PPT Break Even and Startups v1 051815

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THE EFFECT ON STARTUPS OF THE PRIVATE EQUITY

APPROACH A few thoughts on why the private equity approach

might not work for (most) tech startups

JAMES C. ROBERTS III

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GLOBAL CAPITAL STRATEGIC GROUP | GLOBAL CAPITAL LAW GROUP PC

2Q15

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WHY THIS PRESENTATION?

In Europe, some VCs come from private equity funds and apply PE metrics to startup investments.

Why is that (potentially) toxic to startups?

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CAVEATS

1.  The argument is general—and based on generalizations and simplistic characterizations of private equity and venture capital.

2.  There are many counter-examples. 3.  Different tools for different tasks, i.e.,

private equity works in certain environments where VCs could fail—and vice versa.

4.  This argument is neither right nor wrong—just trying to look at structural differences and, from experience, some consequences.

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PRIVATE EQUITY FUNDS

Private equity funds acquire: 1.  existing assets with a track record 2.  that are under-valued and/or 3.  that can be operated with greater

efficiency And manage them so that the assets:

1.  Make money or 2.  Stop losing money

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ENHANCING ASSET VALUE

Both private equity and venture capital funds want to enhance asset value and monetize the increase but . . .

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PRIVATE EQUITY FUNDS

PE funds enhance asset value by increasing margins. . .

in a (relatively) short term with a break-even milestone followed by early &

healthy EBITDA or FCF

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MARGINS EXPAND . . .

. . .by increasing revenues or lowering costs or both

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BREAK EVEN=LOWERING COSTS

In the absence of substantial revenue growth opportunities, lowering costs often means reducing investment

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PRIVATE EQUITY FUNDS ARE SANE

Every business school class has taught us that:

1.  Companies are supposed to make a profit

2.  Good management makes more profit.

Nothing wrong with that approach.

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TODAY’S ASSET VALUE

Not all of these high-value companies make/made a profit (or EBITDA) Twitter

Pinterest Instagram* Magic Leap

Uber Square SnapChat Cloudera

*OK, so it’s now part of Facebook

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VENTURE CAPITAL FUNDS

Venture capital funds invest in: •  New assets •  In either new markets or ones that (they

think) can be disrupted •  Where value comes from growth in

market penetration (rather than efficiency)

•  In global markets (digital access) •  Using metrics other than EBITDA, etc.—

mainly traffic (B2C), market penetration (B2B)

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SCALING INCREASES VALUE

VCs need startups to “scale” fast per relevant metrics—i.e., rapidly gain traffic (users/visitors) or sign B2B (e.g., enterprise) contracts

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STARTUPS MARKETS ARE (OFTEN) DIFFICULT FOR REVENUE GROWTH

New markets might have no or low revenues

or New(ish) markets have high growth rates demand substantial investment

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DIGITAL STARTUPS DIFFER

Startups use little money to test the concept and then a LOT of money to “scale up” in markets where revenue is difficult to acquire.

“Scaling”=growing marker penetration

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SERIES B IS FOR SCALING Series B: Scaling the business. Purpose: The Series B is typically all about scaling. You have traction with users, and typically you also have a business model that has come together. If your user traction is out of control, sometimes you can raise a Series B without an existing business model, as most VCs assume you can eventually monetize large #s of eyeballs.

–  Scale your business model. You need to hire a bunch of ads sales people, enterprise sales people, or the like

–  Scale your userbase. You have a great business in the US and want to go after Europe.

–  Make acquisitions. Sometimes a Series B is raised to buy other companies.

Amounts: Anywhere from seven million to tens of millions.* *This slide is an excerpt from http://blog.eladgil.com/2011/03/how-funding-rounds-differ-seed-series.html

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VALUE IN POSITION

VCs may position their startups to earn substantial revenues once they arrive in a market (e.g., mobile advertising, ERP)

Grabbing market share=positioning

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STARTUPS & BREAK-EVEN

With no revenue in a new market or massive investment required, how can a startup reach break-even? •  (Usually) no or little revenue •  Costs are many multiples of revenue •  Costs are investments—tech platform,

sales team, marketing

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STARTUPS BREAK EVEN BY CUTTING COSTS

But if costs are investments to scale, how will cutting costs lead to revenue increase or break-even?

Well, it can, if there are some revenues

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AND THE COMPETITION?

What if the competition has received the funding to scale—to position itself by grabbing market share? The startup trying to break even on a low

revenue basis and in a market where revenue requires investment is in a

challenging position

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SO WHAT?

Startups typically need a lot of Series B funding (the scaling phase) that they will lose quickly to gain market share

Or they will lose against better-funded competitors

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STARTUPS NEED TO SPEND Expecting a startup to achieve break-even prior to Series B funding is to undermine its success and potential:

•  It has proven its model, technology & market •  It needs investment to build market share

Every Euro taken from costs to achieve break-even is a Euro taken from investment that can be used to establish critical market presence

. . .And market presence is what leads to revenue.

PPT Break Even and Startups v1 051815

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