Over the last 18 months, I’ve seen expansion-stage valuations steadily (and, on occasion, precipitously) rise.I keep reading articles and statistics to the contrary, but then again, perhaps I’m just experiencing the misfortune of chasing deals that are overpriced.

Or maybe I’m not. My hypothesis for steep enterprise valuations is shared by many: Too much money in the market is chasing too few great deals. Add to that a layer of consumer-oriented investment funds (perhaps feeling neutered by the recent IPO performances of Groupon, Facebook, Zynga, etc.) throwing their weight around in the enterprise market, and we have a perfect storm.

As a result, that frothy market has noticeably impacted some of the expansion-stage management teams that are (or have been) raising money.

My sense is that VCs with massive funds to deploy have emboldened management teams into thinking that they can command any price for their company, and that it’s only a matter of time before they have their own billion dollar IPO.

In the last six to nine months, for instance, a number of entrepreneurs have been disclosing their valuation expectations to me at the onset of a conversation. Part of me thinks that this information is helpful because it allows me to manage my time effectively. If a CEO of SaaS business with $2mm in revenues and $3mm in bookings tells me that they are raising at a $50 million pre-money valuation, I know to not waste my time.

That said, I can’t find any positive benefit of expansion-stage CES acting in this manner, which is why I implore all entrepreneurs to let the market set the price. As my colleague Ricky Pelletier wrote earlier this week, price alone is not a way to choose a VC partner.

The good news is that I have started to sense a slight market correction over the last two months, as several deals that we walked away from over the summer have re-engaged with more humble valuation expectations. Unfortunately for those expansion-stage CEOs, it never looks good when entrepreneurs come back to VCs whom they previously called “cheap” after those VCs were unwilling to deliver the round the entrepreneurs set out to raise.

This is such an easily avoidable issue, which is why I’m suggesting that you to find a venture partner you like first, let them run their process, and propose a deal that they think makes sense. It’s better to get your hands on a term sheet the first time around and reject it, than go back four months later with your hat in your hand!

I’m not sure if i can actually call this the start of a market correction as we at OpenView are still regularly seeing deals that are getting done at valuations far from what we can justify paying. And while these prices can’t last forever, they’ve already lasted far longer than I expected.

So, the question is: What will be the catalyst that brings everyone back to reality?

Typically, I’ll start with a rough top-down analysis to get a quick sense of the scale of the opportunity. This can generally be gleaned from research reports from firms such as Gartner, Frost & Sullivan, Forrester, Ibis World, etc. While the accuracy of theses “market sizes” can vary wildly, they help give context/act as a sanity check for the most important part of our work, which is the “bottom-up” analysis.

Getting to an approximate “bottom-up” analysis can be done relatively simply if you have the appropriate facts or are willing to make the appropriate assumptions.

As an example, let’s say I was trying to figure out the overall market size for an imaginary company, LearnStuff.com, which sells software to higher education institutions for use by their students. An incredibly simple (but probably not sufficiently accurate) way to do this would be to find a figure for the total number of higher education institutions in the US and multiply that number by an assumed average sale price per institution. That figure is approximately 6,700, of which approximately 4,500 are degree granting. We might assume that only degree granting institutions have a need for LearnStuff.com’s solution so we’ll stick with a market of 4,500 institutions. If I then assume that, on average, LearnStuff.Com is charging $100k per institution per year, we would arrive at a market size of $450 million. Though this is helpful in understanding the market size in a “quick and dirty” fashion, it’s probably not completely accurate.

A more sophisticated approach to understanding the total market would be to evaluate the market based on LearnStuff.com’s different revenue streams (software and services/support) quantified by the number of FTE (full-time enrollments) at the underlying institutions (since most consumers of enterprise software make purchase decisions based on number of “seats” as opposed to writing checks for nebulously described services for a non-specific number of people).

If we first assume that LearnStuff.com charges $30 per FTE plus a 15% support charge, we get a blended total cost per FTE of $34.50. If we then multiply that number by the 18 million students we assume attend the 4,500 institutions in LearnStuff.com’s core market, we arrive at a total market size of roughly $621 million.

I then might try to figure out the actual addressable market and would make assumptions about the revenue dollars that LearnStuff.com could compete for (taking into account whether this was a highly competitive market), and what % they would win in competitive situations. For example, I might have reason to believe that only 40% of the market, or $249 million of revenue, was actually up for grabs to a new market entrant. Based on the information that the LearnStuff.com management team has provided to me during diligence, I know that they win 1 out of 3 contracts they bid on, so I feel comfortable making the assumption that they can take 33.3%, or $83 million of the available revenue in the market.

You can see how what appeared to be a $621 million market was quickly reduced to an $83 million opportunity in the eyes of an investor. I’m more inclined to get excited about a company whose initial investor presentation has put serious thought into their target market segment and actual addressable market, even if it’s sub $100 million. Nothing will draw more scrutiny from an investor than the magic $1 billion addressable market size!

Dan Primack seems to have a knack for asking seemingly simple but poignant and pointed questions that stir one to respond (hence my first blog post in quite some time).

Today in Dan’s Term Sheet email, he wondered who venture investors’ perceive to be their primary customer. His question was in the context of Peter Thiel and the venture firm Andreesen Horowitz selling a significant amount of stock in portfolio companies that are now publicly traded. Dan’s hunch is that LPs are VC’s primary customer. He is right. My response to Dan is below:

Dan,

You’re 100% correct. As investors of (primarily) other people’s money, our LPs are our #1 priority. They are the reason we are in business and we have not only given them our word, but are also legally bound as fiduciaries to be stewards of their capital and grow it as efficiently and ethically as we think possible given our firm’s investment strategy. That said, at OpenView we deeply believe that we can drive the greatest returns for our investors by focusing almost all of our activities around helping our portfolio companies grow by providing them as much operational support (and capital) as we can muster/they need. For us, making money for our LPs and doing what’s best for a portfolio company are directly correlated. The cases that you describe with Groupon and Facebook are atypical in that Monsieurs Thiel and Andreesen invested in companies that are (or were to become) multi-billion dollar publicly traded companies.

Generally speaking, these investors should be perceived as having already done everything they could do to make their portfolio companies successful as, by all measures, Groupon and Facebook are wildly successful venture-backed businesses. Those are six-sigma outliers in the venture business (sad but true), and for them not to realize any of their investments for their LPs would have been imprudent. I understand that most of the shares Mr. Thiel sold recently were held by him personally, and I believe that he has every right to realize his own personal investments. However, Mr. Thiel is now a director of a publicly-traded company and is thus a steward of many other people’s capital. As such, he likely did not act in all of the public equity holders’ interests by selling his stake. That was his prerogative and I don’t begrudge him at all. He should probably step down from the board — he has served Facebook and Facebook has served him quite well, but their interests are no longer as aligned as they once were. That’s just my two cents.

What spurred me to action to write this note however, is that a certain sub-segment of our industry portray themselves as maverick do-gooders who have no need for money, but rather their greatest goal is to change the world by investing in transformative businesses. Now, there’s nothing wrong with that sentiment if you’re investing your own personal capital. Heck, I wish there were more wealthy individuals in the world who still had such idealistic and lofty goals. Unfortunately though, as institutional investors we are stewards of (mostly) other people’s capital and our #1 priority is to provide exceptional returns to our limited partners. Full stop. Any institutional investor that advertises themselves as something different is full of it and their LPs should take note.

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I continue to be amazed by the number of entrepreneurs that can show a relative lack of sophistication or business acumen in a conversation until the topic of their business valuation comes up. Once it gets to that point, they can rattle off every Andreesen Horowitz deal and how “X” business was acquired at 10x revenue.

For whatever reason, the math always seems to magically work out to a pre-money valuation of around $100 million. Indeed, there are numerous expansion (and some early stage) software companies that have raised outside capital at $100mm+ valuations, but I thought it made sense to share my (and many investors) thought process on valuation.

First, it’s important to note that in most other areas of investing, businesses are valued off of some proxy for cash flow (EBITDA, EBIT, etc). I point this out because I think some people lose sense of the fact that valuing a business as a multiple of revenue is, to begin with, generous.

It should also be noted that valuation is more art than science, or perhaps a more appropriate statement is that valuing a business is art rooted in science. Very simply, I like to take an average of a basket of publicly traded company EV/Revenue multiples, then apply a 25-50% illiquid discount and start there. On top of this, I’ll look at the revenue components and value each of those individually to get a sum of the parts total valuation.

So, for example, if a SaaS business is doing $15mm in total revenues, but $10mm of that is recurring subscription revenue, $2.5mm is professional services, and $2.5mm is maintenance, I might say that recurring part of the revenue stream is valued at 3x revenue, the professional services component is valued at 1x revenue, and the maintenance component is valued at 1x revenue, yielding a total valuation of $35mm. On top of all that we may layer a further discount or premium based on perception of team, risk, market, etc.

The bottom line is that this is one iteration out of many for how a business can be valued and should help explain where a VC may start a valuation conversation for an expansion stage software company.

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In his book, The 4-Hour Work Week, I love the importance Tim Ferris places on being a “dealmaker” and his dealmaker manifesto: reality is negotiable. Unless you possess a hugely valuable technical ability, I believe that being a dealmaker and having the mentality that anything is possible (and the resolve to work your butt off to turn that “anything” into reality) is the single most important trait in business people who find success at an early age. I also think that organizations that empower employees to act as “principals” are generally more successful and have a happier and more productive work-force.

I wish more college students and recent college grads understood the power of this concept and the fact that you have to go out into the world and mix things up. I realize that younger people are less confident and think that they may not have a ton to offer, but the truth is that almost everyone is a subject matter expert in something. Have you ever come across any type of consumer product (a candy bar, a pair of jeans, an energy drink) and thought to yourself “wow this is incredible, why can’t I find this in my hometown”? The dealmaker in you should lob a thoughtful call or email into the company and offer to help distribute their product in your region. So what if you have no idea how to distribute a consumer food/beverage product? You can figure it out. Have you ever used a service/product that you thought you could improve? Get in touch with the provider of that service and recommend ways to improve it or start putting together your own business that provides a better, cheaper service!

Often, nothing will come of these activities, but I guarantee if you get yourself in the habit of thinking that you have something to offer and are in a position to do something about it, opportunities will begin to unfold.

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I absolutely hate the term “networking.”

Growing up, I had never heard the term and certainly didn’t use it as a verb in my daily lexicon. When I was in college, someone recommended that I read Keith Ferazzi’s book, Never Eat Alone, which I dutifully read and remember thinking how disingenuous it made personal interactions seem. I think Keith’s intention was to write a book about how to be “genuine” in making connections and expanding your professional network, but I think it painted a different picture.  Does everyone have an angle? Does everyone have a hidden (or not so hidden) agenda? Maybe, but I personally find nothing more unappealing than when someone says they are meeting someone or doing something to “network.” I hate the word, and by the way, I maintain that it’s not a verb, though Merriam-Webster would disagree with me.

I do agree with Keith’s sentiment that one should never “keep score,” but do think that people should take care to be sensitive to other people’s time, interests, and past help. In his book, Keith took umbrage when an acquaintance did not immediately fulfill Keith’s request to meet a major Hollywood executive whom the acquaintance knew (and seemingly did not know well). Though it’s my genuine desire to be helpful to just about everyone I come in contact with, I can understand not wanting to bother a new acquaintance (particularly a very busy one) with a third party’s request for an introduction. I don’t think of it as using up “equity” in the relationship, as Keith’s acquaintance puts it, but I do think of it as using up someone’s time. One comes across as pushy and disrespectful of another’s time in immediately trying to “harvest” a new business relationship for your own or someone else’s gain. Use common sense, be genuine, and be respectful of others’ time and feelings.

In my brief adult life, I have generally found success in reaching out to people that I am genuinely interested in meeting or talking to. Of course, I’m interested in meeting with certain people because I am looking for insight, guidance, mentorship, a specific business purpose, or sometimes plain curiosity. I’m always up-front with my intentions and generally have a pay-it forward attitude when people reach-out to me for similar purposes. I have a hunch that if people stopped thinking of “networking” as a calculated activity and started thinking of it as an opportunity to meet someone you can learn from or be helpful to, they might find more success and satisfaction.

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Do you have a killer business that you’d really like to fund with venture capital? Do you want VCs to battle each other for an opportunity to give you money? Here’s what you can do to present the business opportunity opportunity on a silver platter:

• Paint a compelling growth story: It goes without saying, but what excites many VCs above all else is incredible revenue or operating margin growth.
• Clearly articulate a large market size: VCs love to see a market size large enough to support your business. It becomes increasingly attractive if you’re able to further segment the market and define your projected market penetration.
• Have market analysts and customer references ready: A VC will typically want to speak with several market analysts who are experts in your industry as well as current customers. If you have names and contact information available immediately, the investor can get to work immediately and with little friction
• Define the competitive landscape: VCs will always want to understand exactly who your competition is, how crowded the market is, and what your competitive advantage/differentiation is. I have found that a simple grid highlighting the overlapping/non-overlapping features across all the companies in your space to be most helpful
• Map out your exit: Professional investors evaluating an opportunity will typically want to understand potential exit scenarios. I have always found it helpful (and been appreciative) of entrepreneurs who spend time analyzing and articulating who likely acquirers may be, whether their research supports an IPO scenario, etc. It pays to be thoughtful with this exercise: If you suggest selling your business to publicly traded company X for $500mm but company X has $3 million of cash on its balance sheet and a market capitalization or $35 million, you’re not going to appear very smart

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Probably the hardest single aspect of my job as a venture capital neophyte is efficiently managing my time for the greatest productivity. Making great investment decisions is pretty hard too but as far as this post is concerned, we’re talking time management. I’m fairly certain time management is an issue for many people in many professions so I thought I’d outline my time management challenges, and how I attempt to overcome them.

OpenView is a small investment firm and as such, we run pretty lean and mean. My core job is to find great companies to bring into our portfolio, evaluate and execute investments once opportunities are sourced, and then support those investments once they are in the portfolio. Sounds pretty simple right? That’s what I thought…until I came on board and found out that its really difficult. Seriously fun, but very difficult. Why is it so difficult?

Each element of my job is multi-faceted and I can seldom focus on one discrete task for a long period of time. For example, any on any given I’ll have a number of phone calls with prospect companies, an in-person meeting, a post-LOI piece of financial analysis to produce, dozens of emails to respond to, a market research call with an industry expert, an interview with a prospective OpenView employee, and the list goes on.

So what do I do to keep myself on task and organized?

It may sound simple to some of you, but below is the “blocking and tackling” of what gets me through the week in a productive fashion:

• Block Scheduling: I try to block my mornings (from 8:30am to noon) for calls/meetings with prospect companies. This way I always have a time reserved on my calendar for an activity that otherwise may get pushed to the back-burner when new items up pop-up during the week
• Create a weekly “backlog”: Every Monday (or Sunday night) I create an excel sheet with the most important activities that I need to accomplish during the week ahead of me. I also add an estimation of time to completion for each task. I try not to have more than 35 hours of “scheduled” activities on my backlog as this last year has taught me that a) I generally underestimate how long it takes to get certain things done, and b) 35 hours seems to be the magic number when it comes to how much highly-focused work/work-product can be produced in a work-week. You might think that sounds like a small number for a hard-working VC, but if you consider your own week, I have a hunch that you do 35 hours or less of highly-focused activity.
• Schedule time for email: Email is highly distracting. I get emails all day-long almost every day of the week. If responded to every email as I received it, I’d become even less efficient than I already am! As such, I try to schedule an hour every day, or several hours over the weekend (typically on Sunday night) to get my inbox as close to zero as possible.

Venture capitalists are sales people. We sell money.

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The reason we sell money is to make more money. Our investors, aka our Limited Partners, have given us money for the expressed and sole purpose of attempting to return more capital to them than they initially gave us. That’s the business in an overly simplistic nutshell. Am I demented to boil it down so simply? Am I a greedy capitalist trying to suck the money marrow out of the bones of unsuspecting entrepreneurs. I don’t think so.

Why is it then, that entrepreneurs seldom hear VCs talk about making money? Why are Venture Capitalists, in some circles, held up as experts of everything and maverick business people who defied the odds to achieve great success? I have a few ideas…

Let me first clarify something: Venture capitalists are indeed trying to make money, but that said, most of us have chosen this path because we have a genuine passion for building businesses, entrepreneurship, technology (or whatever it is that we invest in), and do in fact have a bit of a renegade streak in us. Many VCs likely had opportunities to make more money in the near-term elsewhere with far less risk. That said, a key part of our long-term goal is to earn our LPs (and ourselves) a significantly above-average amount of money. We’ll make money by investing in promising businesses /entrepreneurs and doing everything in our power to make the people and businesses we invest in successful. This is all pretty obvious but I felt the need to put this down in writing after hearing numerous stories from entrepreneurs (and investors) that VCs aren’t in this for the money. While that may be true on a personal level for some people, it’s absolutely not true at an institutional level, or at least I haven’t met an LP that’s investing in venture capital in hopes of losing money.

Why do I say that we sell money?

Often, a great business or entrepreneur that is seeking to raise outside capital will have a lot of interest from a number of different venture capital funds. We’re all offering generally the same proposition: money in exchange for ownership of a piece of a business. Last time I checked, my ten bucks is the exact same as the next guy’s and entrepreneurs generally would rather not take money from an investor that views them simply as a mechanism to provide a great return to limited partners. So what do we do? We VCs brand ourselves, work to differentiate our model, and try to represent our firms as the most attractive partners. For many this does not involve highlighting a VC’s desire or mission to make money. In order for us to be great at our jobs we need to be able to invest in great businesses, and much of that has to do with our ability to convince great entrepreneurs to take our money over someone else’s.

There’s nothing wrong or nefarious with this business, but I think VCs in particular need to remember — and perhaps be a bit more upfront about — why we do what we do.

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Over the last year, I have found that entrepreneurs contemplating taking on expansion stage venture capital are almost universally concerned with the certainty of deal consummation after signing a term sheet. Here at OpenView, we aim to fund 100% of the companies with which we sign term sheets and complete our due diligence, but occasionally, we’ll discover something over the course of diligence that prevents us from continuing down the funding path. Several months ago, my colleague Firas Raouf opined on how to avoid getting yourself into a busted venture capital deal, so I thought I’d get a bit more specific and lay out the key components of how deals fall apart.

Revenues/Bookings are not as advertised

Occasionally, we will find that company management will either intentionally or unintentionally misrepresent the current financial state of the business. There is not much that we can do to mitigate the intentional or nefarious misrepresentation of revenues/booking information. I suppose people do this in the hopes that an investor won’t figure it out, but the odds of that are extremely low. All it does is waste a huge amount of time for both investors and company management alike and take both parties away from otherwise productive activities. Intentionally misrepresenting financial information is rather unscrupulous and leaves a really bad taste in everyone’s mouth.

Unintentional misrepresentation of financials is easier to understand but should also be avoided. This can occur when investor and management have differing definitions of what bookings are so it’s best to establish that definition at the beginning of the discussion. For example, I may think that bookings means contractually obligated revenue for a period of time and that both parties have signed said contract. You may think that bookings is defined as a verbal agreement with a contract to be signed at a future date. These are subtle differences but can have a huge impact on the way we evaluate a business. Another possibility is that deals that you had anticipated closing at the commencement of your discussion with an investor (and that you had included in your quarterly or yearly revenue numbers) end up falling through. This happens quite regularly and depending on the significance of deviation, perhaps can be worked through with your investor. I think a good rule of thumb is to be conservative with your revenue/bookings representations and to be up-front in saying that a deal has not yet officially closed etc.

Company drastically misses its numbers

This is touched on above but in case its not abundantly clear, if a company is projecting doing $X million in revenues during the quarter that we’re conducting diligence and they end up doing $0.5X, the deal can fall apart quickly. As “growth” investors, we are looking for sustained growth and a significantly “down” quarter would certainly give us pause. That being said, timing may be an issue and the revenue will simply be recognized a quarter later. We will certainly work to understand exactly what has happened and make the sensible and prudent decision.

Previously unknown litigation/legal matters

It’s best to make any current litigation, legal infractions, IRS investigations, etc. known upfront as again, the investors will always find out about them. Let us know at the on-set so we can evaluate the situation and determine if it makes sense to go forward.

Failure to release product in certain timeframe

If a company is advertising a significant product release and fails to release it in the timeframe contemplated, that is another worrisome development. That product release was likely factored into the company’s financial projections and our assessment/interest in the business. A failed product release could lead to weaker-than-anticipated financial performance.

Misrepresentation of sales pipeline/market opportunity/customer satisfaction

Generally, investors will have a decent sense of the market opportunity, sales pipeline, and customer satisfaction/opportunity prior to signing a term sheet. It is possible, however, that a company’s management has either misrepresented certain aspects of the opportunity or does not want to share certain pieces of information prior to signing a term sheet.

For example, if a company fails to introduce us to customers prior to signing a term sheet and then after signing we find out that numerous customers have serious issues with the company’s product or services, that will throw a serious wrinkle into the deal process. This can be mitigated by both providing customer introductions prior to signing a term sheet as well as relaying any key issues that customers may have had to the investor. I have also encountered situations in which a company will accurately represent its revenue/booking information, but have totally misrepresented its qualified sales pipeline. Like bookings, it’s best to ensure that both investor and company are aligned in their understanding of what “qualified sales pipeline” really means.

Bad management reference calls

As part of our standard due-diligence process, OpenView typically conducts reference calls for members of the senior management team (CEO, CFO, VP of Sales, VP of Engineering, etc.). It’s possible that something unpleasant would surface during the course of these calls. For example, if the CEO of a company has universally poor references from the references he provided, that would signal a few things: 1) The CEO isn’t the sharpest tool in the shed if he provided references that would unanimously ding him, and 2) There are probably significant issues with the CEO if numerous past employers, partners, and employees fail to paint a positive picture.

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I’ve found that — largely — this frustration results from poorly managed expectations. Investors often fail to manage entrepreneurs’ expectations with regard to timeline and scope of diligence. Investors find frustration in a management team’s failure to provide materials quickly, and a lack of preparedness for what we investors may think are obvious requests.

In an effort to provide greater clarity into an expansion stage venture capital investor’s due diligence, I’ve laid out a typical post-term sheet diligence process below.

Week 1 – Venture Capital Due Diligence Process

Immediately after both parties sign the term sheet, the investment team will sit down and craft a diligence plan with a framework/goals for the following 30-45 day period.

Day 1:We’ll send an information request list to the management team likely asking for the following:

1. Customer data

• An introduction to at least 10 customers so that we can conduct “customer calls” to better understand the product/services differentiation, value proposition, and customer satisfaction
• Revenue by customer
• Customer churn/cohort data, so that we can perform cohort analyses

2. References

• Introduction to references for the management team

3. Business/financial data

• Historical and projected financial statements (though we will have likely already received this prior to signing a term sheet)
• Discussion about assumptions behind the projected financial model so we can test and construct our own “sensitized” operating model
• Detailed break-out of COGs and operating expenses so that we can deeply understand unit economics and cost structures
• A company organization chart detailing key employees and responsibilities, and a detailed employee headcount
• Updated capitalization table (though we will likely have this already)
• Any board/investor presentations

4. Sales and marketing information

• Sales and marketing team organization chart
• A list of sales representatives with date of hire/termination and revenue by sales person
• Detailed breakout of sales and marketing expenses (if not included in financial information)
• Details of qualified pipeline and bookings
• Details around current marketing initiatives and metrics if available

5. Market data

• Any U.S./global market and industry data available
• Any relevant research reports/articles (the investors will likely spend much of their own time understanding the market landscape and market size, but any additional information that the company can provide is always appreciated)

This might look like an overwhelming list, but remember that it will be sorted over the entire diligence period. In addition, during the first week the investor will likely retain an accounting firm to help with financial diligence and potentially a technology consultant to help assess the scalability and architecture of a company’s software solution. Additionally, attorneys for both the investor and company will be working during this same period to make sure everything is in order on the legal side of the equation. At the beginning of Week 2, the investor will present the findings to-date to an investment committee and ask for permission to proceed.

Week 2 – Venture Capital Due Diligence Process

The investor should be deep into diligence at this point, having hopefully received a meaningful portion of the information requested. The investors will likely be in the process of managing the legal/accounting diligence, conducting and/or scheduling customer calls, and composing their own operating model for the company.

The second week might involve several phone calls with the company’s management team to discuss anything from a particular expense line item to the productivity of the sales team. An investment committee update will probably take place at the beginning of Week 3.

Week 3 – Venture Capital Due Diligence Process

Ideally, both investors and company management alike will feel that significant progress has been made at this point, and the end is near. If no red flags have popped up on the the accounting, tech, or legal diligence, the investor will be working to finish customer calls, management reference calls, market sizing analyses, sales and marketing economics analyses, cohort analyses, and the operating model.

The goal is to have the vast majority of this completed in Week 3 so that the investment committee can evaluate the findings at the beginning of the fourth week and vote to fund the business at the end of Week 4.

Week 4 – Venture Capital Due Diligence Process

If all diligence activities have been completed and both parties are satisfied, the investor will present the final update to his/her investment committee and ask for permission to fund.  If permission is granted and all the legal documents are in order, funding can take place immediately. Then the real work begins…

Please note that this is a bit of a simplified explanation of a venture capital due diligence process and that there are no “written in stone” timelines or methodologies for conducting diligence. At the very least, this will hopefully give management teams a better sense of what to expect from institutional investors and ease frustration along the way.

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One of the greatest aspects of my ever-excellent job is that I have my world rocked at least once a month. And I actually mean my world gets rocked. My heart beats faster, my eyes open wide, and my mind wanders – races even – through the myriad implications of what I have just learned. What have I learned?

There are so many different ways to make money and lots of those ways are sitting right in front of you in some fairly obvious places.

A good place to start your thought process is with market size. If the market is large enough, there is a higher degree of probability that you will be able to build a successful commercial enterprise. It may not be a Fortune 500 company, but if done correctly it could still provide quite nicely for you and your family.

That’s the beauty of starting software company with a SaaS revenue model - 80% gross margins and 20-50% EBITDA margins! A $10 million dollar a year top-line business could produce $2 to $5 million in pure profits. There are THOUSANDS of great software, technology, and services businesses that need to be started to satisfy actual needs in large and unsexy markets.

This might sound obvious, but I’m constantly astounded by entrepreneurs that have created profitable businesses in enormous markets that might bore you to tears. Have an interest in human resources payroll software? Probably not, but that’s going to be a $4 billion dollar market by 2016 (so says Accounting Today). Does the Tuxedo rental business interest you? It doesn’t really interest me either but Men’s Wearhouse did over $350 million in tuxedo rental revenue last year with over 80% gross margins — and according to the Wall Street Journal, the tuxedo rental market is a $1.2 billion dollar a year industry.

Should you go into the tuxedo rental business? Probably not. But should you spend an hour of your life figuring out if there is a way the business could be made more efficient with a piece of enterprise software? Perhaps. The bottom line is that if you’re committed to starting your own business (and building one that is commercially viable and profitable), start with evaluating market sizes in old industries that may be looked over by other investors, hackers, or entrepreneurs such as yourself.

Creating a basic financial model does not have to be a daunting task, though it can often turn into one. I can’t count the number of business models I’ve received from companies that are utterly complex with models inside models, several hundred line items, assumptions that stretch over multiple Microsoft excel tabs — ultimately incapable of allowing me to understand and test the key drivers of the business. Assuming that you have a basic economic model in mind (and one that leads to profitability), I recommend constructing a simple three-tab model to better understand the mechanics of the business.

The point of this exercise is to understand the big picture: the unit economics of the business, the capital efficiency/cash burn, gross margins, etc. Think of your first crack at this as a battleship, not a sniper rifle approach.

Keep it simple, keep it flexible, and improvise if you get stuck!

Create an assumptions or “drivers” tab from which you can drive the model, a sales representative ramp page where you can build out a number of sales people and their productivity, and an output page where you can see what the monthly numbers actually look like.

If you are in the very early stages of business planning, it might make sense to drive all the expense line items (both cost of goods sold and operating expenses) as a  % of revenue. A good sanity check, or even guideline, for those without a sense of their expenses is to use publicly traded SaaS businesses metrics. You may want to use a slightly higher % of revenue than you find in the publicly traded companies as they have achieved scale/synergies and are likely able to have lower costs than you, the small but noble SaaS business.

I also find that it helps to keep the process moving forward, so don’t allow yourself to get stuck in minute details and do resort to plugging in elements like publicly traded metrics. An assumptions page could look like this (note that these are not appropriate values):

The key is flexibility, so that you can test different scenarios by quickly changing or “flexing” different assumptions.

As for revenue, I find it helpful to drive revenue from both the main assumptions page and sales representative ramp assumptions page. On the assumptions page, lay out assumptions for the monthly contract value, churn as a % of revenue, and lag time between awarding of the contract and receipt of first payment. This last component is important for many SaaS businesses as often companies start supporting customers and incurring expenses before they receive payment for services. This could articulate that you need to raise more money to bridge the gap between your expense and receipt of payment, or alternatively, figure out a way for your customers to pay you in a tighter timeframe. For the sales representative ramp page, I think it’s easiest to create something that looks like this:

This way you can make assumptions (and test) different scenarios for the number of sales people on staff, their productivity (i.e. how many contracts they can sell per month) and how long it takes to get them ramped up (i.e. how long are they on staff before they start producing results). Having the visual aid of seeing how many reps you have on staff and what they are projected to produce helps you maintain a more comprehensive view of your sales organization on one piece of paper.

You can then build out each month’s revenue on the third and final tab (the output tab) by creating the appropriate formulas with the various assumptions. The idea is to tweak the model from both the assumptions pages and never change a number manually on the output page!

Building a very basic financial model is a combination of art and science. There are no rules (outside of basic accounting), so don’t allow yourself to get stuck in the details on the first go-around. The beauty of a financial model is that it can be refined and tweaked over time — so long as you’ve constructed one that is sufficiently flexible.

Aside from Instructure building a best-in-class LMS product with its Canvas LMS solution, Instructure has one of the coolest founding stories out there. The story starts with Josh Coates, newly “retired” from the software biz after selling the company he founded, Mozy to EMC. “Retirement” for Josh meant moving to Utah with his family and teaching computer science and entrepreneurship at Brigham Young University. In teaching a class on software and entrepreneurship, Josh gave his students an assignment to develop software for any area that they felt current software failed to satisfy the current need. Two of his students, Brian Whitmer and Devlin Daley, set out to create a better platform to facilitate interactions between students and faculty and voila, Instructure was born. There is a bit more to the story, but you get the idea. I think it’s incredibly cool that a great education technology company was born in the classroom. I’m very excited to be affiliated with the great team of people at Instructure.

Instructure managed to develop a product, Canvas, that is the first “Web 2.0″ LMS. Canvas was built from the ground up using a – you guessed it – blank canvas and leverages the latest web technologies such as drag and drop file uploads, HTML5 video and speech-to-text conversion, all while integrating with commonly used social media platforms and student information software.

Current Canvas customers have to be some of the most enthusiastic and satisfied enterprise software customers out there. One faculty member said that tears came to his eyes upon first use of Canvas. Another said that the SpeedGrader™ has reduced her time spent grading student assignments by 50%!

The Market:

The higher education learning management system (LMS) market has been dominated by BlackBoard (or companies BlackBoard has acquired) since institutions began using LMS in the late 1990′s. The LMS market has seen little disruption in the last decade with only four key companies vying for market share: BlackBoard, Desire2Learn, Moodle, and Sakai. Desire2Learn (D2L) is a Canadian company that was founded in 1999 and has a small amount of market share. BlackBoard is a publicly-traded company with an almost $1.3BN market cap and did approximately $450mm of revenues in 2010. D2L is a commercial vendor that offers full hosting and supporting services but does not make its code/development tools available without a purchase/contract. Moodle is an open-source vendor, which means that their product is essentially free and has a vibrant community of institutions/engineers that add/enhance the functionality of the underlying platform. Moodle (and Sakai) either needs to be hosted/supported by an academic institution or by a third-party hosting/supporting company such as MoodleRooms or rSmart. After BlackBoard, Moodle has the next largest amount of market share. Sakai is another open-source vendor and has the smallest amount of market share out of the four. For more on the LMS market, I highly recommend reading Michael Feldstein’s two-part blog series on the state of the LMS market.

The Market Opportunity:

The LMS market is a market in flux. BlackBoard has a largely dissatisfied customer-base and they provide a dated product that equates to the most expensive product/service available. Historically, BlackBoard has acquired and/or sued any commercial vendor that came close to competing. Because of BlackBoard’s massive market-share and litigious habits, very few companies were formed (and even fewer funded) to compete in the LMS space.

Given the current market dynamics and Instructure’s exciting product and team, it was hard to resist the chance to invest in such an incredible expansion-stage software company that has figured out a way to beat the competition in a fragmented market!