While the best form of business is one that doesn’t need outside investment, you need money to grow your business. That’s where venture capital (VC) investment comes in, to fuel rapid expansion or internalisation. Every startup that has become a “unicorn”, “decacorn” or “hexacorn” has gone through this process.
However, investors and founders alike agree that you shouldn’t take funding just because you need it. You should take it if you are confident you can pay it back, and you should carefully consider your repayment plan in the light of your business plan. That means being responsible. While there is an abundance of venture capital funding out there, not every startup gets a chance, so which startups get funded, how does the process work, who are the VCs and how do they work?
Panjoon Kim, CEO of FIND-US, explains: “For a founder, a venture capitalist is just another customer. “You need to understand the investment market and VCs from a customer perspective, just as the market and customers are important to startups,” advises Panjoon Kim, CEO of FIND-US. “You need to be strategic in your approach by looking at whether VCs have the ability to make lead investments and where they are good at making lead investments.
He added: “If they decide to invest, you can consider them to be on your side. You should share your company’s weaknesses and think about how to make it better. Helping the judges to invest well will bring good results”. The following is a one-on-one interview with CEO Panjoon Kim.
Panjoon Kim, CEO of FIND-US ⓒPLATUM
Venture investment is also a form of marketing.
Venture investment is also a product and marketing. For a startup, there is a market in the broad sense of venture investment and a customer in the form of VCs. The products and services we need to sell can be a company or IR (Investor Relations). From this perspective, we can divide venture investing into market (VC market), customer (VCs) and product/service (company or IR).
Is the market for start-up investments big enough?.
As a founder, you need to look at the investment market first, just as you would look at the market when starting a business: is it big enough and is it growing? If you look at recent data, there’s been a steady increase in the number of co-operatives set up and the amount of money invested. If you widen the scope to include new technology investment funds, it’s an even bigger market.
So why is the venture capital market so large? There are three factors. The first is that we’re in a low-growth period, so there’s not a lot of profitable assets to invest in. There’s not a lot of growth in real estate or bonds, so there’s not a lot of things to invest in these days. That’s why venture, startup investing is such an attractive alternative.
Secondly, the government sees venture, startup as the industry that will drive the next generation, the growth engine, so there is a lot of institutional support from the government for startups to grow and become unicorns and become global companies.
Investors wouldn’t be flocking to this market if it was just investment and no return, and now the return market is growing rapidly. The IPO (initial public offering) market is opening up a lot more than it used to, and the M&A market is picking up.
Venture investing in startups is a long cycle and it can take five to ten years for a startup to get to an IPO. If you don’t get a return in that time, investors have a liquidity problem. Government policies to support this and the demand for private capital are driving the secondary market. And the buyback market is growing.
So, you can see that the market is big enough and the growth is high enough. A market with this kind of funding cannot die a quick death.
Think of venture capitalists as ‘customers
For founders, venture capitalists are another customer. They’re the ones you meet and communicate with the most. Venture capital investments usually come in the form of equity investments and funds that use a combination of investments. An equity investment is when you invest with your personal or company funds and take all the profits, but also all the risk. However, because it is a high-risk investment, equity investing has not been very active. Most investments are made in the form of investment combinations and funds.
Let’s categorise the investors. Early stage venture capitalists are usually individual angel investors or companies that see the growth potential of a startup at an early stage. There are also many startup organisations called accelerators, and there are more than 300 registered startup organisations in Korea. These organisations provide investment and support to early stage companies. There are also so-called “micro VCs” that specialise in investing in the early stages of a company’s growth. They provide the initial investment.
Series A, B and C rounds, the mid-stage rounds, are where VCs and newcomers come in. Conglomerates are also entering this space to make strategic investments, and you can see examples of conglomerates like Naver, Kakao, Samsung, Hyundai, SK and others frequently investing in startups.
Late stage investors are a bit different from early to mid stage investors. Late stage investors are the typical, classic capital market investors. They’re looking to maximise returns, but they tend to be a bit more focused on delivering stable returns. Rather than investing in a company and getting a 10-20x return, they’re more interested in investing a large amount of money and getting a steady 10-20% annualised return. That’s an area of scale.
If you look at the current composition of investors in Korea, there are more than 300 accelerators, 160 registered VCs and about 62 registered new technology business finance companies. Of course, there is some overlap or duplication among them, but it is clear that there are many more investors than there used to be.
In summary, what venture capitalists do is attract other people’s capital, create leverage and make investments. They invest a lot in high risk, high reward. They tend to invest in things that are risky, but they expect a high return.
Venture capitalists like professional sports leagues.
If there is a market for venture capital and investors are your customers, you need to structure your services and products accordingly. Early-stage investors are looking at the founding team and the market, so when you meet them, your pitch should focus on how big and growing the market you’re targeting is and what your team’s capabilities are. For mid-stage investors, you need to focus on how good your current growth is and how far you can grow, how much market share you can take, how far you can expand, and how you can gain competitive advantage based on the BM (business model) and PMF (product market fit) that you validated early on. And for late-stage investors, you need to focus on whether you can do an IPO with stable operating income, or whether you can do another round of valuation and M&A. Fundamentals are also important, such as whether the company is at risk of going out of business. The later you go, the more important the financials become.
The best way to prepare a good investor pitch is to tailor it to your target audience. Venture capitalists prefer popular sports to unpopular sports. They look for a large market, as in professional baseball, and they prefer one-hit wonder home run hitters to reliable players who hit well. They also look for franchise stars who have low injury rates and can play reliably for long periods of time. You need to think about whether your company fits the bill, what you need to work on to get there, what you need to appeal to… You know what they say: ‘If you know your enemy and know yourself, you need not fear the outcome of a hundred battles’, so you need to know yourself well, and then you need to understand the customer, which is the investor that we’re going to be dealing with.
What do investors care about and want?
What are the concerns of limited partners (LPs) investing in venture capital funds? LPs are typically large asset managers, ranging from pension funds to financial institutions to insurance companies. They don’t just invest in ventures, they also invest in publicly traded stocks and bonds. They make venture investments as an alternative to all the other different investment businesses. Their challenge is to take money from individuals or institutions and grow it. They are limited in their ability to manage all the resources to do this themselves, so they look for investment firms that can give them a good, stable return on their money. They also diversify because it can be overwhelming to put it all in one place. So the LP perspective is which VCs have a good track record and are sourcing a lot of good companies in the market. They don’t want to invest in one VC, they want to invest in specialist firms that are good in each sector.
The entities that manage an LP’s money are a general partner (GP) and a venture capitalist (VC). Most venture investments are made using funds under management. While it may seem like there is no risk in raising money from others to make an investment that fails, the capital markets are pretty cold. If you give it a chance and the investment doesn’t work out, it becomes very difficult to raise the next round of funds. References follow you around like a badge, so VCs try to build a good portfolio. They also try to maximise the returns of their funds in a stable way, because if, for example, one fund is doing 200% and another fund is doing negative, they see that as risky from the point of view of entrusting their money. That’s why when VCs invest, they don’t invest $10 million at a time, they invest in chunks of $1 million, $2 million. It’s not because they don’t have the money, it’s a strategy to reliably maximise returns.
It’s common for VCs to operate through funding. In the past, it was quite difficult to get funding, so VCs were not active, but recently the government has provided policy support through the parent fund, which is 30 to 50 per cent of the venture fund and encourages them to invest in purpose-driven businesses. You can think of it as a combination of fund of funds (FOF) funds and the VC’s own fundraising to execute the investment. It is therefore a very important mission for most VCs to be selected for FOF funding.
What are the concerns of investment judges?
First of all, there is an agency issue and let’s face it, most of them are salaried and although there are investment incentives, they are too long term and there is not a lot of certainty that they will get them. They are looking to build references and later build their own house or become an executive or partner in a large investment firm, so the focus is on building a good track record. They therefore tend to make group investments (club deals) in companies where a large investment firm is the lead investor.
And they have a physical limit to how much they can invest in a year, so if venture capitalists have $20 million to invest in a year and they have to invest in 20+ companies, they can’t possibly see every single one of them, so they take a strategic approach to networking. If you have five people networking, one of them is going to do a really good job of researching the number one company and the industry and say “This company is really good, I’ll put in $2 million and the rest of you can come in at a million, million, million, million” and they’re going to believe it and they’re going to invest.
At the end of the day, founders and startups need to be strategic about understanding who the lead investors are, whether they have the ability to lead and which ones are good at leading investments. It is also a good idea to reach out to judges who are well known or have recently invested a lot in that area.
Investment judges are initially in a position to review the investment, but during the IR phase they become the startup’s representatives. They want to understand your business so they won’t turn you down. If they decide to invest, you can count on them to be on your side. You need to tell them about your company’s weaknesses and how to improve them. If they support you in your pitch, you’ll get a good result.
How do VCs make money?
Typically, VCs create and manage start-up investment funds, venture capital funds, and the average size is about $20 million to $50 million, and the duration of the fund is often between five and eight years. They don’t invest for the whole period, so they invest for three or four years, and then the other three or four years are more for burnout and recovery than investment. For the ones we don’t get back, we look at things like whether we’re going to pass them on to a secondary. Founders need to think through this investment period and come up with a plan for investors to exit. It doesn’t matter how good your technology is, if you say ‘you’ve got a 10-year payback’, you’re more likely to get a response like ‘we can’t do that with our current fund’. So when you’re communicating with VCs, you need to look at what kind of fund they have, what their investment objectives are, do they have a fund room and so on, so you can save each other time.
As I said earlier, a VC fund raises money from institutions called LPs and then pays out distributions when it makes a return on the investment. It’s also important to note how VCs make their money: their main sources of income are management fees and performance fees. When you set up a VC fund, you get on average 2% of the combination as an annual management fee. If it’s a $10 million fund, that’s about $0.2 million. We take that every year to run the office and hire people, and then we calculate the performance fee at the time of liquidation, so if we put in $20 million and it’s $40 million later, we split it according to the IRR. The IRR is between 6 and 8 per cent, usually compounded at 6 per cent, and we take 20 per cent of the excess return as a performance fee. You deduct all the management fees and things like that from the previous stage as an expense, and then you get performance fees on the excess returns. That is how VCs work.
Let’s understand purpose funds.
You have to look at a purpose fund strategically. Because a purpose fund means that at least 50% of the fund has to be invested in a particular sector. So if you set up a fund that says ‘we have to invest in food tech’, then at least 50% of the fund has to be invested in food tech, and there’s a penalty if you don’t, so you fill in the percentage of purpose companies. You fill in the primary purpose first and then you make another investment with the remaining space. As a side note, companies that are primary purpose investments can get a slightly better valuation than other sectors.
The typical VC investment process
If you’re looking to raise investment, you’ll first need to decide how much you want to invest, how you want to value your company, which VCs you want to meet with, and create a targeted IR deck (an explanation of your company’s business model for investors).
You then contact investors, distribute your IR deck and hold an investor meeting. A common misconception is that an investor meeting is an IR, but it’s actually a presentation of your company to all members of the investment firm. If the VC thinks the company is worth investing in, they’ll do what’s called an investment review, and the reviewer will write a review report detailing the exit plan and valuation. If it passes, they’ll do financial due diligence to make sure the metrics are well managed and there are no risks, and then you’ll negotiate key agreements and sign a detailed investment agreement.
Questions to consider before raising money
When you’re looking to raise money, you might ask yourself, “How much money do I need for this round, and if it’s going to be around $2 million, should I just go for, or should I get a loan or something? There’s no right or wrong answer here, and you should leverage as much as you can from loans, government projects and other sources.
In fact, VC funding is the “highest interest cost financing” for a company. But institutional investment is a little bit different from other types of funding because when you get an investment, you get a valuation, and that’s the basis of your valuation, so you can grow and hire good people. It also gives us strategic access to large amounts of money in a short period of time that we don’t currently have access to on our own credit.
VC investing can be difficult. There’s a lot to think about, like “what should I value my company at when I’m trying to raise money, what do other startups value their companies at, what’s the timeframe, how should I structure my IR deck to make it attractive, what are the must-haves? And once I have my IR deck ready, which investors should I meet with, how should I meet with them, how should I approach them, what’s the due diligence that comes after that and how should I prepare for that, and I hear that investment agreements are complicated, where and how can I get help with that,” and so on.
How much should a company raise and how do you decide?
Every investor you meet will ask you, “CEO, how much do you need, why do you need it? What are you going to use it for?” These are the questions you need to be prepared to answer so that the investor thinks “this company has a plan when it asks for funding”.
The truth is that there’s no right or wrong answer to the question of how much money to raise, but there are things to consider when deciding how much to raise. Firstly, you need to look at your burn rate and what your runway is. You need to think about the timeline to funding first. “How much money do we have now, how much are we burning every month? How much money do we need to get to a certain point with what we have left?” That’s your funding plan. And then when you’re done raising money, you need to have a plan that says, “What are our milestones, what is our burn rate based on our marketing plan, our staffing plan, how much money do we need until the next round and how much money do we need for the duration of the runway?”
It is good to do a monthly financial projection on a cash basis. It doesn’t matter if it’s rough. but you put your business plan into the financial plan and say, “How much money is going to go into staffing on a monthly basis, how many people are going to be hired after the point of investment, so how much more is going to go into staffing, how much is going to go into marketing, and we’re going to have this burn rate because we have to invest in other things. How much of those things can be covered by the revenue of the business. If you take a month-by-month plan like that and project it out over a year or two, you get a pretty clear picture of the money you’re going to need.
Even with that, there are some things that you can’t see in the plan, so you have to do a reference check, which means looking at the investment history of your competitors or your peers and seeing how many rounds they’ve raised and what kind of background, plans and metrics they had. These are things you need to check through startup references or investor references.
Once you’ve decided how much you want to raise, you need to think about how you’re going to get the money. If you can’t raise it yourself, you’ll need to find out how much you can borrow. For example, you need to check how much credit you can get through various support schemes from places like the Korea Credit Guarantee Fund. You also need to check how much money you can get through government projects or grants. These are the things that will get you on the road to funding.
How should you value your business?
There’s no right answer to valuing a company, and I don’t think anyone can do it accurately. Typically, investment rounds don’t happen in one go. Unless you have a single business model or you’re getting a strategic investment from a large company, you’ll usually go through several rounds. It’s common to see dilution of around 20% of equity in each round, so if you’re talking about a $1 million or $2 million investment, the dilution will be in the range of 10 to 20%. When you get diluted, you multiply that by 0.8, so even if you have 100% equity, after three or four rounds your equity goes down quite a bit. Because founders don’t always take 100% equity in the beginning because they have co-founders, they have angel investors, so there are a lot of cases where they don’t make it early on and then when they raise later they have a smaller equity stake, so you have to be careful.
If you need to raise $1 to $2 million, you need to work backwards and think about what is the 10 to 20 percent valuation range of the company so that you can raise money within that range, and then look for benchmarks in your industry. If you don’t have any domestically, look at the global market. Use global benchmarks strategically. You can suggest or say, “There’s this company in the United States and we benchmark against them. We’re growing by these metrics and this is our valuation for this round. They’ve got this much in a market that’s 10 times bigger than ours, and we’re in a smaller market, so we can get a valuation at a fifth of their valuation. If you have a benchmark like that, VCs would also use it internally to convince investors.
People also do a lot of valuations based on financial performance, and when we talk about financial performance, it’s traditionally based on profits, and startups usually grow by burning money and losing money. So the PSR (Price Sales Ratio) came to the fore. It’s a measure of how much of your revenue base you’re generating in terms of value.
Platform companies have a slightly different approach. It’s hard to value a platform company on its revenue base because the BM (business model) comes later, so the valuation of a platform company is usually based on a multiple of the transaction value. Typical examples would be Coupang or Mushinsa. What these platform companies are saying is: “A lot of platform companies that are losing money were invested at a valuation of 1x GMV. We’re profitable, so we should be worth at least twice that. The idea is to convince investors that they’re worth more than that. Instead, these negotiations should have a benchmark. If you don’t have a deal or a revenue number, you can use a membership number or a MAU (monthly active users) or DAU (daily active users) number, or you can bring in a good example from a global company or a peer group, or you can bring in valuation information from companies that have been funded.
The other way is psychological. When investors set a valuation, they often look at the multiple of the last round. Even if you’ve done a lot better than the last round, they won’t like it if you increase your valuation by more than 4-5 times. Unless you’re disrupting a market like the Karrot market (Daangn market), or you’re going to change everything with AI and technology, if you were valued at $20 million in the last round and you’re suddenly talking about $100 million, they think that’s too much. You’re going to get requests for adjustments. The valuations that investors like to see are usually between two and three times the previous round.
As a startup, it can be frustrating when you’ve worked hard and grown your company’s metrics significantly, only to be asked for a valuation that’s lower than you expected. In fact, one of the founders of a startup told me that he felt lost after one round of funding. He raised the next round a year and a half after the previous one and the valuation went down and he regretted that “it would have been better to double the valuation in 10 months instead of a year and a half and then do the next round 10 months or a year later”. It worked for the investor and he’s seen it happen with other startups. He’s right, it’s better to strategically spread out the valuation than to take one round too long, so there’s less equity dilution. If you get a $5 million investment and you don’t spend all the money but you hang in there for two years and you work hard on your metrics and then it’s hard to get a triple valuation in the next round, it might be better strategically to get a $2 million investment instead of a $5 million investment and then you can double or triple your metrics and get a $3 to $5 million valuation in the next round.
In other cases, the valuation is based on key people. In technology areas such as biotech and AI, key people become the basis for valuing companies. The multiples could be based on the number of key people involved. That’s how they do it in Silicon Valley.
More important than a high valuation
Of course, it’s always good for a company to have a high valuation. With a high valuation, you can get a lot of funding for a small amount of equity. However, it’s important to remember that it’s more important to know which investor you’re getting funding from than it is to have a high valuation.
Let’s say a lesser-known investor values your company at $10 million, but a major investor values it at $7-8 million. You might think it’s better to take the $10 million valuation because money has no label, but I think it’s better to take the latter. The market doesn’t often recognise earlier valuations in later rounds. Most investors accept the valuations of the big VCs, but they think they have to vet investors who have no credentials like investment history and expertise. So if you raise money from such investors, it is often difficult to make a follow-on investment because of the high valuation.
So while the valuation is important, it’s the composition of the investor base, which investors are coming in and what they value the company at. That’s the backdrop for future company valuations and follow-on investments. Once these good investors have set the valuation, other VCs will usually follow suit. Even if they set a low valuation initially, they play an important role in steadily increasing the valuation of the company to the right level after the investment.
When to start an investment round.
If you start fundraising when you’re about to run out of money, you’re setting yourself up for failure. There’s a psychological issue with fundraising. Valuations are not set in stone. You’re selling an intangible asset, so it’s a supply and demand situation between people who want to sell and people who want to buy. A lot of the valuation decisions are based on who has the time. It usually takes about six months to raise an investment round, so you have to think about and prepare for that timeframe. It takes about a month just to list and contact investors, set up meetings, send out IR materials, and then it takes about two months to meet with investors, and then it takes at least another two months to do follow-up meetings, IR, pitching and investment agreements. So 6 months go by. It’s not uncommon for fundraisers to hit a dead end in the last process. If the company is running out of money and the investor wants to reduce the valuation, the founder has fewer options. It’s not a negotiation, it’s a bite the bullet situation and I’ve seen many founders regret it. So it’s good to be prepared.
A startup that knows the investment cycle will spend six months raising money, and when they’re done, they’ll use the money to refresh and spend three to four months developing the technology and hiring C-level and other talent. Then they’re getting ready for the next round of IR. That’s why it’s so important to have a supportive team. In the early stages, you have to drive the business and do the IR, but the further you go, the harder it is to do that because you get a bottleneck phenomenon in the business and the numbers. So from the Series A round onwards, you need to have C-level talent behind you to help you with the big picture of the business.
How VCs vet companies
Each company’s vetting process is different. Some VCs have a consensus decision, some have a majority vote and some have a few key partners. Just because your company is in the vetting stage doesn’t mean it will be invested in, but the more you communicate with the VC, the more likely it is. So, when you’re communicating with them, you need to look at how they go about vetting startups with a process.
Is it better to choose SI (Strategic Investors) or FI (Financial Investors) for your first fundraising?
Many start-ups consider SI. SI has certain clear advantages and disadvantages. The advantage is that SI investors bet on the investee company and support it strongly, but it can also be a factor that prevents the company from growing. Let’s say a mobility company, A, is approached by T-Map and Kakao Mobility at the same time. What if both companies invest on the condition that they can’t interfere with each other’s services? If you get a strategic investment with such a condition, you are bound. At that point, you need to understand whether the investment company is committed to the deal. This could be a type of investment that prevents competitors from expanding from a well-funded SI perspective. This is the case when the FI invests an ambiguous amount of money that is neither high nor low and limits the company. The FI has to recoup its investment, so it has to contribute to the growth of the company, whether that’s by investing in the next round, but the SI may have other things on its mind. Often the SI investment becomes a bottleneck and it’s difficult for other investors to come in as FIs. They would say, “Since an operator came in as an SI, it’s going to be hard for them to expand to other platforms. It’s not going to be easy for them to do mergers and acquisitions”. Also, if the next round comes and the SI doesn’t come through, that’s a problem in itself.
The SIs don’t tend to agree with the FIs’ investment valuations. If the owner agrees, they’ll go along with the higher valuations. They’ll go along with whatever you call $20 million, $30 million, but they’ll ask you to go with themselves. If you get invested in that way and the valuation is too high, it can make it difficult for FIs to come in for subsequent rounds. It’s frustrating when you need to raise a follow-on round and other SIs and FIs can’t come in, which happens quite often. Or the SI comes in too low and they’re going to help you a lot strategically and they’re going to suggest that you lower your valuation and they come in. This also affects the subsequent valuation, but to a lesser extent than the first.
I think I’ve only highlighted the negative aspects. There are a lot of positive aspects to SI investments. They can fill a lot of the gaps that startups don’t have. SIs basically increase the valuation of the company. It’s also very good for your references to have a strategic investment from a company that has expertise in your field. Having a strategic investment from a large company can help you in future funding rounds.
How much equity dilution per round is good?
It’s always better to have a little bit more money than a little bit less money from the perspective that you’re trying to grow your business. Otherwise you try to avoid too much equity dilution. As I said, you want to keep it below 20% equity dilution per round. Most of what I see is in the 15% to 20% range. A little bit over or a little bit under is also good. If you get to 30% equity, the next round can be tough, so Max, I’d say try to stay around the 20% level and if the investor asks for more, you might be able to discuss a follow-on investment and a bridge or follow-on round with them.
How company valuations affect M&A.
When an M&A proposal comes along, a high valuation can be a negative in the negotiation process. Investors look at exactly how much money they’ve put into the company to see how much it’s going to be worth in the future and how much it’s going to be able to exit and go public (IPO). There’s a big difference between that and the valuation you’ve created in the venture market. The private market valuation is often higher than the public market valuation, and that’s often the hurdle for an IPO. In M&A, it can be harder because they actually see the numbers more.
If a company has invested in a startup at a $30 million valuation and the company decides that an M&A is a better way to grow the company. But the buyer wants to negotiate a $20 million valuation. The management team wants to take that, but the investors won’t just agree to that because it’s a loss if they agree to a lower valuation. That’s where the CEO has to coordinate. You have to negotiate with the approach: “Here is what came in at a $30 million valuation, $3 million, 10-20% equity, and we will accept that equity at a $30 million valuation”. And then you have to negotiate with the early investors for the rest of the value. The two people who have to make the most concessions in this process are management and the largest shareholder. Sometimes the largest shareholder will say, “I’ll give you my stake at a low price, a $10 million valuation,” and then you’ll lose money later.
What if the business plan or business model you discussed with investors during the fundraising process changes after the investment?
In the industry, we like to compare an investment to a marriage. When you’re in a relationship, you really commit to various visions, but then you get married and you don’t fulfil them all. It is not common to go to the extreme of divorcing immediately, but you just have to adjust and adapt to the circumstances and do it again. Investors have been in a lot of marriages, so they know that not all the promises you make in a relationship are going to be fulfilled, so there’s plenty of room to pivot.
There are exceptions, of course, like if you say you’re going to do business in a different market, they’re going to have a hard time with that because they’ve invested in you because they think you’re going to do well in the market you’re targeting and you pivot to something completely different. If you insist on doing that, it’s going to have a negative impact on your relationship with the investor and on future rounds of funding. Otherwise, pivoting is perfectly acceptable as long as it’s done with enough persuasion.
I think it’s fair to say that most successful startups are built on two or three pivots, and some shift the focus of the business to scale the business. But pivoting is fine up to Series A, but it’s hard for later rounds like Series B and C. If you’ve got that kind of funding, you’re a recognisable company, and then all of a sudden you go to a completely different business model, your investors won’t agree or they’ll be confused.
What should be in an investment IR deck?
The essential parts of an IR deck for an early round of funding are first of all the founding motivation: who you are, what your mission and vision is, why you’ve come up with this vision, what problem you’re trying to solve. That’s really important for early stage funding.
Next, you need to spend a lot of time on the market description. I see a lot of market descriptions that just say “here’s the size of the market” and that’s not differentiating and it gives the impression that you don’t know the market. It’s important to show the national and international trends in the market, how big it is, how much it’s growing, etc. It’s also important to show a breakdown of the market landscape, what the markets are made up of. I know there isn’t a certain way of doing it, but it’s important to show the whole market landscape, including the supplier market, the consumer market, the related markets, and where the company is focused in those markets. It is good to use the TAM(Total Addressable Market), SAM(Service Available Market) and SOM(Service Obtainable Market) approach to make it easier to explain, going from the big markets down to the accessible markets. It doesn’t have to be one size fits all, just a clear description of how the market is shaped, what it consists of and who the players are. In particular, describe what your competitors are doing, what you do well, what you lack, what you plan to fill, and what your competitive differentiators are.
The next thing you need to do is describe your customer, and a lot of times in IR decks, you’re very good at describing your products and services, but you’re missing your customer. It’s surprising how often you don’t do that. You usually do some kind of marketing analysis, whether it’s PMF or personas or whatever, but in some way, we need you to summarise who our customers are, what their characteristics are, what they want, what they’ve been using, what we’re trying to replace, what we’re trying to offer them, what the cost (price) is, what the benefit is. Don’t just say “our customers are women in their 30s”, research what their spending habits are, what their income level is, what their lifestyle is and what they respond to.
There should be products and services in your business model. You will also need to write a business model framework and value chain. You’ll need to show what it takes to make your business model work. You’ll need to explain whether it’s through partnerships or internal capabilities, who your suppliers are, what your primary and secondary customers are, where your revenue model comes from, and if you don’t have a revenue model now, how you’re going to grow your revenue lineup. It’s a good idea to diagram this so that you and others can see it at a glance. You can also explain how value is created from a value chain perspective, so if you’re a manufacturer, how do you manufacture, how do you distribute, how do you market, how do you deliver to customers. You’re telling us where you are in the value chain and how you’re going to scale, and that’s what’s going to convince investors.
You also need to identify your core competencies and differentiators. If you don’t, they’ll ask you about them. You need to say what your core competencies and capabilities are compared to other companies. It’s much more convincing if you can back it up with real data, not just assertions.
Once you’ve explained your business well enough, you need to provide a roadmap of what your business is worth in the medium to long term. This is also linked to your financial plan. Your business plan roadmap and how logical your financial plan is will make or break your business plan. You need to be able to support the projections you’re presenting. You’ve got to be able to create data around it and put in a five-year projection and have a business strategy around it. With that you need a financial projection that you can present to investors, even if it’s rough.
IR decks are great with the strategic use of appendices. If you have a lot of stuff in your IR deck, investors can get tired of reading it or lose focus, so it’s a good idea to keep as much detail as possible in the appendix so that when questions come in, they can understand it. When founders get a question, the best startup founders will go straight to the appendix as if they’ve been waiting for a question, then open up the relevant part and explain it. That’s often the end of it, just the Q&A, and the judges will say ‘this company does a lot of IR, so they’re really good at it’ or ‘their IR is perfect’ or whatever. Those companies will inevitably score higher in the judging.
It is impossible to give an exact valuation of a start-up. But there are reasonable guesses.
As I’ve said before, it’s impossible to accurately value a start-up company, but I can tell you how to do it reasonable. I don’t think there’s any ambiguity if you understand the basic valuation framework.
The classic valuation is probably the domain of accountants or PE (Private Equity), and one of them is called DCF (Discounted Cash Flow), where you take future cash flows. You take the future cash flows for 5 years from the current point in time, you put in a growth rate, you put in a discount rate, and you say how much cash flow can this company generate in the future, and you value that at the current point in time. It’s a way of using financial logic to evaluate the future and put a value on it, but it’s very uncertain. It depends a lot on the future projections, the variables that you apply. So, it is used a lot these days as a complementary valuation method to get the valuation that I want.
In practice, several methods of relative valuation are often used when negotiating valuations for start-ups, including PER, EV, PBR and PSR.
Listed companies is valuated by using the price-earnings ratio (PER), which is a number that indicates how many times a company’s current share price is trading relative to its earnings. Companies that are at the end of their growth cycle, such as manufacturers or retailers, tend to have lower PER ratios, while technology companies that have grown recently have very high PER ratios. A similarly popular metric to PER is EV/EBITDA, which measures a company’s ability to generate cash relative to its market capitalisation. EV/EBITDA is often used in M&A and buyout deals with PE firms. It’s the most common valuation method in the M&A market. Then there’s something called D&A. D&A stands for ‘Depreciation and Amortisation’ and is used to depreciate tangible and intangible assets. Put simply, it’s operating cash flow. It’s not about how much profit you make for accounting purposes, it’s about how much operating cash flow comes into the company, and that’s how you come up with a multiple.
EBITDA is operating cash flow, which used to be a big difference because manufacturing companies had a lot of capex, so they’ve already spent all their money on capex, so the operating cash flow has to be good afterwards. EBITDA is what’s mostly used in the M&A market and it’s usually decided in the 6 to 12 times range. If you look at EBITDA multiples in other industries, even if it’s not our industry, it gives you an idea. Different industries have different multiples, but food or retail, even if it’s profitable, it’s around 6 times, usually 8 times, if there’s a little bit of growth, 10 times, and the maximum is 12 times.
PSR (Price Selling Ratio) is also widely used and is usually used for companies that have a lot of sales but don’t have much profit or are in the red. To value these companies, you use sales instead of profits. You take the market capitalisation (share price) and divide it by sales (earnings per share). It’s a classic metric, but it’s also used a lot in startup valuations. There are industries that use PSR a lot, like media, where you have a lot of sales. These are companies that spend a lot of money on marketing to increase their market share, so they’re losing money. It’s very predictable that these companies will be profitable once they don’t have to spend more on marketing, and these types of companies can use PSR to calculate value, like a multiple of sale ratio.
Platform companies don’t have a lot of member transactions as their main BM, so if they’re only valued by PSR, they’re undervalued because they don’t have a proper revenue model attached to them. They’re valued by GMV, which is what platforms and marketplaces do. Coupang is valued by GMV and so are Kurly, MUSINSA, ZIGZAG, BRANDI and other commerce companies. So if you’re a platform or a marketplace, transaction growth is an important KPI.
For companies that don’t have transaction volume, they could try to forecast future transaction volume based on MAUs or memberships and set a valuation based on that. In fact, there is no right answer to the question of how to convince investors. As long as the logic is right, you can negotiate.
Next is the market approach. That is the use of benchmarks. As I said, you look at how much similar and comparable companies, both domestically and internationally, have raised in the same round, at what valuations, and you look at those things and you talk about the valuation of the company relative to the international market versus our market.
There’s also something called the PDR (Price Dream Ratio), which is a bit of a joke in the IPO industry, where you look at how big the company’s dreams are, how big the company’s vision is, and you value that. You shouldn’t just talk about dreams without a plan, you should have a logical plan and say: “We want to be a $10 billion company in the future. Our valuation is really low right now,” and that can be persuasive in some cases.
And then there’s the people-based valuation, where you say “this is how many core developers we have”. You can try a valuation based on core employees. You can say “here’s how much we’re worth with this reference base of core employees” and “we’re worth this much” and that’s not a bad approach.
How to conduct due diligence and audit.
Founders worry a lot about due diligence. The bottom line is that it’s rare for a deal to fall apart because of due diligence issues before round A. I’d say 95% of deals are done before due diligence. Due diligence is about getting on the same page as the investor and seeing what the company is missing. In fact, VCs don’t look too much at financials either, as early-stage startups are invested for growth and marketability. However, you should avoid giving the impression that the company is poorly managed, as this can affect your credibility.
Due diligence is done after or just before you’ve passed the VC review. The cost of due diligence is not high and doesn’t require a lot of resources, usually around $4,000 and the investor will hire an accountant. The due diligence process starts with a request for financials and business documents and based on that the accountants come out for a day or two of on-site due diligence to ask questions and based on the financials you send them they may have more questions or request additional documents and based on that they prepare a due diligence report and share it with the investor and that’s the end of the due diligence process.
Unlike the early stages of M&A due diligence, in later rounds the due diligence report is really important. It can make or break a deal, or adjust the amount of investment or acquisition. If there’s a contingent liability, if there’s an asset of the company that needs to be written down, if there’s a number that’s different from what’s in the IR, there’s a pretty good chance that it’s going to break, that it’s going to be discounted, but it’s not likely to happen until the Series A round. Just know that the further back in the round you go, the more important the due diligence report becomes.
The whole due diligence process should take about two weeks. Early-stage start-ups will usually have outsourced their accounts. It’s a good idea to ask for half-yearly or quarterly accounts at the beginning of the investment round. If you don’t do this in advance, you can need a week or two more of the time. It can also be a problem because of late payments due to closing accounting issues. So if you’re going through an investment round, even if the investor doesn’t ask for it, it’s a good idea to have quarterly or half-yearly accounts in advance. You just say, “We’re in the process of investing, but we need a preliminary set of accounts”. We’ve had cases where we’ve burned through the company’s funds and the CEO has been pulling money from here and there.
Due diligence requests materials for early-stage startups are often basic. Financial statements are not a big part of due diligence for early-stage companies, but if you leave it to a third party, there will be a lot of adjustments due to poor bookkeeping, so it’s better to get a preliminary balance sheet and check it once. If you don’t understand the figures in the accounts, meet with a professional to check them and it will give the impression that you are a well prepared company. When giving figures relating to business information, it is better to give them as they are, without inflating them. It’s better to back up any volatile or eventful figures with a good explanation. Another thing I ask for is the history of stock options.
If you look at the financial statements and you see a lot of suspense receipts, suspense payments, it’s better to ask them to check them out and get rid of them, because it can be seen as an accounting misstatement, and you need to avoid making any transactions like earn-out, branch payments, and you also need to avoid issuing stock options without an internal policy, but it’s not a big deal if you do it after the fact.
Also, if you have inventory like a commerce company, it’s important to have an inventory receipts and payments daily to see the cost of goods. There are many cases where this is missing or inconsistent, and it needs to be sorted out. A lot of start-ups treat it as a development expense or as an intangible asset, but it’s quite possible that it will be written off in the future when the accounts are audited, so be careful because it can be written off in a couple of years and come as a big expense all of a sudden.
Types of investment contracts
Firstly, common stock is just stock – it’s not convertible, it’s not redeemable, and if the company goes under, it’s just a piece of paper.
Then there’s redeemable convertible preferred stock, which is what VCs invest in the most. They’re ordinary shares with two options attached, a conversion right and a redemption right. The conversion right is the right to convert into ordinary shares, which doesn’t mean much. It’s the redemption right that matters, which is the nature of the debt. The contract says: “You have the right to be redeemed three years after your investment”. You may be wondering what the difference is between a redemption right and a conversion right. A redeemable convertible preference share is only redeemable if the company makes money. If the company is not making money or has no retained earnings, it cannot be redeemed. Even if the company redeems it arbitrarily, it is invalid. Since it is a legal issue, it is impossible to redeem if there are no retained earnings.
However, there may be situations in the future where the investment contract is violated and redemption is required as a penalty, which requires legal interpretation. If there is a profit and the investor exercises his rights later, he can redeem at a reasonable rate of interest.
Under normal corporate accounting standards, the investment is all equity, but then you have to switch to IFRS (International Financial Reporting Standards) to go public, and then the investment become a liability. That’s when you get a lot of derivative liabilities, and that’s when you get a lot of valuation losses, and that’s when you delay your IPO plans. If you go public later, you can ask your investors to convert it in advance. Convertible bonds are accounted for as debt, but you have the right to convert them into equity.
The main difference between convertible preferred stock (CPS) and redeemable convertible preferred stock (RCPS) is whether it has a conversion right. Convertible preference shares are very similar to ordinary shares.
Key rights of preference shares
Preference shares have redemption rights and preferential dividend rights. The redemption rate is sometimes simple and sometimes compounded. It used to be 12%, but it would be good to know what the normal level is. Recently, the most common is around 6%, so if it is above 6% and goes to 10%, you can ask the investor: “The interest rate is high. Can I have a simple interest rate?” You can ask the investment company to discuss this. The payback period is three years, but the longer the payback period the better. A conversion right is literally the right to convert. There’s something called a refixing clause that you need to look out for.
Investment Agreement Key Checkpoints
Make sure you have a clear understanding of what’s in the investment agreement. Decide from the first valuation discussion whether you want to go pre-money or post-money. Some founders are surprised when the valuation in the agreement differs from the valuation they discussed. Most stock option pools are set at 10% and issued at market value. However, venture capital firms may grant them at a lower price.
Look out for restrictions on how you can use the investment. Because if you break them, there’s a right of recourse, you’ve got a claim and you’re in legal trouble, regardless of the retained profits. In fact, we had an investor come in and sue us for breach of contract, including the use of the funds, and they won, and they got their money first, and the company had a hard time raising money, which made it even harder. So it’s important to keep your word about how the money will be used. Representations and warranties are also a prerequisite for investment support, and they’re important because if they’re not met, the investment can be broken.
Then there are a lot of sanctions, such as prohibitions on shareholders selling shares or leaving the company, prohibitions on them having a second job, and you need to respond well if a co-founder or key member leaves the company. So you need to negotiate the specific terms of that sanction well. If you look at some contracts, the penalty is sometimes $1 million. It’s best not to have a penalty, but I think it’s better to have a general level of less than $500,000. It can act as a poison pill.
And in the contract there are rights such as the investor’s right of first refusal (ROFR), the right to demand a halt to the sale and the right to buy shares. These are inherent rights of the investor, so I think it’s pretty standard.
The next thing to look for is a refixing clause. It allows investors to reprice by reducing the conversion price or the purchase price together if the share price goes down, so if the valuation is lower than what the investors invested in, you get more shares and adjust the conversion price to get your equity. That’s fine if it’s in there, but if the company increases the valuation based on earnings or revenue targets, it’s not recognised because of the refixing clause. If there’s a covenant like that, if you can take it out, take it out. I don’t see a lot of investors asking for it anymore, but it can be a toxic clause, so it’s worth checking.
Get an NDA and a term sheet before you get any investment.
As a start-up, you have two rights. First, you can insist on an NDA (non-disclosure agreement) if you are being considered for investment. This is to ensure that our internal materials, such as our IR deck, don’t end up in the hands of competitors or other investors. Investors do business in networks and people who know each other will share materials without realising it.
You can also ask for a term sheet, which is an agreement outlining the key terms of the investment. The right time to ask for this is before or after Investment IR. You can look at the term sheet with the key terms, make sure it’s OK, agree to the terms and then go through the rest of the process. If there’s anything in the deal that’s additional or that you’re not sure about in the term sheet, you should raise an objection right away. Most startups raising Series B, C or higher rounds will ask for a term sheet as standard.
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