Tech Uncensored - An Altitude Accelerator Podcast

[00:00:02.890] - Hessie Jones

Hello. Today on Tech Uncensored, we are deconstructing the myths in investing for early stage founders. Welcome. My name is Hessie Jones. What an investor wants is not always aligned with what founders expect, especially in how they appeal to investors. There is a gap between what investors expect and what founders believe when it comes to funding, and it's often attributed to disparity in goals and perspectives between the two parties. So investors are primarily focused on maximizing returns on their investment and also managing risks, while founders are emotionally attached to many of their ideas and prioritize growth and innovation of their companies. So there is this gap that can lead to some misalignment and expectations. And founders may not always have a complete understanding of investors decision making processes, their criteria. So regardless of their own confidence in being able to develop a unique value to the market, it may not necessarily conform always to these elements for which they're being judged. So especially now, in this time of inflation, we have uncertainty, we have rising interest rates, we have conditions that increase the cost of capital, which may in turn result in down rounds for startups. And this ultimately influences a shift towards safer investments for many of these people within the investment community. So while environment plays a key role in determining whether a company is funded, there are many other factors as well. So I'm pleased to welcome today two seasoned investors here in the startup space, Karen Grant. Thank you for coming. Karen has been involved in early stage investing since the 1990s after a twelve year career in IBM. So it looks like you've been in technology forever. She has launched four angel investor groups. She's operated a business incubator and a commercialization center for the University of Toronto, and has been a founder, investor, and director for a number of technology companies. David Wright has spent his career supporting technology enhanced high growth companies, and he provides capital markets, corporate finance, and valuation advisory services through capital advisors. He's also a mentor for a few of Ontario's regional innovation centers, was an equity research analyst, investment banker, and an executive director of an angel network. So both Karen and David will actually help us develop a better understanding of what matters to investors and help us deconstruct the myths in startup investing, especially in today's climate. And I think we're going to have fun on this one. So, welcome to you both.

[00:02:58.570] - David Wright

Good day. Pleased to be here.

[00:03:00.680] - Hessie Jones

Thank you. So, let's start with David. You were an equity analyst. You're the guy who I'm going to point to to tell us about what's happening in the current environment and the overall, I guess, readiness of VCs to invest in startups today. So can you talk about these market conditions and what does it imply for startup investing?

[00:03:26.350] - David Wright

Sure. And very sorry to start out on a negative note, but I think the glory days of the VC era are behind us. So first thing to think about is that interest rates and valuation multiples work in opposite directions, right? So when interest rates go up, valuation multiples come down. If you look at the performance of VC funds over the last 40 years, the best years were in the mid to late nineties, and that was a period where interest rates had been high. So that puts pressure on valuations. When the VCs are investing into companies and startups, the valuations are contracted and then interest rates fell through the so the valuation multiples expand. So they got in when valuations were crunched and out when they expanded. And that was fantastic. And over time, the average returns from VCs has actually, over the last 40 years, only been about 9%. And that's equivalent to what you can get in the public markets. So, in fact, to invest, the VCs returns are not paying up for the fact that when you invest privately, there's risks and you don't have liquidity and things like that. So you would normally expect to see a higher return or should get a higher return than what the public market is giving now, looking a little bit deeper, that's the average returns over the last 40 years, if you actually looked at the median return. So the middle of all the returns of the funds over the last number of years, the median return is only 1.8%. So what that's telling you is that a very few number of VCs got very high returns, but most have really underperformed. And so that sets up conditions that says that if investors are looking for excess returns, chances are you're not getting it in the VC industry. What about today? Well, if you look at the last ten years, we've had the lowest interest rates in modern history. And so anyone that's already invested has probably invested at high valuation rates. Now, interest rates have just recently spiked, so they're going up. So that's going to push down the valuation multiples. So it creates an environment that's kind of going to make it difficult for someone to get an excess return because they will have invested at a higher level. Certainly a company's valuation can go up over time because they've grown the company, but the multiples that you're going to put on the valuation are probably going to contract.

[00:06:19.290] - Hessie Jones

Okay, thank you. So, Karen, based on what David has said, from your perspective and what you've seen probably in the last year of volatility in investing, what has been your sense or even confidence level about investing in this climate as an investor?

[00:06:43.330] - Karen Grant

I think that certainly within the group of investors that I know, they've been being very careful. They're seriously analyzing the opportunities. And I think for founders, it's difficult too, because they are looking for investors that are prepared to take high risk. Investors over the last, we'll call it ten years, have not seen the kind of returns that they'd hoped for. And so you've got this perfect storm where you've still got founders that are trying to raise money and they're doing it earlier and earlier. So they're being taught through various mechanisms that they should be funding their entrepreneurial initiatives on other people's money. And then you've got investors that have not seen the returns any more than the VCs have, and so they're becoming a little more cautious. I don't want to use the term risk-adverse because they're prepared to take risks, but they're not prepared to take the leap of faith that perhaps they used to.

[00:08:00.570] - Hessie Jones

Okay, so that leads us into the next topic of pre-seed investing. Because, Karen, I know you have very strong views about pre-seed, so what I'd like you to do first is let's define what pre-seed investing is and maybe just comparison to the later stages and what does it mean for the founder from the perspective of stage, product readiness, evaluation, et cetera?

[00:08:30.050] - Karen Grant

Well, pre-seed, yes, I do feel strongly about, but let's see if we come to an agreement. So pre-seed is very little is in place for the company, so they may have an idea. Their IP isn't protected, they don't have product market fit yet there's no evidence that the market will accept their product and the team may or may not have any experience, mostly won't. So pre-seed would typically be something that would come from friends and family. So these are people that know the founders that are prepared to give them some money to give them a chance to get their thing going. But you rarely find professional investors, venture capitalists, family offices, et cetera, going into a pre-seed opportunity.

[00:09:26.950] - Hessie Jones

Now, can I ask, is there a difference for, let's say, angel investors versus VCs at the pre-seed level?

[00:09:37.370] - David Wright

Usually the valuations are so small for a company that a VC wouldn't be involved in pre-seed normally because the levels.

[00:09:47.860] - Karen Grant

Would be high too.

[00:09:48.890] - David Wright

Yeah, much higher as well. So normally a VC probably has a large pool of money. So if they have, let's say, $100 million, their minimum investment is going to be about two and a half million dollars. So if a company is only worth $5 million, they're not looking to sell half the company. So normally it's angels that are in the pre-seed area if they're involved. And as Karen has defined, the pre-seed as the company is basically an idea, really. It's not quite into a business yet, right? It's a concept, it's people, they're looking to define the company. It's when it becomes a business where you have customers and revenues, then that's where someone can value it based on the customers and the revenues and the market size and eventually the earnings and cash flow of the company. So this pre-seed area is really friends and family who are betting on the people because they've known them for years. And then is there an interim stage, which is an investor, which is an angel who's really a stranger looking to invest on the hopes that there will be a business here.

[00:11:02.390] - Hessie Jones

Okay.

[00:11:02.860] - Karen Grant

The other thing that's evolved for pre-seed are these quasi-governmental investment funds and kind of sidecar funds. So there are groups that are forum that will invest alongside of a group of angel investors. They don't do a lot of valuation, they just ride the coattails, if you will, of the group of angel investors. But these quasi-governmental funds are really there, and they come from Ontario Centers of Excellence, for instance, mars has a number that are under their management. The Graphite Fund now started out as a pre-seed investment fund when it was IAF. So there are those funds, and they will co invest on the same terms with a group of private capital investors, angel investors. And so that's what I'm seeing more in that pre-seed stage, because these funds are typically specialists in a given area, and so they've got the knowledge. They are doing kind of almost quasi-economic development efforts to help these entrepreneurs get into the marketplace. So they'll come in very early, they'll take that gamble, and they'll be prepared to take some losses, but they're there to help fuel the economy as well as make a return on their investment.

[00:12:39.090] - Hessie Jones

So what do you think has changed from, let's say, 1520 years ago when investors wanted to put money into companies, versus the investor mindset today, especially at this early stage? I know you've said to me that maybe investors are not as vested, they're not helping as much. Can you expand on that?

[00:13:07.290] - Karen Grant

I've watched over time in the investment world how the average check size has diminished down to $25,000. And there are even some groups in an effort to try to get more people involved in this asset class that are encouraging, well, encouraging even smaller investments. So it's almost a spray and pray strategy where I've got to throw in $5,000 into 25 different companies and hopefully I'll get a return out of that. But for these high net-worth individuals, and they have to be to qualify as accredited investors, it's easy to walk away from $5,000 to $10,000 dollars, even $25,000 dollars. It might impact a trip one year, but it's not going to hurt them. They're accredited. They can afford to lose the money. That's kind of the acid test that the government's looking for. For accredited investors. If it's easy to throw your money in and not get involved because you're too busy or you don't have anything to contribute to the company or you've moved on to another project, then the companies aren't getting the benefit of the funding and industry knowledge, business knowledge, to coach that company through and help them not just survive, but also thrive and grow. So if it's just what we reverently would call dumb money, it doesn't help the entrepreneurs. It's just cash that they're going to burn through and maybe not in the most efficient way.

[00:14:57.860] - Hessie Jones

Right.

[00:14:59.150] - David Wright

And I'd say that two things that have changed is so if you put $25,000 into a company and you lose it, and you put another $25,000 in and you lose it, how many times are you going to come back? Right? So if the sector has not been providing decent returns, then people eventually are going to walk away. And there's always a new group, a new cohort that's coming in with money. But if the sector is not expanding, then they're not coming back. But the other change that you can look at is interest rates, right? Ten years ago we had negative interest rates. The government was guaranteeing that if I bought $100 fund, I would get $95 back in five years. So that says, jeez, I might as well risk because there's no cost to it. Whereas today I can get 5% opportunity cost, I can get 5% of cash return on my cash in the bank account. So now if I'm going to risk the money, you got to give me a better return than that. I might be better off just sitting doing nothing. So there's an opportunity cost that exists today that wasn't there ten years ago.

[00:16:09.720] - Karen Grant

David and I have both managed angel groups and if I had a nickel for every time that one of our members said, I've invested in four, seven companies and I'm not going to invest anymore until I get a return. So they're taken out of and to David's point, historically well, recently, they're not getting those returns. And so we've been seeing members, angel investors that are part of groups, they either age out, they actually hit a point in their lives where it just doesn't make sense to make new investments that may take ten years before they see the return. They don't want to be dealing with it at 80, 85, 90 years old or they've put in all of their play money and now they're waiting.

[00:17:06.250] - Hessie Jones

Okay, let's move on, because I think that's an important consideration for many of the early-stage startups, especially even choosing who the right investor is, then maybe they should target better. So let's get into a myth. Getting funding guarantees success. So I read this in an article earlier where somebody said, venture capital is a hell of a drug. And more often the question investors hear is, how do I get a VC to back my startup? So these founders could be scrambling to get anyone to actually be the first one to sign their term sheet. And there's this widespread belief among founders that venture capital is really a precursor to success. So Karen, I want you to respond to this because I guess even in my limited experience, I've seen many early stage startups who have caught on to this, I guess VC drug, and they have a lot of money, they don't know what to do with it. What has been your experience?

[00:18:14.140] - Karen Grant

Yeah, I don't think anybody deliberately starts off with maybe not being as cautious with this cash as they need to be, but they'll start hiring people and they'll start paying more for those people than maybe they should have. Maybe I can't tell you how many times I've seen a company raise money and then they go and hire a bunch of their friends who aren't necessarily qualified for the work. And they seem to lose sight of the fact that the investors are expecting them to not just return the funds, but also return a return on those funds. And so again, it's just this misalignment. And then lastly, they've completely forgotten the fact that the reason they raise the money is to help them make more sales, which creates increased value in the company and allows them to eventually provide a return to their investors. So raising money, every time I see a company celebrate that they've raised money because it is hard, it's very hard work raising money, but they're celebrating the wrong thing. They should be celebrating every time they break a million in their revenue stream. So that's my two cents on that.

[00:19:44.010] - Hessie Jones

I want David to come in here because now it seems like when you get that first bout of funding then I guess the hard part starts because from my perspective, and I remember getting funding in one of my old companies, you get lots of calls from investors. So can you kind of break down? What are the expectations that start to befall the founder from an investment perspective?

[00:20:11.310] - David Wright

Sure. Well, it's no longer a hobby, right? You're not just creating a company for fund in this idea, it's now become a business. So investors are looking for a return. They could put it in the bank account and get 5% back or they could put it in the stock market and over time get 10% return. So they're taking more risk and they're looking for a better return out of this. So that means you've got to perform. So you've got to use the money to build your milestones, grow your customer base, grow your revenues, get to profitability at some point in time, or cash flow positive anyways. So that's what you have to keep focused on. It's almost like the most common mistake is that a CEO goes after too many markets, they've got all this money, so they say oh, we've got the opportunity in five different marketplaces and they spend the money and they don't get the cash flow positive in any one of the five markets and they run out of money. So it's almost like you gave them rope to hang themselves. So it'd be better off if they were really constrained financially and said we can only do one thing, let's get that market to cash flow positive and then use the funds to get to the next market. And if we have the opportunity, raise more money to get to that market in the next one. But do it one at a time because the expectations are you got to get a return and perform with the investment.

[00:21:43.010] - Hessie Jones

I know in my experience that funds that have been promised to startups get deployed at different times. And so from that perspective, there is almost like this forced budgeting that a startup has to go through in order to and maybe but by the time they've exhausted, those funds met a specific set of milestones, then the next tranche happens. Is that typically how it works today?

[00:22:07.290] - David Wright

With angel investing? No, because you do a round and angel investors put their money in on that round. With VCs, actually, with the way VCs raise money, if they're raising a pool of $100 million for a fund, what they might do is they actually only get access to maybe 30 million to deploy the first amount of money into companies. And then how that follows into the companies is they might say to a company, I will do my first investment with you, but I'm hoping to put $10 million in you over time on multiple rounds. So I might put $2 million in the first time I invest with you. And then the next round I'm putting $5 million in and I'm saving $3 million in case you hit a wall somewhere and you really need it. So that's how the funds go in there.

[00:22:58.810] - Hessie Jones

Okay, so let's shift gears because there are those that actually want to conserve, I guess, investment for a later time. So let's talk about bootstrapping. Karen, can you tell me about the importance of bootstrapping for a founder at this early?

[00:23:20.750] - Karen Grant

You know, there used to be an old saying, the best source of capital I sales and because it does two things, it keeps your staff fed and watered and it adds value to the company at the same time. So it's a beautiful double whammy you're establishing yourself. Let's say you take the strategy that David just outlined, which is you're going to focus on one market. So I'm going to successfully penetrate, let's call it the Quebec market with XYZ, and I'm going to hit all my sales targets. So I'm going to let potential future investors watch my performance. Over time, they can gain confidence that I know how to forecast, I can deliver on my plan, I can hit my milestones, and I can increase the value of my company while they're watching. Then I'll go and talk to them about money. And under those circumstances, the founders have a much easier job of raising the money that they're looking for because they've demonstrated their reliability through bootstrapping, of capturing even a small market. But that's a huge success. And then when they say, okay, so we've captured Quebec, now we're going to go after Western Canada, and then the year after that we're going to start penetrating into the US. And here's our plan. And investors are very happy to see that sort of thing because they've got evidence that this team knows what they're doing, that the marketplace is accepting their product and therefore it takes the risk. It starts lowering that company's risk profile with the investor.

[00:25:13.760] - Hessie Jones

Okay, so when would be, I would say the optimal time to stop bootstrapping? Because there's a point where things your risks could be higher from a market perspective. Can you talk about some of those areas where bootstrapping is no longer needed?

[00:25:34.970] - Karen Grant

There's no question that as you start gaining traction in the marketplace, you're watching what's going on with competitors. And there may come a tipping point where if you could accelerate your entry into the marketplace, you could maybe capture more of that marketplace. And again, that's an attractive gamble for a venture capitalist institutional funder than a company that doesn't have any of that right. And they can see that with this much money. It will help accelerate this company into that size market, which is going to create these kinds of returns. And that kind of profitability just changes the entire profile of the company.

[00:26:29.470] - Hessie Jones

Yeah.

[00:26:31.050] - David Wright

I could use Karen's example here. And let's say you're an Ontario-based company and you've decided to go into Quebec, and in order to expand into the Quebec market, let's just say you need a million dollars. It's going to cost you a million dollars and you're generating that out of your Ontario business. So you generate the million dollars that allows you to expand into Quebec. Now you're a bigger company, so you're generating $2 million, and that now allows you to go to out west and capture that market. And when you get to the point where you're generating $5 million, you can go into the US. So that's the internal generation and the bootstrapping. Now what if as you're going into the Quebec market, you suddenly realize that a competitor is taking over the US. Market and you have to go now in order to capture the US. Market? That's where you would say, okay, bootstrapping is not going to get me where I need to go, because if I then go Out West and build my company, by the time I get to the US. Two years from now, there's going to be too much competition. So that's where you turn to external funds and raise external capital to be able to go into the US. Market right away and boost your valuation.

[00:27:46.170] - Hessie Jones

Okay, so that leads us into this whole idea of dilution, because I think this is an area that a lot of founders don't understand, is that the more that they accept funding, the more it reduces their equity stake in their own company. So David, can we start with understanding what dilution is first?

[00:28:07.440] - David Wright

So dilution is the reduction in the founder's ownership stake in a company when new equity is issued. And that's typically through funding rounds where investors purchase shares. So think about it this way. If you own the company, you own 100% of the company, and you're bootstrapping it, you're funding it yourself, and you maintain 100% ownership. But at some point, if you want to bring in, let's say you're worth $10 million and you need an extra million dollars, so you sell 10% of the company. So now you only own 90% of the company, but you brought in this million dollars. You would only do that if you could expand the valuation of the company. So let's say that that million would enable you to double the value of your company. Well, now your company is worth 20 million. You own 90%, which means you've gone from 9 million to 18 million. So despite the fact that you don't own 100%, you've still expanded your own net worth. And that's why you take on the dilution as long as you can expand the value of the company.

[00:29:12.190] - Hessie Jones

Okay, so, Karen, I know David's touched on this, but from a founder perspective, what should they be aware of, like, when they're seeking funding, what are the specific risks to them from a dilution perspective?

[00:29:27.810] - Karen Grant

It's I think it's unfortunate because I think they don't see the potential upside opportunity of accepting dilution. So they want to raise money. They fight tooth and nail for increasing the value of their company and then fighting also to only release, only sell a very small percentage of their company. And what's interesting, the scenario that David just gave was perfect. It would be great if we were talking about companies at those numbers, but we're not. So you've got a little company. It's got a value of maybe $4 million when it's raising its first tranche of cash. And the founders maybe there are multiple founders in the organization, so they end up selling 35% of the company first round investors. Typically, they do not want to just they don't want the founders to not feel empowered to succeed. They don't want to disincent them.

[00:30:50.580] - Hessie Jones

Got it.

[00:30:51.480] - Karen Grant

So that's not an issue. But founders will just fight for every tiny little bit. And it's a bad use of their time, because if they are getting the funds that they need so that they, in fact, can grow, then even if they end up only owning 25% of the company again, you're going from a $1 million or a $4 million value up to a $20 million value. That 35% is worth a heck of a lot more than if they owned 100% of a company that didn't go anywhere. So it's a very interesting thing, and it's more emotional, I think, than logical. If you can get the founders to go through the logic and actually run the numbers, they start to see and relax about selling off more of their company, it makes more sense. And then if you develop a level of sophistication, you realize that, in fact, you don't have to have an exit event to pay off these investors. The companies can buy back those shares from the investors at a reasonable return for the investors and they can end up owning all of the shares of the company if they want to. I know you've got something.

[00:32:24.880] - David Wright

Yeah, well, that's not the common exit, but that is a potential exit for sure. It's a challenge definitely for entrepreneurs because they're going to likely have multiple rounds, so you're going to have dilution each time. So the problem is, in Karen's example, if you give up 35% at 4 million now, you only own 65%. And if you have to do another round at 10 million and give up another 25%, your valuation is dropping very quickly, where the fear is that you're not going to control the company. So to some extent, you do need to plan out how much capital do you need at each stage and what's that going to cost you. Typically, companies issue roughly around 20% of the company. So you've got to plan out, okay, if I'm getting a million dollars today and if that's 20% of the company, how many more times can I do that? So I need the next round to be where it's 20% is $2 million and the company is worth ten and whatever, and then $5 million, so on. So it is challenging. What they also have to kind of digest is that you don't need 100% of the company to control the company.

[00:33:36.550] - Karen Grant

Right.

[00:33:37.000] - David Wright

You probably don't even need 50% to control it. When you think of if you're the person that came up with the idea and you have become the visionary. Typically an angel investor doesn't want to run the company, they want you to run it. So that's where kind of the goldilocks range comes in, is in fact, they don't want the valuation to be as low as possible because they know that if down the road, you, as the entrepreneur, don't own very much of the company, you're going to walk away from it.

[00:34:08.030] - Hessie Jones

Is there a magic number I've heard about? Is it never give away more than 20% of your company? I don't know. Is there something that there is no rule?

[00:34:17.370] - David Wright

What do you guys think? No, because it happens on you can be ready to issue shares and all of a sudden there's a catastrophe in the stock market or whatever, and the valuation drops and you got to decide, do I close today? Do I adjust the valuation. Do I do whatever? So, no, there's been issues above and below 20% all the time.

[00:34:38.240] - Karen Grant

Yeah.

[00:34:38.940] - Hessie Jones

Okay.

[00:34:41.210] - David Wright

If multiples are really high and it's a great day for sure, issue more than 20% of the company if you can.

[00:34:46.890] - Hessie Jones

Okay, so I know we're running out of time, but I do want to get to one question from both your perspectives because it plays into what's happening today. Here's the myth. Investors will invest in people more than product. True or false? So let's take that from the perspective of this huge hypecycle that's happening today in generative. AI. It's almost similar to what happened last year in the crypto-bubble. So I want both your perspectives on this specific issue on whether or not it's market-led. Is it founder-led? What is it, Karen?

[00:35:30.250] - Karen Grant

I actually think it's a bit of both because absolutes don't work. So if you have a spectacular team, but they have no product, what are they taking to market? If you have an outstanding product and a very poor execution team, you're going to fail. So you need that combination of quality team, hopefully with some experience in taking a product to market, doing the commercialization of that product, being able to handle quality assurance and all of the different aspects needed to be able to successfully take a product to market and realize not just revenue, but also profitability over time. So really it's that perfect combination. But I have seen a lot of investors not quite as worried about the tech. So, yes, there's technology. Do we think it's the best thing in the marketplace? Don't know, but the team's superior, so they're going to eke out everything they can out of that product and they'll find more stuff along the way.

[00:36:42.130] - Hessie Jones

Okay, what do you think, David?

[00:36:44.520] - David Wright

Yeah, I think people invest in concepts, and concepts takes into account both the idea of the product and the team that's going to execute. So let's not lose sight of what the goal is here. It's not the entry, it's the exit. What will my return be at the end? So I get excited about a concept and I look at the team. Is this team able to execute over time to capture the potential of the concept? And if they are not quite it's an early-stage company, then if they're not quite what I'm looking for, maybe I can augment it through my connections or others. I know that they'll be hiring, so I got to work with that. But really it's all about can you execute on this idea so that there is a return at the end of the day and we all get money back and then some for taking the risks.

[00:37:46.010] - Hessie Jones

Okay, perfect. Well, I thank both of you for joining me. I'm sure this actual session is going to provide some extreme value for a lot of our founders and answer a lot of questions that they had no idea how to get information on. So thank you for joining me and sharing your wisdom on this important topic for our audience. We dealt with the topic of funding and investing in startups a few times, so check out one of our previous podcasts, What VCs Don't Tell You, and Things That You've Always Wanted To Ask. And if you have topics you want us to cover, please don't hesitate to contact us at communications@altitudeaccelerator.ca. Tech Uncensored is also available on podcasts. You can find us anywhere you get your podcast. So until next time, have fun and stay safe. Bye.