The other fact everyone knows is that the general investment climate at this time is one of fear. Investing, which includes VC, is a pendulum that swings aperiodically between greed and fear. We are in a prolonged period of fear. It is a fear of calamitous losses resulting from any investment, and especially illiquid investments like those in technology start-ups.
I wish the environment were better since the technology sector in Ottawa is moribund with no obvious signs of improvement in the foreseeable future. Money is the fuel that will light that fire, but it is staying put under investors' mattresses. What I want to talk about in this post is why that money is not seeing the light of day. I think it is better to understand what's driving this behaviour rather than reading more articles about how awful things are, or about the new models of investing that are nothing more than ways for investors to reign in their risk.
Investing of any sort, which naturally includes VC, is all about making money. Forget the mushy words about how investors' purported enthusiasm for telecom (or Web 3.0, mobile, clean tech, etc, etc). While often true it is irrelevant. Pleasant feelings may drive their interest in playing the VC game, and this includes angels, it remains (always always always) about the money. If they don't see the prospects of a substantial return the money stays under the mattress.
Now we can look at how they determine the prospects for a beneficial financial outcome. For the moment let's gloss over their due diligence of prospective start-ups; we'll assume the company is good to go so that is not at issue. We will also assume the VC has a portfolio of companies so the usual start-up attrition rate is taken into account.
The way I would then summarize the thinking of a VC is as follows:
The valuation at exit 'x' must exceed the valuation at investment by some factor 'y', and the exit must happen within 'z' years.Take these numbers and the start-up attrition rate, do some rudimentary actuarial calculations and you get an expected rate of return. Simple, isn't it? Except of course for knowing the values of x, y and z. And there's the rub.
If you don't know the exit parameters it is not possible to come up with an acceptable post-money valuation. Forget all those fancy algorithms and charts that depend on rigourous scientific and market analysis to come up with a number. It's almost entirely a wasted effort. Of course it sounds good to the company making the pitch ("our company will be worth $500 million in 3 years based on our business plan and industry valuation metrics..."). Now go sit on the other side of the table. That isn't the sort of talk that pries money out of their hands, and especially not for angels who you are asking to part with their own money rather than money from a fund being managed for their limited partners.
What will instead impress them is industry comparables (or simply, comps). These are ongoing exits of other companies that are operating in the same space as the prospective start-up. Those companies don't have to be identical to yours, just close enough to make the comparison meaningful. Let's say your start-up makes widgets. You have competitors who also make widgets (except that your widgets are superior). Several of them were acquired or did an IPO in the past 6 months and their valuations at exit ranged between $300 and $450 million. You make better widgets, you have delivered prototypes to customers and they even like your prototypes better than the other guys' widgets (guys who just got bought out for $375 million).
Now you have the investor's complete attention. Their next question should be something like, "if you get the money you're looking for how many widgets can you produce by next Christmas?" Give a good answer and they'll offer you twice the amount you want. They see the exit possibilities and want to strike quickly while the iron is hot; widgets could fall out of favour next year. So you negotiate and end up doing the deal and go on to fame and fortune.
Except that back here in the real world there are no IPOs or acquisitions of companies making widgets. In fact, while the market for widgets is healthy it really isn't growing much if at all. So no comps. No comps, so no exit prospects or any way to judge exit valuation. The money stays under the mattress and customers make do with today's batch of widgets.
Perhaps a very aggressive investor will offer some money for a disproportionate fraction of the company (i.e. low post-money valuation) to allow you to make a superior but far less featured widget by the Christmas after next, in the hope that the environment will eventually improve and offer an exit. Sure the exit valuation may be depressed, but since the post-money valuation is kept very low there is still a prospect for an outsized return, and if you flame out, well, at least the investment wasn't large.
So that's how to know the investment environment in Ottawa is improving - when the pace of technology exits picks up, if it picks up again. If you cannot wait you should do what others are doing, which is to build their businesses with little or no investment capital. It is especially doable for software products and services. Or, you can follow the money to a sector that does have better exit possibilities, like clean tech.
There are strategies for entrepreneurs to follow that don't involve waiting for the world to change. Patience is not a virtue since the wait could be very long.
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