies at scale
Part III: Other investors in the ecosystem
Part IV: How systematic investing will help entrepreneurs
For many founders, the sheer amount of time it takes to pitch investors, negotiate terms, and be subject to due-diligence can be overwhelming. So much so that it’s one of the three most important factors for founders when considering who to take capital from according to a March 2018 survey of founders.
In our previous posts on our plans for systematic investing, we have briefly mentioned the value of efficiency in raising capital as a core tenet around why we want to build this product. Here, we will go into detail on how our systematic investing strategy speeds up fundraising so founders can spend more time growing their businesses and less time raising capital. Interestingly, the VC industry seems not to realize how important speed is to founders. In that same survey, VCs were asked to rank the perceived value of those factors to entrepreneurs. They listed speed as dead last in its importance. In our mission to reinvent venture capital in ways that are both founder-friendly and scalable, we are focused on helping solve that pain point for founders; one that other VCs have overlooked.
When we commit to being able to move quickly our goal isn’t to be 10% better than the conventional approach to closing a deal. Our goal is to be 10x better. Oftentimes a CPG company can take 8+ months to raise a round. Spending 60, 90, or 180 days fundraising is a massive distraction to founders. We want to change that.
It is our vision to be able to complete a round of financing within 14 business days of first contact. This is a meaningful improvement from the current state of investing. How will we accomplish this stepwise transformation in efficiency? By rethinking the entire process for outreach, evaluation, negotiation, and closing and making it entirely rules-based. This sounds like an impossible task at first glance, but we’ve learned a lot over the last several years of working with hundreds of founders and their teams. That learning has enabled us to create a system for delivering an efficient investing process at scale.
Driving Efficiency From Discovery to Close
To arrive at a 14-day close we have developed a rules-based system for advancing companies and have simplified the investment process into four key steps: 1) Discovery and Outreach; 2) Validation; 3) Terms and Negotiation; and 4) Legal Documentation and Closing.
Much of how we will accomplish this improvement in efficiency comes from process improvements developed and refined in our nearly six years of building scalable practices for working with companies. Piecing these learnings together enables us to realize efficiency gains that for any other investor would be deemed next to impossible.
Discovery and Outreach
Finding a potential investment is a meaningful use of a typical investor’s time. The act of sourcing a deal requires a host of different tactics many of which depend on the establishment of a broad and deep network or demonstrating some real competitive advantage to founders. According to Homebrew’s Satya Patel, a leading early stage tech investor, 75% of his fund’s ideas stem from its network. And while relationships certainly matter, demonstrating real differentiation is important from day one.
For CircleUp a core differentiator is our information advantage which resides in our machine learning platform, Helio. Helio enables us to identify promising companies quickly, and also sheds light on companies that other investors may not have seen yet. Its ability to synthesize data from multiple sources gives us a unique perspective on a company that we have never spoken with. That perspective enables us to be more informed when our outreach team speaks to founders and helps underscore our ability to understand (and ultimately help) companies and their levers for growth in our discourse with management.
The result of that more informed outreach translates to meaningfully higher conversion with the companies we want to connect with. We want to be able to help companies from our first conversation with them and demonstrating that we can help with our information advantage has shown to be helpful in getting that message across.
When we connect with a company, our outreach team makes a point of speaking directly with a founder to discuss his/her business. We believe in the power of relationship building and the value of human interaction (especially when founders have put so much to get their businesses to where they are today). There are areas where systems and processes to go a long way in driving efficiency; in our opinion relationship building isn’t one of them.
For typical investors, once a prospect has been identified, it’s necessary to assess the company to determine whether to engage in diligence. It isn’t surprising that less than 1% of companies a VC meets with get funded. Through a detailed and cumbersome due-diligence process, companies often fall out of a process. And this process can take months. How can we get the same positive selection when diligencing companies in a rules-based way?
To drive efficiency, we rely on two important and differentiated tenets: 1) the information advantage of Helio and 2) the power of diversification.
When one of the 1.4 million tracked companies in Helio is flagged as a potential investment, there is valuable information that comes with that flag. A company’s estimated revenue, potential for future growth, product characteristics, brand equity, category and competitive information, and distribution trajectory, among other metrics, are used to build conviction around an investment. In the blink of an eye, a company that a traditional investor would have looked over becomes a viable prospect, which makes it possible to find companies earlier and take on theses that appear contrarian in nature. The signal that Helio provides allows us to perform due-diligence before we have even spoken to a founder.
The process of assessing a company is made easier by holding a diversified portfolio. Our portfolio will likely be 100-200 companies, allowing us to mitigate certain risks. Our Chief Data Officer Tuhin wrote about the value of building a diversified portfolio in a recent piece. While we need to be diligent in working with founders, we actually can be more efficient and forego some of the more time-intensive diligence activities that drags down a process (such as deep regulatory due-diligence).
However, what is important for our approach is validation. While Helio is powerful, it is not (and will never be) perfect. Statistical modeling and machine learning gets us close to building the perfect portfolio, but there will always be a margin for error. Additionally, there are certain risks that we cannot diversify away. As such, we have developed a set of efficient processes for validating those areas that require further confirmation. Examples of such areas include: 1) company revenue, growth, and distribution; 2) corporate documentation; 3) management expertise; and 4) a management background check. Each of these steps in validation is meant to help reinforce an investment thesis. Each step is also structured in an objective rules-based fashion so as to maintain objectivity and remove any heuristics or biases that an individual may have.
At the end of a validation process a company is scored based on the findings of that process. The metrics used to quantify and score a business are entirely rules-based and tie back to our conviction around a company’s growth propensity. However, the score that emerges from our validation helps us be more intentional in the next step of our rules-based process: valuation and deal structuring.
Valuation, Terms and Term Sheet Negotiation
Arriving at a dollar valuation of a business can be challenging and is too often more art than science. However, with the right data it is possible to become more scientific on valuation. Our proprietary dataset of valuation multiples is one we’ve collected over the last several years of working with thousands of companies in this segment of the market and it allows us to gauge that optimal range of valuations for companies in particular categories with particular trajectories. These data give us unique insight into pricing dynamics in the early stage market, enabling an efficient and objective approach to arriving at a valuation.
We can further use our validation scoring methodology to adjust terms to meet the needs of specific situations. With the score, we can not only, when needed and warranted based on the performance of a company, adjust validation within a range, but also set appropriate deal terms to align incentives and manage risk.
Over the past few years, market deal terms have emerged in consumer that should make the process of reaching a deal simpler. While sometimes terms are included in a term sheet that are less founder-friendly, such as warrants, >1.0x liquidity preferences, and full-ratchets, these tend only to lead drawn-out negotiations and potentially harm the company’s long-term ability to attract capital.
The term sheets we present to founders will be standard, founder-friendly, and designed to arrive at an efficient negotiation. The terms that are included in our term sheets are a function of the terms that are reflective of 90%+ of deals that we have done with our current funds. In other words, after negotiation, the terms that 90%+ of our current portfolio have in-place will be our starting set of terms.
In starting with a straightforward and founder-friendly set of terms it does reduce the room we will have for negotiation. Any flexibility we do have will stem from the scores that were calculated on a company during the validation process. In creating a more scientific approach to the price and terms we present to companies we are able to do exactly that.
Closing the Deal
Once a term sheet is signed, deals can still take weeks or months to close. This process can be lengthy for two reasons. First, it involves collaborating with external lawyers and creating a set of documents (stock-purchase agreement, side letters, investor rights agreements, etc.) that are traditionally tailored to a particular deal. Second, coordinating with other investors often drags a process out for additional days or weeks. We aim to address this issue in a similar fashion as with term sheets.
In the spirit of transparency, we plan to make our core template documents available to the public. While the specific terms, number of shares, rights etc. will be informed by validation and term sheet negotiation, our core legal language will not change. As such, we can get lawyers a head start on the language we prefer, which allows us to preempt any issues that may arise when it’s time to close.
There’s no question that what we are embarking on is ambitious. However, we believe it’s the future of private investing. We believe our systematic fund will be faster and fairer, and will help more entrepreneurs get the capital and resources they need.
In Part VI we will discuss how we will embrace the VC platform approach to value-addition post-close and and how our approach to value creation can help hundreds of companies in scalable ways.