Yash Patel, GP at Telstra Ventures, speaks with Shawn Flynn, Principal of Global Capital Markets, about what founders should think when they’re facing a possible down round, why founders shouldn’t rely on investors for a bridge round, how can VCs attract the best investments, what happens to a fund when they start winning logos of known companies, and much more.
When you move into venture capital, I think the skills that are helpful are not just around technical analysis of companies, but around reading people because ultimately we’re investing in people. So it’s about relationships and networking.
I’d say interpersonal relationships, networking are key, right? When we have our own LP investment, looking at investing in us, they want to understand that we have a prior mode which is effectively our network, right? And we can not only find great entrepreneurs, but we can quickly find great companies by checking in with a few other experts in our network. But I’d say that’s pretty critical for anyone in the venture capital space.
But many times it’s a referral from an existing investor that we’ve co-invested with deals within the past or an entrepreneur in our portfolio who tends to see a lot of interesting deals. And so LPs get very granular around attribution there. They want to understand how many of your deals have actually been sourced through a network or cold outreach.
In an increasingly more competitive VC environment, it was very important to also have allies and other co-investors. And that’s effectively your network. They’ll value your network based on how well your deals have done. It’s a pretty selective process. And for us to get conviction, we need to have a strong network of experts and other co investors, we feel comfortable partnering with.
We try to think on our own two feet, and we look at more of the kind of validation that the specific partner at maybe a larger fund who’s led the deal, it gives us more confidence that they understand this space. We do a lot of primary diligence, but we also take in other signals like a founder’s background, who are the other co-investors on the cap table, to understand how in-depth they are in a particular domain that the startup is operating in.
If you’re a founder and you have less than a year’s worth of cash runway, you really need to think about several options to basically ensure that you have at least 18-24 months of cash runaway. A lot of times that’s maybe through a down round with the existing investors or even new investors. We’ve seen some high profile down rounds recently like Tonal, the tech-enabled fitness company, which did a down around 90% of its valuation. That’s probably a bit more extreme. But then you also see structured rounds, right where you see capital being raised at terms that might not be ideal for existing investors, or existing founders who hold common stock and are last on the liquidation preference. You also have alternatives around venture debt.
There’s other banks out there like First Republic, that continue to play a big part of the ecosystem in terms of underwriting venture debt for some of these fast-growing startups that might be losing cash early on.
If you’re an entrepreneur, the one thing that I always advise is, think about your founder stock, your early employees stock and your common stock, because you’re last on the liquidation preference. And so if things go somewhat sour you’re not gonna get paid out anything, and your latest investors that are at the top of the liquidation preference, the preference investors, are gonna get whatever is left. To avoid that, I recommend doing more vanilla deals that are more down rounds. So the only thing you’re really changing is the valuation, but you don’t have like a 2x liquidation preference for new money coming in, or you don’t have some special warrant coverage or some sort of way of diluting existing investors more than need be.
I’d say at the earlier stages, at the A B and C, you have a few more options in terms of funding and for those existing investors, it’s important to, for those that are considering giving out these “predatory term” sheets. It’s important to consider your reputation because it’s everything, not just with your founding team and the employees, and the key management of a startup that you’d like to invest in, but other co-investors because your network in general is one of your biggest moats as an investor. So if you are giving too many predatory term sheets and really trying to squeeze these companies unfairly, you’ll get a pretty bad reputation and I don’t think you’ll last too long.
We think venture is absolutely a people-first game both on the entrepreneurs we are investing in, but also the co-investors that we partner with. And that’s not to say that we don’t use a lot of data and we have a data science team internally as well as look at a lot of quantitative metrics and KPIS to get conviction.
I think it’s really important to look at covenants. They can be revenue based milestones. They very much vary. My personal preference is you never want to put too much debt on a startup at the earlier stages. But there’s definitely a place for debt as you scale and really it’s pouring more gas in the fire for companies doing really well. The structured rounds and the mezzanine rounds, I’d say they’re more appropriate for later stage companies.
And typically what you see there is usually it’s moving up from a 1X liquidation preference to 1.5 or up to 2X based on certain milestones. And that may be appropriate for certain companies to say for early stage companies. I really avoid that. I’d almost put that in the predatory kind of category. If somebody is coming in with 23 X liquidation preferences for a series A company, there’s got to be other sources of financing and then you’ve got revenue-based financing. A lot of people will engage with that. I mean, the challenge with that is you’re giving up a piece of your revenue every time a transaction happens or if you’re a company, you’ve got to purchase a subscription you sell.
A new source of financing was just announced by a venture fund called General Catalyst. They’ve launched a fund that will fund all sales and marketing for a company and the company only needs to pay it back until they get a 1X or 1.1X or something like that. And I think it’s a really interesting way to basically manage your sales and marketing costs which can get out of control. And instead of raising a lot of equity or sales and marketing, you’re doing this in a way that is more controlled.
One, we try to be thematic about the sectors we’re looking at and then two, we try to incorporate data science into how we’re actually reducing that top of funnel down to maybe three companies in a sector. We have our own internal algorithms that we use to score companies pretty quickly. And so in terms of outbound prospecting, that’s really important. Next comes the thematic kind of work that we do with our network referrals from co investors.
There’s four things, one is a great team and you’ve got to have assembled a great founding team with great experience and ideally previous kind of leadership experience that has resulted in a good outcome. Number two is a product market fit, but then also an inflecting kind of point where if you’re at 400K ARR , we can actually see that based on this pipeline of great logos that you’ve got, you’re probably going to hit a 5X year on your return. That’s where we prospect from primarily right now. Number three, there’s got to be some sort of change event or tail tailwind that we can see this company riding on. And as an example right now, I’d say there’s a lot of tailwind and generative AI with open AI making a lot of these foundational models accessible to anyone.
I’d say diligence should be welcomed by founders because you can learn a lot about what’s working in business and where you need to improve, not just on finance and accounting, but we look at like the actual code base, we look at the technical infrastructure and we have a tech consultants that will make recommendations and they can be invaluable further down the line.
We’ve been fortunate to have some great logos like Snapchat, Docusign, Crowdstrike and the cyber security side or Box, GitLab more recently, which went public. These logos give a lot of credibility, not just to other entrepreneurs, but especially to our LPs so ultimately, everyone wants to see a company that they invest in, see a nice trade sale or IPO, and it generates confidence that if we have a good track record of getting these companies from SERIES A to IPO and seeing a good outcome there that we can actually do this in a reputable way. So, logos are absolutely critical, just like a logo would be critical as a case study for an enterprise software company.
