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Any metric of VC activity has slowed down over the past 12 months – anything from the number of deals to the average capital investment and even valuations. This was triggered in 2015, and had a waterfall effect on VC activity and caused a change in the perception of many VCs.
What caused this switch from favourable conditions for investments?
What changed exactly?
And what should you do to succeed in this new environment when raising funds?
A domino effect started in 2015
VC firms are institutional investors that invest someone else’s money. Their limited partners are most likely mutual funds, individuals or in general top-tier investors. The VC firm is responsible for giving back a certain return and if it fails to do so, they will not be able to raise another fund from their limited partners. Hence, the VC firms are more prone to taking risks and making investments that will ultimately give high returns.
Last November publicly listed tech companies such as Twitter, Linkedin, Square experienced a drop in their stock price. Stock market investors started to doubt the valuations and market capitalization of these companies after seeing their quarter performance.
This created a domino effect. The message was clear – stock market investors want to see stronger profitability and fundamentals and marked a fundamental shift in the valuation of private companies.
This message was received by institutional investors, such as Fidelity. They own large stakes in top-tier tech private companies (Dropbox, Zenfit, Caldera). Fidelity marked down their own estimates of the valuations of these companies back in March 2016 resulting into another shock in the market.
The message was clear again:
“Valuations in the past were likely too high and now we are looking for stronger fundamentals to justify high valuations”
Nowadays, VC firms are increasingly revenues-driven, which means that they mostly focus on revenues and growth potential.
So how did the criteria change?
There are three main changes:
1| Recurring revenues
Over the last 5 years, it was somewhat easier to raise a Series A, since VCs would invest in companies with 10k monthly recurring revenue. Today, to be considered for a Series A, a company is required to generate between €30k and €50K in MRR.
This shows that VC firms are focused on revenues as indicators for momentum, rather than user growth and other indicators frequently used in the past.
2| Unit economics
The exact metric that interests VCs depends to the specific business model of the company. Generally, they are interested in the lifetime value of a customer (LTV) and customer acquisition cost (CAC). As we explain in another post, even if a company is not profitable, strong unit economics improve and strengthen the overall investment proposition of the business.
3| Growth track-record
The history of growth shows that the company has been performing and improving on unit economics, as well as, revenues. Even if a company has $30K-50K in MRR, lack of substantial growth record could affect the investment deal.
Overall, if 12 -18 months ago you were able to raise capital as big as 8-12 times your annual recurring revenue, nowadays that multiple has decreased to maximum 4X. 12 months ago you could raise $1M with only 10K MRR, for the same amount today you need at least 30K in MRR. Hence, the risk taking attitude of VC firms has cooled down.
How to prepare when pitching to investors
For these reasons, financial projections are more important than ever. You need to be prepared to justify every aspect of them for the moment when you are going to be dealing with VC firms. More specifically:
Highlight big market and growth
Nowadays, VCs want to make a scenario where they can see that factors such as big market and growth add up when put in the context of projecting the performance of a company.
Know your benchmarks
You should also be aware of benchmarks, for instance, comparable companies. Knowing the benchmarks is essential because if you price your company twice as much as competitors and comparable services with no reason, your projections decrease in credibility.
Always keep track of your unit economics
Another important part is that you should always keep track of your unit economics and be ready to explain how you came up with them. If you are confident in your calculations, you are going to have an easier time dealing with VCs.
Show the growth trajectory
Finally, what is also important is to put on paper and explain the growth trajectory of your company so far. You should show how the unit economics and the variables of your business model have developed over time.
Being confident in all these parameters shows not only that your business is a viable investment proposition but also that you know what is important to keep track of in the execution of your plan.
As an externality, you are providing investors and analysts with valuable information that would be the basis of their decision, instead of prompting them to make their own calculations, which is a process you have no control over.
For you as an entrepreneur, putting your projections into context allows you to understand the real potential of your business – what’s feasible and what’s not. It’s not only a good reality check but also one that investors are going to run anyways.
There are a lot of different ways to evaluate and make a decision for an investment activity. However, all these methods are based on projected cash flows and projected exit. So financial projections are indeed a crucial requirement for fundraising.
Still struggling with financial projections? Download our financial projections template!