I received a lot of queries (along with raised eyebrows) from founders I talked to about why we decided not to invest in their startups. For many instances, the answers were simple enough: it was a hardware business (which we don’t typically invest in), or it’s out of our geographical focus. However, when it comes to explaining why a startup that ticks all the boxes but might be ‘too early’ for us, I often find myself digging deep into its business model and its founders to come up with a reasonable answer. For the benefits of the general public, this article seeks to shed light on our thought process in determining whether a startup is VC fundable and whether it is ripe for a Series A round.
On the face of it, Monk’s Hill Ventures is known as the SG-homegrown VC fund which invests in 4 – 5 startups a year with an average deal size of $1-5M. Of those, we expect a number of these portfolio companies to be successful so that we can return our investors (so called Limited Partners or LPs) their original capital along with returns expected of a Series A VC as an asset class. This is because we are paid by the LPs to take risk, and risk needs to come with return. It is the LP’s expectation on returns which shape our risk-return appetite, and consequently, the deals we invest in as a Series A investor. For example, we may deploy $100M into 20 individual startups, $5M each for a 25% stake, with the expectation that when we exit after 5-10 years or by the time they progress to Series C or Series D, our diluted stakes (say 10%) in 2 of those 20 startups would, on a reasonable worst case scenario, be valued at least at $50M each so that we can return LPs their $100M. The rest is the upside. However, within that quick break-even analysis there lies a fundamental assumption that both startups would need to grow its value by ~25x. In other words, we would need to hit home-runs on those deals, and while businesses with stable cash flows and steady linear growth are perfectly fine investment opportunities for many investors, VC might not always be the right people to fund them given their growth potential.
I often ask founders whether they would be happy to drive their startups like an E-Class or they would aim to drive it more like a Ferrari. This is because if they are looking for funding from VCs, they are really telling investors they no longer want to bootstrap (i.e. self-fund) to grow their startups, but are striving for an exponential growth by going after a sizeable total addressable market and potentially IPO one day. Many founders see this as a chicken-and-egg problem – they think funding is required before their businesses can achieve exponential growth. Our experiences, however, have been that funding is not a causal factor for an exponential growth trajectory. In fact, funding often comes after a display of an exponential growth, but only to accelerate it.
So how do I identify evidence of an exponential growth trajectory in a startup? Two leading indicators: a real business model targeting a big TAM, and demonstrated scalability.
A real business model is a must have for startups at all stages.
It must provide a solution to address a top-of-mind pain point suffered by a large audience who have enough means to afford and benefit from it. The more severe the pain point you are solving, the more fundable your startup. Too often we have come across ideas that attack a valid pain point but is not felt by enough people to warrant having a business around it. A founder who succeed in raising the Series A round often displays a strong understanding of what their customers look like and why they will pay him / her to solve their pain points.
A strong signal that a startup is ready for Series A is demonstrated scalability
A show of traction or revenue proves the business model can be monetized, but it does not dictate future returns. As such, we look for companies with capital efficient Sales Engines (read Peng’s article [here] to learn more about the construction of Sales Engine), specifically those with high retention, engagement, and virality (REV) metrics. Businesses that have demonstrated the ability to retain and engage its users, while being able to acquire new users via viral effects, can avoid the trap of increasing customer acquisition cost and stagnant or lower monetization per user. In other words, they must be able to do lots more with a little. A Series A-ready startup does not generate 100 times more traction by working 100 times harder or hiring 100 times more staffs; they simply focus on what scales which make them 100 times more efficient.
Lots of founders have wasted their energy and hard-earned resources chasing VCs for answers that are difficult to stomach, and while we tried our best to explain why we may not be the right fit, their time may be better spent on seeking alternative sources of financing or pivoting their business model which have characteristics of one that is capable of an exponential growth. Nevertheless, I believe the startup ecosystem in this part of the world is still relatively young, and with the right amount of guidance by peers, will blossom over the next few years.