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I’m Sophia and, along with my other beats, I’ve been covering the late-stage venture scene and IPO markets at Crunchbase News for the past year or so. I’ve written about how much it actually costs to take a company public through an IPO, how the 2021 IPO pipeline was shaping up, and how newly public companies have initially performed.

I missed the boat to write about the GameStop–Reddit–Robinhood madness last week, so this week I thought I’d write about something else that often seems to rile people up: IPO pricings.

If you follow the initial public offering market, you’ve surely seen the first-day surges of IPOs in recent months. Perhaps most memorable was Snowflake’s blockbuster IPO, when its stock closed nearly 112 percent above its IPO price on its first day of trading. And if you’re on tech/VC Twitter (my condolences if you are), you’ve surely seen the outcry and incredulousness that comes with every large jump in a stock price.

Typically, there’s a lot of blaming of underwriters and questions about how a company’s stock could jump so much. I don’t have an easy answer for that, but I can shed some light on the somewhat opaque process of how IPOs are priced in the first place.

The IPO process

The mechanics of an IPO work something like this: When a company wants to list on the public equity markets via a traditional initial public offering, it first files an S-1 registration document with the U.S. Securities and Exchange Commission, baring its soul (read: its financials), any associated risks that come with investing in the company, and so on. 

The company hires an investment bank and goes on a roadshow (or, in the time of COVID, sits through long days full of Zoom meetings) where execs solicit interest, primarily from institutional investors. The underwriters set a price range for the company’s stock, often increasing it as the first day of trading nears. 

Finally, the night before trading is set to start, a block of shares is sold to investors at a set price, allowing a company to raise capital in the process.

Why the outcry when a newly public company’s stock surges on its first day of trading? The idea is that when that happens, money was essentially left on the table — if the stock had been priced higher, the company could have raised more money by selling the block of shares — while underwriters had the chance to buy at a below-market price.

Determining price

The two primary factors in an IPO’s price are the company’s financials and demand from investors.

“Depending on the level of demand among institutional investors, that’s how pricing is supposed to be set,” said Patrick Healey, founder and president of Caliber Financial Partners. “They’ll put a range out there initially, and if there’s oversubscribed demand that pricing will go up.”

For investment bankers, the main influence for pricing is the demand for shares, Healey said, adding that he’s noticed investment bankers tend to be more conservative with pricing to improve stability of trading activity for the stock’s first day. Pricing too high could cause “huge swings in volatility,” he added.

“If you ask the investment bank, they would rather have a stable trading environment and leave some meat on the bone,” Healey said. “And if you ask the company, they would rather capture as much money as they can and fuel growth.”

Another factor in understanding demand for a stock is peer groups, according to Louis Cordone, senior vice president of data strategy at AST. Underwriters will typically look at a comparable publicly traded company and “build a basket of those peer groups to try to understand demand,” he said. 

For example, a private rideshare company looking to go public might look at Uber and Lyft, publicly traded rideshare companies, to understand demand. And besides the financials and stock performance of a peer company, underwriters will look at what kind of investors are purchasing a company’s shares. 

As for the first-day surges that newly public companies like Airbnb have experienced, Cordone said that could be attributed to more retail investors investing in equities.

“I do think that the amount of cash that’s in the market today is certainly driving demand for IPOs, and the participation of retail investors is really driving the price of these things,” he said.

The participation of retail investors in the market was clear last week with GameStop’s stock surge, something Cordone said likely contributed to several of last week’s IPOs not seeing the giant pops we’ve become accustomed to. 

“If you look at the back half of January, the most recent IPOs didn’t do that well,” Cordone said. “I think it’s market participation, and if you look at the overall equity markets throughout COVID, it’s been pushed by retail investors moving into equities, taking on more yield.”

Up next: Bumble IPO buzz

January was a busy month for companies going public, and there are a lot more in the pipeline gearing up to debut on the public markets, either via traditional IPOs, SPACs or direct listings. The next IPO I’ll be watching closely is dating and networking app Bumble, which recently indicated it aims to raise up to $1 billion via an IPO and set its share price range between $28 and $30.

Send me your thoughts

I’d love to hear from readers about what public market topic I should cover next. My email is sophiak@crunchbase.com and you can also connect with me on Twitter @SophiaKunthara. If you have a question about the public markets, chances are someone else is probably wondering the same thing. Just let me know, I’m happy to dig around and find some answers.

Illustration: Dom Guzman

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While taking a private company to the public markets is a big deal that comes with much fanfare at the stock exchanges and in the financial press, it also comes with a big price tag.

Beyond the one-time fees, there are a host of other costs that aren’t obvious, according to David Ethridge, PricewaterhouseCoopers’ deals managing director and U.S. IPO services leader.

PwC is typically involved with companies for one to two years prior to an IPO to help them determine what they need to do to be a public company. Being a public company has major implications for a company’s processes, systems and employees, such as the requirement to report financial information to shareholders every quarter.

“Normally that’s going to mean implementing systems and new processes that are going to make you effective as a public company, but would require you to do things that you would say ‘I don’t have to do that as a private company,’” Ethridge said.

For example, it could mean hiring an investor relations team and more people in tax areas. Those kinds of costs aren’t disclosed in filings or databases, as they’re more structural costs. Most companies currently use two accounting firms: an auditor and an advisory tax firm. While the auditor fees in context of the IPO will be disclosed, there’s often a second accounting firm that advises the company on aspects of the going-public process such as taxes, structuring, HR and compensation.

Underwriting fees also make up a good chunk of the costs associated with going public, and are often presented as one of the arguments in favor of direct listings, which offer an alternate route to the public markets.

The dollar value of an IPO is what will determine the bank fees: around 6.5 percent to 7 percent for a $100 million IPO. That percentage will get lower as the deal size increases, according to PwC, with deal sizes at $1 billion or larger having an average 3.5 percent underwriting fee. (PwC has an online calculator to help estimate some costs of an IPO).

An investment of time

One thing management teams often don’t anticipate is the time element of an IPO and how so many things are interconnected. Some elements of preparation for an IPO can be done while drafting an S-1 statement, but a lot needs to be done before sitting down with bankers because some elements can affect a company’s ability to deliver quarterly results, per Ethridge.

“I think sometimes the comprehensive nature of this is something some management teams are surprised by,” Ethridge said.

In the past, initial IPO conversations often took place three to six months before an IPO, according to Ran Ben-Tzur, a partner at law firm Fenwick & West, who advises on capital markets and public companies. Nowadays, however, the initial IPO conversations start about 18 months before a company’s public debut.

“Typically, the way I would think about it is once you’ve raised your mezzanine large financing … that typically starts the 18-month clock in terms of preparing for going public,” Ben-Tzur said.

Board composition requirements–such as California’s gender and diversity requirements–have increased the lead time to an IPO, he said, as companies are spending more time thinking about board recruitment, which can be a long and expensive process.

Toward the beginning of that 18-month time frame is when Fenwick advises companies about board composition, Ben-Tzur said. Law firms do the bulk of the work, like drafting registration statements, around three to five months before a company selects bankers for the IPO. According to Ben-Tzur, that’s when costs start to ramp up.

Law firm fees are somewhere around $1.7 million to $2 million for this type of transaction, and auditor fees are also around $2 million, Ben-Tzur added. Banks on a typical tech IPO charge a standard 7 percent commission on the proceeds raised.

Law firms and consultants also advise companies on compensation, communications, and on founder control, or helping founders figure out how they can potentially keep their long-term vision for a company following an IPO.

“I think it is important to note that it’s an expensive process. It’s a time-consuming process, but I think every company we’ve taken public, no one’s really regretted going through it,” Ben-Tzur said. “All of these processes and systems you’re putting into place to be a good public company are actually processes and systems you should put into place to be a good company.”

But companies should also weigh the pros and cons of going public, given how costly and time-consuming the process is, according to Stephen Curry, CEO of Endurance Advisory Partners.

“It’s important because at the end of the day you don’t want to go public and then not have the proper investor support to make sure your stock gets the attention it needs and to craft the story you need to be successful,” Curry said. “You don’t want to do it halfway and then run the risk of poor execution or a story that can’t be well-supported in the marketplace.”

Illustration: Dom Guzman

It is known that vocabulary simplifies our understanding of rather complicated matters. In the case of SaaS companies, we quickly understand by SaaS that these are centrally hosted software-centric products or services with monthly or annual subscription business models. We don’t have to say all that, we just use SaaS.

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However, when I hear entrepreneurs and investors say things like “You need to focus on a single industry, that’s how you succeed,” I think it could indicate the speaker is simply not aware of the two valid SaaS approaches: vertical and horizontal.

SaaS companies can differ on several fronts

When creating your own SaaS company you immediately choose to build a product using a specific type of tech that caters to a need of specific audiences in a specific industry or industries. Each choice you make will greatly affect your future in terms of product design, go-to-market strategy, marketing and sales budgets, funding options, growth potential, financial planning, exit potential and more.

Technology type: Are you a cyber SaaS company or a CRM SaaS company, or are you a communications SaaS company or an ERP SaaS company? This is the easiest decision to make from the start, and is usually not debatable. However, some technologies are “hotter” than others and get more attention from investors in ongoing hype cycles.

B2B vs B2C: Are you catering to businesses or consumers, or both? This decision will affect your go-to-market strategy, pricing model, product features and capabilities, as well as your fundraising process. You simply have to choose what type of company you want to be and go with it. In my experience, venture capitalists today prefer to invest in B2B SaaS companies, as their customers should have a clear business model and clear willingness to pay. Consumers’ willingness to pay is low, their churn levels are high, and their customer acquisition cost is also high; the key ingredients to a nonsustainable company. These basic financials make B2C companies less attractive to VC investors these days.

Vertical vs horizontal SaaS: Are you targeting clients in a specific industry or are you agnostic to your customers’ industry? The former would be a vertical SaaS, the latter would be horizontal SaaS. For example, nCino, which offers a cloud-based operating system for banks and financial institutions, is a vertical SaaS company. On the other hand, Salesforce1, a horizontal Saas company, does not target specific industries so it could have clients in banking, health care, cyber, retail or any other industry.

My experience also shows that some VCs tend to prefer vertical SaaS, as they require less capital to quickly capture a market share of a specific industry. The marketing and sales budgets are lower, the messaging is simple, their product is laser-focused to cater to a specific industry, and the competitive landscape includes smaller companies with a lower barrier to entry.

Horizontal SaaS companies, however, have their advantages as well; they have a much bigger addressable market which means they can grow to very large-scale companies with much higher company valuations upon exit.

Source: Flavors of SaaS report by Allied Advisers

The choices you make will affect your trajectory

Product Design. Should you make a separate product for each use case or create a single product to cater to all use cases? Supporting multiple products means high R&D costs. At this point you may want to choose a specific vertical and run with it, or you may want to become a horizontal SaaS company and create a single platform to cater to all industries.

VC fundraising potential. The lower capital requirements for scale of vertical SaaS make it a good fit for mid-market funds.

Financials. Sales and Marketing Budgets: The Sales & Marketing (S&M) to Revenue (LTM, Median) ratio is 19 percent in vertical SaaS vs 41 percent in horizontal SaaS. EBITDA Margins (LTM, Median) are 13 percent in vertical SaaS vs 0.8 percent in horizontal SaaS.

Source: Flavors of SaaS report by Allied Advisers 

Written by Itay Sagie, a lecturer, contributor, and strategic adviser to startups and investors. He is also co-founder of VCforU.com, which helps over 18,000 startups with their Investor One Pager while hundreds of investors use the platform for deal flow. Itay is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

Illustration: Li-Anne Dias.

In my journeys, I get to speak with many software as a service companies as well as venture capitalists focusing on SaaS. I often see a bit of confusion around Monthly Recurring Revenue and Annual Recurring Revenue, and when each is more appropriate.

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SaaS companies rely on recurring revenues to fuel growth. In a highly competitive environment with high customer acquisition costs, the aim is to get the maximum lifetime value out of customers. See full article about Unit Economics.

Key success factors include:

1. Monetization: Provide measurable value to your customers and capitalize on that value. While this seems trivial, it is not. Figuring out the exact value you bring to your customers is not trivial, and often they are not transparent about it. Moreover, customers require close attention and have very little time and tolerance for a poorly built product that doesn’t exactly meet their needs.
2. High Retention: Create a corporate mindset around customer success, proper onboarding, continuous product improvement, and value creation. This will help keep your customers around for longer, resulting in high retention/lower churn and a longer lifetime, calculated as 1 divided by churn. Annual Churn of 20 percent equals a lifetime of five years.

To make sense of the basic definitions: ARR is relevant to annual plans–it is possible for the payment schedule to be monthly, as long as there is at least a 12-month commitment by the customer; MRR is relevant to monthly plans only, where the customer can cancel the plan at any given month.

In order to increase retention, SaaS companies tend to prefer an annual subscription model, however, there are various considerations to choose the right model.

Considerations for choosing MRR vs ARR

1. Product maturity – In the early stage of a company’s life, when the product doesn’t have a known brand name, customers tend to prefer monthly plans. During this stage, the company has a great opportunity to monitor churn, create an active dialog with the customers, and improve their product in an agile manner. After a period of time when the product is more mature and there is clear market acceptance for the product, creating an annual plan at a discount would make sense.
2. Fundraising for Series A or not – Let’s assume you raised a $1 million Seed round last year and have finally reached your first year of sales. If you have three large customers, all paying an annual subscription of $500,000 each, the result is $1.5 million ARR. At this point you, the entrepreneur, would feel it is the perfect time to go out and raise your large Series A to boost sales. While investors in later stages often prefer to see ARR, in your first year of sales ARR does not indicate any proof of actual churn figures. It is a real possibility that after the first year of the subscription is over, all three customers will churn, leaving the company with zero revenue. This is a very high risk for a Series A investor. Therefore MRR in the first year of sales would provide continuous churn figures you and your investors can learn from. As written in the previous point, during the first year of sales, product maturity is also low, so MRR would make sense from that angle as well.
3. Customer type – Enterprise customers tend to prefer annual subscriptions because they also require closer customer support, integration, training and more. In this high-touch relationship, it would make less sense to use monthly plans. Consumers, as well as small to medium-sized businesses, tend to prefer monthly plans, at least to begin with. This is a low-touch relationship with looser integration, which can be tested for a few months at a low cost. Companies can then decide if they want to commit to an annual subscription at a discount.

Written by Itay Sagie, a lecturer, contributor, and strategic adviser to startups and investors. He is also co-founder of VCforU.com, which helps over 18,000 startups with their Investor One Pager while hundreds of investors use the platform for deal flow. Itay is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

Illustration: Li-Anne Dias.

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The coronavirus has not loosened these criteria. Commercial traction is not a magic phrase that gets you money. The quality of this traction and how that projects into the future matters even more.

Investors will ask questions such as:

• How much money are you spending to get each client?
• What is each client worth to you?
• What percentages of your clients will churn?
• When do you expect profitability?

These types of questions help investors create an economic health check, otherwise known as Unit Economics. The outcome will determine if you have potential for sustainable growth and if your company has the potential to be valued at 8 or 10 times your revenues upon exit, meaning Enterprise Value (EV) / Revenue will be 8 or above.

Source: Allied Advisers

Shift in the investor’s mindset

Unit Economics were not always in the investor’s mindset. Not long ago, investors rewarded high-growth companies, without looking at the costs. These companies survived and thrived for years, at the expense of their investors, and normally hit a wall when attempting an IPO and more conservative investors analyzed the numbers. We’ve witnessed a drastic pivot in the VC industry toward a more conservative result-based mindset. COVID-19 has made this even more apparent.

Basic requirement at any stage

Investors are looking for entrepreneurs who understand Unit Economics. Even if the economic indicators will straighten out in a few years, they want to know that you, the entrepreneur, know where you’re headed, and that you’re measuring the right economic indicators to steer the ship in the right direction.

The three main rules of Unit Economics

• Rule of 3: The lifetime value (LTV) to customer acquisition cost (CAC) ratio is at least three. Lifetime value is calculated as the gross profit per user, multiplied by the lifetime. Lifetime is calculated as one divided by churn. Having a high LTV/CAC ratio may not be an advantage, as it could mean you are not spending enough on marketing and sales while your competitors are. Hence your growth will be slow and you will lose market share. If your LTV/CAC ratio is lower than three, investors will question the scalability of growth and spend needed to grow larger.
• Rule of 40: EBITDA margin in percentages, plus annual growth in percentages should sum up to 40 percent or higher. Balancing profitability with growth is essential. As most SaaS-based tech startups are not profitable, they would require a growth rate of 40 percent or above to survive in the long term and provide the revenue multiple of eight or above. Profitability (EBITDA margins) of 10 percent means you can grow at 30 percent or higher.
• Rule of 4: The growth to churn ratio should be four or higher. Churn is the percentage of people who leave in a period of time. So a growth of 40 percent allows for a churn of 10 percent, which is not easy to reach. It should be noted that churn figures are very hard to come by as companies tend to keep them a secret. Enterprise B2B SaaS companies can have a churn of 5 percent to 10 percent. Companies focusing on medium/small size business or B2C startups normally see a double-digit annual churn rate.

Summary

While you build your forecast and business plan, you should note the basic Unit Economic indicators. Beyond the numbers, the C-level executives have to create a culture of great customer service, of value-adding products that continuously evolve, with a good pricing strategy that makes sense to the end user, and that rewards long-term engagements. Adhering to the Unit Economic mentality could help you commercially as well as with your fundraising efforts.

Written by Itay Sagie, a lecturer, contributor and strategic adviser to startups and investors. He is also co-founder of VCforU.com, which helps over 18,000 startups with their Investor One Pager while hundreds of investors use the platform for deal flow. Sagie is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

Illustration: Li-Anne Dias

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This step will save you years of redundant hard work and millions of dollars spent on building and marketing the wrong product. Validating a need should precede both fundraising and building a commercial-grade product. A common concern I hear, often comes with an analogy along the lines of “how did Steve Jobs know people would buy the iPod if it didn’t exist before?”

While it is true people didn’t own an iPod before one was invented, there were other MP3 players out there, which gained popularity and also had some disadvantages. Steve Jobs saw the existing state-of-the art and understood that the missing ingredient was a great user experience. Jobs was known for his customer-centric approach. Customers wanted a device with simple controls (hence the click wheel was born), that would fit in their pockets, that would have longer battery life and that would support at least a 5G hard drive to store many songs.

Though we are not Steve Jobs, we can be smarter about how we validate the market need as early as possible. Here are a few ways to validate your market need early on:

• Competitive analysis: Look into other companies and competitors, learn about their positioning, offering, pricing, target audiences. See what they are doing well and what they can improve on. Are there many small players or a handful of large players? This is important on several fronts, including attractiveness to investors, exit potential and more. If you feel you have no competition, think again, you may be looking through a narrow window. Your competition may be other solutions to the same problem, using other or no tech. Competition can also be similar technologies solving other use cases today. Knowing your competition will help you benchmark your product against theirs, making sure you are not building a sub-par product, rather a much better one.
• Market research: What is the size of the market, how fragmented is it, what is the annual growth in this market that would indicate a growing need? What are the trends that may indicate future needs? COVID is an example of an event that will define new industry trends moving forward. These trends will help you understand the market today and also a few years from now.
• MVPs: Create a minimal viable product with limited resources that will showcase the basic capabilities of the product, this should be enough to show to potential customers and get initial feedback.
• Surveys: Talk with as many potential customers as possible and ask them about their current needs, what they feel is missing in the market, in terms of user experience, spec, pricing features and more. You can also give a glimpse of your product and ask what they feel about your potential solution. What is their willingness to pay and more. Some startups also create a website that shows a mockup of the future product and offer pre-registration for early birds, this helps to verify there is a need in the market.
• Design Partners: Work with a potential customer who will help build the spec based on their specific requirements, under the assumption that there will be other customers who would have similar requirements. This approach will help build a useful and practical product, based on real market requirements, rather than a product you think customers will use.

Itay Sagie is a lecturer, contributor, and strategic advisor to startups and investors. He is also co-founder of VCforU.com, which helps over 18,000 startups with their Executive Summary while hundreds of investors use the platform for deal flow. Itay is also the Israeli advisor at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

Illustration: Li-Anne Dias.

The question of whether raising capital during the Coronavirus epidemic environment is feasible at all is a valid one.

According to Crunchbase, there have been more than 1,000 reported seed and Series A investment rounds from mid March to mid May 2020, which is a 55 percent decrease compared to the same time period last year.1

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Therefore, while it may be even more competitive, fundraising is very much alive. Putting this matter to rest, a common concern for entrepreneurs facing a funding round, is figuring out how much capital they should raise, and for how much equity.

While each company has its own set of unique circumstances, the following may help founders navigate the various considerations.

First, when should you be raising capital?

Having a business idea is not sufficient for raising capital. Investment rounds are normally set to help you achieve a significant commercial goal, which reduces a risk for the investor. For example, a seed round usually funds your move from Proof of Concept (PoC) to initial sales.

Series A rounds fund your sales growth and so on. Therefore, if you wish to raise a seed round with no PoC or raise a Series A with no initial revenues, you will most likely be turned down by today’s investors. In case you are turned down, I advise you to handle rejection in the right way.

Let’s assume you did manage to close a round with an investor, at a very early stage, without showing proof of technology or commercial traction, you will most likely part with 20 percent to 30 percent of your company’s equity, for a very small check size. A small check size means you will not have sufficient funds to reach big commercial milestones, and as I alluded to earlier, these milestones are key to raising your next round of financing.

Therefore, if you have yet to reach your milestones, I would try to reach those milestones first. If you can reach market traction and initial sales, your check size could increase from a few hundreds of thousands of dollars to low digit millions, for the same 20 percent to 30 percent equity. Some companies, such as Braintree, GitHub, MailChimp and Shutterstock, have succeeded in bootstrapping themselves without any external investors, or managed to postpone their initial investment round until reaching massive commercial growth, thus raising tens of millions of dollars for relatively little equity.

Second, your long-term cash need does not equal your round size.

Assuming you are raising a seed round, and you have a financial forecast which is rooted in realistic revenue and expense assumptions, you have all the basic ingredients to assess your estimated cash need. Let’s assume your revenues in years one through three are: $200,000, $500,000 and $5 million, respectively, and your EBITDA in years one through three are: negative $800,000, negative $800,000 and negative $1.4 million, respectively, and assuming year four is already profitable, your “cash dip” will be $3 million.

This is calculated by simply accumulating the annual EBITDA and looking at the biggest negative figure. In this case, many entrepreneurs will wish to raise $3 million or slightly more. In most cases, depending on the entrepreneurs, $3 million is a large ticket size for Seed stage.

If you do manage to find a $3 million commitment at seed stage, it will most likely include a set of milestones to achieve before receiving another chunk of capital. This is also known as a “tranche.” While this method does make sense in certain cases, in most cases entrepreneurs will not reach their milestones to the dot, and will be penalized with heavy dilution.

A second option, which I personally tend to prefer, is to raise a $1 million seed round, (20 percent above year one’s projected cash need, as life is slower and more expensive than your excel spreadsheet) reach initial revenue, and then raise a separate series A to cover the cash need for the next two years.

In this scenario you avoid being penalized (diluted) for missing your revenue projections. The downside of the latter strategy is working on two separate fundraises, each of which takes months of work from the founders and may impact the business itself. I personally believe it is worth it.

Third, sticking with industry norms will help you in your next funding rounds.

Haggling equity with an inexperienced seed investor, giving them substandard equity for a standard check size, will result in a bloated valuation at an early stage. For example, let’s say you succeeded in raising a $1 million seed round for 5 percent equity, this will result in a $20 million post-money valuation.

Your future Series A investors will hopefully be professional and, as such, will require a valuation that sits well with industry standards. If your bloated seed-stage valuation is higher than the standard Series A valuation, that would require a “down round.” For example, a $2 million Series A for 25 percent equity, means $8 million post-money valuation. Such a down-round, from $20 million valuation to an $8 million valuation, means heavy dilution to both you and the previous investor and is generally considered a red flag to future investors. Red flags greatly reduce your chances of raising capital in the future.

Recap

A solid fundraising strategy will greatly impact the success of your company from your seed stage, all the way to liquidation. It could help you become more attractive to current and future investors as well as to buyers for M&A.

Knowing when to raise capital, setting a right valuation, reaching relevant professional investors, knowing what terms to negotiate, and adhering to industry standards, can be the difference between your company’s success and failure.

Illustration: Li-Anne Dias.

As entrepreneurs, we often face rejection.

We are rejected by potential customers not yet ready for our innovation, strategic partners who prefer to wait until Q2 next year, and investors who say we’re too early or too late for them. In the COVID-19 days, getting a positive response from anyone seems like an impossible mission.

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The first time I got rejected from a venture capitalist was in the summer of 2008, when I was about to graduate as a biotech engineer. At the time, my co-founder and I filed for a provisional patent for what we thought would be a revolutionary, “failproof” medical device to treat hypertension. We figured, “Who wouldn’t throw money at it?” Well, apparently nobody would. Every single investor said we were both very genuine, but not fundable. My friend and I did not understand what had gone wrong.

Twelve years later, both my friend and I have pivoted our careers from biotech research to business, entrepreneurship and coincidentally (or not) into the investment community. We did not end up raising the capital, and I have made many mistakes along the way, but the one thing we both did well was to keep in touch with many of the investors we met in our process.

These VC connections led to future investments by the same VCs that rejected us, and led to other collaborations years later. Looking back, I understand why we were rejected. Putting aside the commercial readiness, and lack of understanding of what early-stage investors really care about, entrepreneurs today need to handle rejection gracefully.

Some entrepreneurs I have encountered take rejection the wrong way, either ignoring the investor, or worse, taking personal offense and even lashing out at the investor. While your feelings may be hurt, the way you handle yourself during and after VC meetings says a lot to an investor about your potential success.

Entrepreneurs must understand that venture capitalists sometimes filter more than a thousand startups annually and can only invest in a handful. Therefore, by definition, their job is to say “No.”

Hence, you will likely be rejected by VCs multiple times. It is true that some investors could be more polite and respectful, however, the truth is they will most likely not be too emotionally sensitive to you and your venture.

How should you react after being rejected by a VC?

1. After every meeting, and certainly if you are rejected, which could happen in person and more often via email, you should reply and thank them for taking the time to meet with you. Also affirm that you value their comments and that you reserve the right to update them periodically as your business grows. This type of attitude will go a long way with any investor and, in many cases, will leave the door open for future investment opportunities once your company matures commercially.
2. Maintain a long-term relationship with all your VC contacts. As you promised earlier, make it a habit of keeping all your VC contacts updated on your progress. They may find you relevant down the road. Also, circumstances do change, and after a couple of years you might lead a new startup or they might work for another VC at which point the circumstances could be ripe for investment.
3. Don’t fall in love with your idea. This last point is easier said than done. You need to understand that your startup is not your baby. As an entrepreneur you should assess your own startup in an objective way and put yourself in the shoes of the investor. Perhaps your startup is not, and will never be, fundable by a VC.

VCs require very high returns in a specific time frame that may not be relevant to your specific startup. Perhaps your market potential is simply too small, perhaps there is just not enough need or willingness to pay for your solution. Perhaps there is not enough M&A activity in your domain, or that company valuation compared with revenue is too low. If you learn to identify these truths yourself, you may save yourself years of hard work, money, sweat and tears. Perhaps you should seek alternative sources of capital or perhaps pivot your venture altogether.

Wrapup

In summary, do not take VC rejection personally. Keep your inherent entrepreneurial optimism alive and bring actual value to the market, and you will most likely get funded. I believe that good startups will get funded during any economic cycle, including during these COVID-19 days. Perhaps VCs are pickier, timelines may increase and round sizes may get smaller, but most of the investors and buyers will not back down from a good deal.

Illustration: Dom Guzman

These days, when fundraising has become even more tricky, it is crucial that entrepreneurs get into the investor mindset if they are to increase their chances of success.

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This is not a time to miss opportunities. However, in my line of work, I often find a clash between what entrepreneurs think investors care about and what investors actually care about.

While entrepreneurs believe their technology and their revolutionary products are the most important topic, early-stage investors want to mitigate their innately high risks in exchange for high returns. This results in a very different prioritization and a drastically different mentality between an entrepreneur and an investor.

Early-stage investors seek to reduce risks

As an entrepreneur, you need to understand that early-stage investors take the biggest risk by investing in your company first, before you prove you can deliver on your promises. I find that early-stage entrepreneurs jump to technology, but beyond verifying that the technology works, the investor needs to verify that there is a real need for the offering in the market. Are there potential paying customers? Do you have the right unit economics in place to scale in a sustainable way? Is your team capable of delivering on your ambitious forecast? There are many other issues that investors care about, beyond your technology. Looking at the investor’s mindset from a risk point of view can also help clear up your pitch, your deck and so on.

In my experience, investors tend to look at three main risks, and it is your job as an entrepreneur to try and mitigate these risks as best as you can.

1. Technological risk

Does your technology work, and is it better than the current best-practice?

How do you mitigate the technological risk?

The technology risk is the most trivial to mitigate, and unfortunately where most entrepreneurs get stuck. In order to mitigate the technology risk, you can simply create a working PoC, and do some industry benchmarks to make sure your product can outperform currently available products.

2. Market risk

Is there a real need for your product, are people willing to pay for it? How much? Do you already have paying customers? What is the market size and potential?

How do you mitigate the market risk?

Lacking paying customers, ideally you will find a “design partner,” a potential customer who will help define the basic features that will make your technology usable in a real-life scenario. This will reduce two risks at once: That there is a potential customer and thus real need, and that your product is good enough to be used in a commercial environment. You can now replicate your success and scale your company.

Various market research to identify the market size, trends, growth etc. is also useful.

3. Personal risk

Let’s assume your technology is great and people are willing to pay for your product. Are you the right team to grow this into a multibillion-dollar business which will create value and returns for your investors?

How do you mitigate personal risks?

This is probably the most important and hardest risk to mitigate. Short of having a previous exit history, early-stage investors have very little to go on to assess your personal capabilities in terms of building a large and successful company. They can look at your educational background and work history, they can get an impression of how you interact with them in meetings, how you pitch, how you look, and how you interact with your team and with their team. But all of this still has very little indication that you have what it takes to build a large and sustainable business.

So what can you do as an entrepreneur to prove that you have human capabilities which will indicate a higher potential for success? You can show that you were able to attract a talented team. In an early-stage environment this is not an easy task, one that takes personal gravitas. You can also pitch in a professional way, win startup competitions, get accepted into prestigious acceleration programs and so on. Any major achievement may showcase an indication of personal capabilities.

Looking to the future

Beyond (bias) intuition, some forward-looking investors try to take it to the next level and use textual analysis to assess your characteristics. While it is still early and perhaps controversial, I believe the future will utilize artificial intelligence to gain real insights into the potential success of a particular investment opportunity, and one of the main factors will be a team’s capabilities.

About VCforU

VCforU.com is a leading resource for entrepreneurs raising capital. VCforU serves over 17,000 entrepreneurs in more than 140 countries to create professional investor one pagers and locate relevant investors. VCforU helps investors find relevant startup investment opportunities that match their exact criteria.

Illustration: Li-Anne Dias.

Here at Crunchbase News, we cover a lot of tech and tech-adjacent startups as they go public. The process by which they’ve done so has been pretty much the same: through an Initial Public Offering (IPO). But lately there’s been more and more talk of going public through a direct listing, so we thought we’d break down exactly what that means.

An initial public offering entails the sale of newly-issued securities to underwriters and their clientele, whereas a direct listing is more like a secondary sale of existing shares designed to give founders, prior investors, and vested employee shareholders a path to liquidity.

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Both ways of going public achieve the same thing (bringing a private company to public investors) but there are key differences between the two. Let’s explore.

What Is A Traditional IPO?

What we’ll call here a “traditional IPO” is the process through which most companies historically have gone public. The steps go something like this: File an S-1 with the Securities and Exchange Commission, set a goal of how much you want to raise with your IPO, set a price range of how much you want to sell each share for, settle on a price and sell a block of shares for that price to institutional investors, and then commence trading on the public markets.

On the first day of trading, investors watch closely to see what price the stock opens at when the market itself opens for trading, and what price the company closes at when trading closes.

Generally, it’s a good sign to see the company’s equity open above the price at which it sold shares during its IPO process. However, companies generally don’t want their newly-tradable equity to open too much higher than the set price, because that could mean money was left on the table (i.e. the company could have raised more money from investors by selling shares at a higher price) .

What Is A Direct Listing?

A direct listing is just what it sounds like: direct. It brushes off most of the pre-trading steps that traditional IPOs take and gets straight to trading. There’s no setting a price range, settling on a per-share sale price (though a reference price is determined), going on a roadshow to woo investors or selling a block of shares to institutional investors before hitting the market.

Conventional wisdom says that direct listings are best suited for companies that have a lot of brand recognition: If the majority of the public is familiar with your brand, you don’t need to put a lot of work into selling it. Conversely, if your company wants to go public but isn’t as well-known as, say, Spotify (perhaps more of a problem for B2B companies), a traditional IPO may be better.

According to Jay Heller, Nasdaq’s Head of Capital Markets, an ideal candidate for a direct listing is a well-known company that doesn’t have a need for capital, has a seasoned management team with an established track record, and is willing to give financial metrics and forecasts ahead of time.

Direct listings have benefits like no lockup periods (a time restriction preventing early shareholders from selling stock), but they also have challenges like liquidity and potential volatility, Heller said.

What Else Is Different?

A major difference between IPOs and direct listings is the role of banks. In an IPO, there’s a capital raise when banks commit to buying shares of a company at a set price, according to Heller. With a direct listing, banks aren’t acting as underwriters, but more like financial advisers.

“In an IPO the banks are setting them up on roadshows, working with investors,” Heller said in an interview with Crunchbase News. “In a direct listing, banks have no say on that…to get out and tell the story, it’s really on corporate’s responsibility to facilitate that.”

That makes it more challenging, Heller added. With an IPO, banks help a lot with generating interest from the investor community. With a direct listing, a company has to do that on its own.

“You need a shareholder base with a direct listing.That’s probably large and they have a desire to sell,” Heller said. “Because with a typical IPO, the company is offering a set amount of shares at a certain price. With a direct listing you really need your early shareholders to come in to the marketplace on day one to provide for liquidity, and that’s really tough.”

Execution on the day a company makes its debut on the public markets is very much the same for both direct listings and IPOs, Heller said.

Which Companies Have Listed Directly?

Not many companies, though obviously there have been some. Direct listings have been more in the spotlight recently because a couple of high profile unicorns went public that way. Spotify seems like it was the OG (though it certainly wasn’t the first) when it had a direct listing in 2018, and Slack chose to go the same route when it went public earlier this year. They aren’t the only ones, but may be the most visible. Nasdaq has been listing directly since 2006, Heller said, pointing to insurance company Watford Holdings as a direct listing on Nasdaq this year. There’s been talk of Airbnb (another well-known unicorn) doing a direct listing when it goes public in 2020, and startup executives and venture capitalists gathered to discuss the prospect of tech companies going public via direct listings earlier this fall.

A company that wants to go public should do its due diligence on its options, and really think about what it’s trying to achieve and the purpose of the listing. Is it trying to raise capital? Provide liquidity?

“It’s really do you need capital or do you not, and if you do need capital then a direct listing is probably not for you,” Heller said.

Nasdaq doesn’t have a preference either way a company goes public, Heller said, and it will support corporate pre-listing, the day of, and after it goes public. But companies need to do their research and choose the path that will set them up for success in the future.

“It’s not for everybody,” Heller said of direct listings. “But that doesn’t mean that everybody shouldn’t be asking the questions.”

Illustration: Dom Guzman