How do VCs review start-ups? My experience

Today I've found the question What metrics do VCs look for in early stage companies? on Quora. I decided to post my answer to the blog too. Through my experience is quite limited, I've become pretty familiar with the process during my five months in the VC fund. Maybe someone will find it interesting.

I'll talk about my experience, but it should be quite similar for every VC fund.

The process of reviewing early-stage companies at the fund I work for is quite structured. 

First of all, we do some kind of screening trying to evaluate the company. At this stage, we just need to decide if we are generally interested in the idea, and the main thing to evaluate is the core idea of the project. The company's profile is not that important for now, as even if this particular start-up will fail to go through our reviewing process, there may be some interesting competitors. 

If the idea looks interesting enough, the process continues and we look at the products the company has to offer, the current stage of development, team's profile. Talking about team, it is somehow important to have professionals with some experience in the field, but I would dare to say that it's not that much important as it's sometimes stated as there are tons of qualified people with great backgrounds who fail to deliver products, and sometimes a bunch of teenagers can create something truly amazing if they understand the needs of the market. 

The it's time to take a closer look on the market, trying to evaluate the potential of the products, direct and indirect competitors, the current state of the market and if there is any interest for such products. 

Usually if we go that deep we interact heavily with the founders in order to understand if they understand the market, have necessary skills to develop their ideas into successful products and if their vision of the future is similar to ours. We also prefer to have some kind of financial model to evaluate such metrics as IRR, CoC multiple, amount of cash need to be injected and so on. Also to have financial model is quite helpful as we can review in details the assumptions on which the model is based, see how they correllate with our understanding of the market and try different scenarios. But of course, all models are quite simple at this stage and aren't always accurate. 

With $2-$5mm average deal size we rarely invest in companies without some kind of prototype or launched beta and some statistics to make forecasts but for seed stage there may be no financial models and such things so then this stage is skipped and all the process will concentrate on the ideas, team and product development. 

The whole process takes from 2 to 5 months on average, and about 1 company out of 30 goes through it (this number should be hugely variable and depends on the market VC fund looks for, the focus and their channels to get information from).

Observations About Tech Market, Part 1: E-commerce

In the comments to my previous post, I was asked about what companies on Russian high-tech market can be described as interesting and what start-ups have managed to develop into profitable companies. Well, I will try to answer this question, but I'll start a bit from afar.

 It's impossible to write about everything in one post, besides it will be too long and boring to anybody to read it. So I'll break it into a series of articles each covering some segment of the market or some piece of timeline. If the topic will get some attention, I can write more specifically about some companies or areas.

First of all, let's try to divide high-tech into some sectors. Of course, such classification will be very subjective, and the best and most interesting companies are usually created on the edge of a few completely different spheres or even bring into being a new one area or business model. But if we still want to get some kind of classification, here is one possible variant:

• E-commerce
• Social networks
• Search and its applications
• Mobile payment
• Online travel services
• Online education
• Games (mobile and PC)
• Consumer web (all that doesn't fit previous categories goes here)

Now, a few more words about this classification. First of all, it's incomplete. There should be no such thing as Consumer web, as almost every company can be added to this area - in fact it has no specific description. Secondly, some of these areas may be divided into several independent sectors, or vice versa, merged into one. So, it is just some type of classification which I feel comfortable to work with.

Now, let's try to begin observing each sector. Today I'll talk about E-commerce.


E-commerce

This sector seems to have little connection to high-tech or startups, but in fact it has been probably the most profitable area during the last few years. The large share of venture capital is also invested in this sector.

In the last 5 years or so a lot of great businesses were launched in this field - and there were created two completely new business models. Their creators managed to develop their startups into multi-billion dollar companies, a lot of competitors tried to copy their ideas, and many of them successed. These ideas are group deals and shopping clubs.

Group deals - new view on the whole retail business or the way to nowhere?

The first site of its kind, Groupon, was launched in November 2008. Two years later, it covered North America, Europe, South America and Asia, and had over 35 million registered users. There were four major investment rounds, and that's excluding seed financing and the last relatively small financial round in February, 2011. Through these rounds, the company got a fantastic $1.1 billion, including $950 million in the last huge round of financing. After that, Groupon was valued at about $12.8 billion during its IPO, an impressive amount of money, but way less than predicted by analysts $25 billion valuation. Today, its market capitalization is about $3.43 billion, and the downfall continues.

According to the description at Crunchbase, Groupon "brings buyers and sellers together in a fun and collaborative way that offers the consumer an unbeatable deal, and businesses a large number of new customers". The model is quite simple and very appealing. The company has been expanding its operations throughout the world at a fantastic pace. So what's happened?

Several reasons have been named, and much more can be imagined. The main problems are the need of huge marketing spends to acquire new customers (and also to maintain the current ones), the rising competition from the global clones (such as LivingSocial, which received more than $800 million in funding, including two last rounds led by Amazon) and local ones (such as Russian Vigoda.ru), and the inability to continue to scale up by acquiring local competitors, as almost all market are either already controlled by Groupon, or have its own established players now.

So, the future of the company and the sphere itself is uncertain.

Shopping clubs - just another view on group deals process, or something entirely different?

Another, and a more interesting, at least in my opinion, idea is so called "shopping club". It is also a relatively new, as it was created just about 6 years ago, but today there are dozens of successful companies with revenues exceeding hundreds of million dollars all over the world.

Basic idea of shopping clubs is quite simple - there has been demand for some new business model from the apparel's retail, which is extremely unstable business, with high dependence on brands' popularity and seasonal changes in demand. The percentage of returns there is also higher than in any other segment and usually it is almost impossible to sell returned items as they can be returned in the end of the season, when there is no demand for them, and the next year they can become no longer popular.

In this situation, shopping clubs appeared to be able to provide great opportunity for the stores to sell unsold inventory. Shopping clubs are positioned as luxury clubs with by invitation-only membership. They collect unsold items from the stores and then sell them at heavily discounted prices for just a few days to its members. This model, in some aspects quite similar to group deals concept (large discounts provide an attractive opportunity to customers to buy goods, and large volumes help businesses to sell otherwise unsold inventory) is much more effective and stable, because in the business of selling apparel there was demand for some suitable solution in the industry, and group deals services do not adress any specific demand, and, while they can be quite profitable for customers, value proposition for businesses and group deals services themselves (due to high marketing costs and low loyalty and return rate of businesses) is really questionable.

The list below includes some examples of shopping clubs:

• Gilt Groupe (USA, the company that started the industry, received $220 million in funding)
• Hautelook (USA, acquired by Nordstrom for $270 million in 2011)
• BuyVip (Spain)
• One Kings Lane (USA, received $63 million in funding)
• ideeli (USA)
• Rue La La (USA)
• Markafoni (Turkey)
• KupiVip (Russia)

It is also very interesting to look at Russian market, as there is one very interesting company there named KupiVip.

KupiVip was started in 2008 by Oskar Hartmann, an expat from Germany, who created maybe the most successful startup in Russia since Yandex. Today it was funded with more than $100 million, including huge in terms of Russian market the most recent financial round of about $55 million, in which participated such famous VC funds as Accel Partners and Mangrove Capital Partners. Now it is not just a shopping club, it offers a full range of servicea including all-in service for offline stores to enter online retail market. KupiVip provides all infrastructure, and all that is required from the store is to provide goods and to run advertising campaigns to promote online store. That is really great service, and the list of stores using it includes such brands as Central Universal Department Store (ЦУМ). In the interview to Forbes in March, 2012, Oskar Hartmann said that he expect the company to have revenue exceeding $1 billion by 2015. Well, it seems definitely possible.

Of course, there are much more interesting companies in E-commerce segment in Russia and in the world. Ozon.ru, Russian version of Amazon, has got $100 million in funding, an enormous sum of money for a local (yet quite successful company), so its IPO is postponed now. Lamoda.ru, an online store focused on apparel, has just received an undisclosed sum of money in the $40-$80 million range from J.P. Morgan.

It's impossible to cover all events, but as anybody can see, both local and global market are alive and developing on a high pace.

I hope that somebody will find this article interesting enough to spend time on reading. Next time, I'll write about major trends in social networks' segment.

The Return of the...

Hello, everybody!
There was no single post from me in this blog for more than 3 months, sorry about that. I doubt that I still have any readers, but I hope they'll return eventually. Now I hope to write a bit more often.

A lot of things happened during these three months - I have started a full-time job as an analyst at VC fund after completing a three month internship, I have begun my last year at the university, some other things have changed... But I don't want to bore anybody with all that stuff. Let's just talk about a new format of this blog I want to use from now.

Earlier this year I used to publish some thoughts on events and news in the world of economics and finance that I found interesting. And while it was quite funny and educating (for me in the first place), I don't think that this format has any future for me - not in this way, at least. I just don't have enough time for it - and besides there are always more news I would like to cover than I can just because it can be very time-consuming.

So, from now I will focus on one particular sphere - tech and especially tech startups. As I work in VC, I spend a lot of time monitoring market for new interesting companies and ideas, so I think there can be some interesting information I can put on this blog. I don't try pursue any particular goal - just want to share some of my thoughts on the market and maybe to get some comments in response (comments are highly encouraged, actually :-) ).

Well, that's not completely true - I do pursue one goal - I hope to draw some more attention to the Russian startup scene and at the same time to tell people in Russia (yes, I am writing in English, but quite a lot of people there actually know English so they won't have a problem reading this blog) about some interesting startups that are being created in their home country.

In fact, Russian tech market looks quite attractive - there are quite a lot of interesting companies created in the last few years, and at the same time the amount of possibilities still seems to be bottomless and competition is low. But there are two major problems - seed financing is underdeveloped and the culture of entrepreneurship in the country is awful. These problems can be solved, but it'll take time and some efforts from both entrepreneurs and investors.

I don't aim to contribute anything particularly valuable to the solution of this problem, won't publish any information that is not in public access, and won't try to write a magic article on how to create a successful billion-dollar company - if fact, I want to know that kind of things myself. But maybe some information and links provided there will be able to help somebody or at least will be a bit interesting.

Anyway, I hope it'll be funny for me to write and to somebody to read all the stuff. Frankly speaking, I have missed this blog.

Facebook: Biggest Technology IPO on Record

"Facebook Raises $16 Billion in Biggest Technology IPO on Record", states Bloomberg headline. With the shares priced at $38, the top end of an increased range, Facebook becomes one of the biggest technology companies in the world based on its market capitalization. $16 billion are raised in this public offering, and the whole company is now valued at $104 billion.

Trading will start tomorrow, and stock price will most probably increase even more. There is no reason to try to predict the situation, but it will be a historic day. And I'm afraid not necessarily in a good sense.

Stock Trading Fleeing U.S. Exchanges

While the markets are recovering slowly from the financial crisis of late-2000s, trading volumes on NYSE and Nasdaq OMX, the biggest U.S. stock exchanges, decline. A variety of possible reasons can be named, including overall slowdown in trading and the rise of popularity of smaller exchanges such as BATS. But there is one more reason - the increasing number of trades being executed at the wholesale brokerages or in so called dark pools - private trading venues.

There is a large article in Businessweek on the topic, called Where Has All the Stock Trading Gone?

According to the data collected by the market research firm Tabb Group, the share of trades executed "off exchange" has increased from 26 to 32 percent in four years, while the volumes traded on Nasdaq and NYSE have fallen by more than a third since 2000. Dark pools attract traders who execute large deals and don't want the market to know about them, and high-frequency traders. And wholesale brokerages now can compete with exchanges offering slightly better prices for sellers and buyers due to the rule for exchanges to increment quote prices at least for one cent.

Dark trading can help investors to earn more on the same operations (though essentially it is available only to the institutional investors) but the main problem of the last crisis was the lack of transparency, and off exchange trading is barely regulated at all. And today, while NYSE struggles to get the permission to provide prices in fractions in order to be able to compete with wholesalers, Knight Capital and the Securities Industry and Financial Markets Association, a lobbying group that represents big Wall Street banks, does its best to ruin this proposal. It looks like bulge bracket banks still prefer not to become subjects of regulation, and to earn money on the unfair markets. Some things never change, unfortunately.

Facebook IPO: An Event We Have All Been Waiting For

On May 3rd, Facebook Inc. announced that the price of its stocks intends to be between $28 and $35, valuing the company between $77 billion and $96 billion. This week the roadshow must be started, and later in May we'll see the biggest IPO in the history of tech companies. After the rise in the beginning of this year, the markets remained quite weak for two months. Maybe this IPO will be able to boost them.

But aside from the possible rise of markets, is an IPO of Facebook with such a great valuation a good or a bad thing? As usually, opinions differ.

In fact, Facebook IPO is quite unique even for the tech sector, or at least it's unusual for the companies of its size. Unlike many other companies that have eventually become giant, Facebook is already very large. When Google went public in 2004 it was already quite famous, but its value has increased ten time since then. And it was the biggest tech IPO in history at that moment. Even if Facebook will go public with $77 billion valuation, it is nearly impossible to imagine that it can grow ten times - then it will cost more that Apple today.

So, it seems that the potential of the future growth is very limited there, and it has always been the main incentive to buy tech companies' stocks. What can Facebook suggest as an alternative? Only great revenues and large dividends in the future. But there is one problem - with present revenues, Facebook's Price to Earnings Ratio will be higher that 50x in any case. And while many companies in tech sector have higher multipliers (LinkedIn, for example, has P/E at level of 900x), all of them are way smaller that Facebook. Of course, the revenues of Facebook have been growing steadily for years, but it can by no means guarantee that the growth will continue. In fact, the last report concerning revenue for the first quarter of 2012 is even disturbing - Facebook seems to begin to spend much more on marketing, and while the revenues continue to grow, net income is less than a year ago. After we have all seen Groupon, which stocks have lost more than 50% of the price since the public offering because of its ineffective business model, large expenses on marketing seem definitely disturbing.

Nevertheless, it is obvious that Facebook IPO will draw a lot of attention, and the price of the stocks is likely to soar after the public offering. Facebook is by no means similar to GroupOn today, and it can be a good investment. It just seems that you need to find an answer to the question "What If Facebook Isn’t So Special After All?" raised in Businessweek a month ago, before investing.

New Europe In A Weekend: French And Greek Election Results

It can be said that this weekend has changed the face of Europe. Yesterday François Hollande, the candidate for presidency from the French Socialist Party, won the election. A Socialist will be a president for the first time in 24 years. François Hollande secured 51.7% of votes. And now he is literally responsible for the fate of Eurozone.

In the meantime, in Greece the elections rouse even more fears, putting, according to the Guardian, "neo-fascists in parliament for the first time, the hard left in second place overall". The future of Greece can be called absolutely unpredictable now, but it's obvious that the policy of austerity has failed, and the same can be said about France.

As Paul Krugman writes in his column for The New York Times about Greece,

Voters take their anger out by voting against the insiders. And since all the respectable people are inside the political tent, backing and being identified with failed policies, that means a big vote for extremists right and left. 

In response to the results of Greek elections, the Greek stock market fell almost 8%. The French markets reacted less vigorous, French CAC 40 down only 1.7%.

Now, it seems that the main question is whether Mr Hollande supports Angela Merkel or not. Angela Merkel is loosing influence, her coalition of Christian and Free Democrats lost an election for control of the northern state of Schleswig-Holstein on Sunday, and if François Hollande doesn't back her, the whole policy of Eurozone may change rapidly.

Ron Paul vs Paul Krugman: Federal Reserve Problem

Hello! I haven't posted anything in almost two weeks, and I sorry about that but I have been extremely busy, and unfortunately things are not going to be better anytime soon.

First of all, I would like to share a spectacular video "Ron Paul, Paul Krugman Face Off" from Bloomberg TV. As the description states, Republican Presidential Candidate Ron Paul and Princeton University's Paul Krugman discuss their views on spending, inflation and the Federal Reserve.

In fact, some parts of this conversation are very funny - especially the moment when they both refer to Milton Friedman. Nonetheless, the problems being discussed are extremely difficult, and the views on them can be absolutely opposite, the video once again demostrates this.

High-speed trading: when time really matters

Earlier this year some information on so called Project Express, $300 million transatlantic fiber-optic line between New York and London, had appeared. This line will allow high-speed traders to execute orders in 59.6 milliseconds, and today the best time that can be achieved is about 64 milliseconds. Project Express should be finished by 2013.

However, it seems that a small company called Perseus Telecom have already found a way to reduce time to less than 60 milliseconds. Instead of building a new cable, Perseus Telecom has chosen to modify FLAG Atlantic-1 North cable. And it looks like the competition is far from over, as it is possible to reduce the time to 40 milliseconds, or even less if someone would choose to drill through the surface of the Earth rather than to run cable along the ocean's bottom. Soon we'll see.


Businessweek:
High-Speed Trading: My Laser Is Faster Than Your Laser (Perseus Telecom story)
Stock Trading Is About to Get 5.2 Milliseconds Faster (about Project Express)

The IPO market's activity

While the number of IPO deals in the first quarter of the year is the largest since 2007, the deals are relatively small in size and the markets are quite calm. It seems that today the whole market is waiting for Facebook's IPO. And if it is successful enough, it may be able to kindle the growth of the internet technology industry at least.

Businessweek: The IPO Market: More Deals, Smaller Prices