To understand the metrics necessary to attract a Series A round of investment, we begin by discussing the objectives of venture capitalists. Series A investors are professional venture capitalists (rather than angel investors), who scrutinize every operational and financial characteristic when evaluating a company for investment. After a thorough description of investor objectives, we review some common metrics necessary to meet investor expectations for a given industry and series A funding.
What are the objectives of Series A venture capitalists?
Venture capitalists manage the money of investors (limited partners). They invest this money in growth-based companies with the hopes of reaping a profit by selling their interests to later investors or back to the company (as part of a leveraged buyout or initial public offering). The expectation is that the company investment will rise significantly in value using the investors capital as the fuel for growth. The idea is that the company will grow in revenue extremely quickly. Ultimately, the company will be valued based upon some multiple of total revenue. In some cases, the company will be valued on free cash flow, but this is generally only the case for later-stage businesses.
Despite the growth, the company will also potentially incur extensive losses. The reason is because of the high costs of marketing associated with such rapid growth. The investment capital is used to cover these loses. A series A investment should generally cover the company’s losses for 18-24 months. The rate at which the company uses the investor capital to grow is known as the burn rate.
In practice, once the company has a large customer base and brand recognition, it will be able to cut marketing costs and become a profitable company with sustainable revenue. This is why startup companies are attractive targets for acquisition by larger companies. The larger company can often purchase the startup (and all of its sales/repeating customers/market share) easier than it can grow organically. The larger company will be able to cut marketing costs and piggy back on its existing marketing. Thus, the company can become instantly profitable or a valuable revenue contributor to the acquiring company.
For these reasons, the venture capitalists will only invest in companies that have the potential for rapid, extensive growth. The venture capitalists expect to return an above-market-average rate of return to the limited partners. As such, they need an internal rate of return on all investments of 20-30%. The problem is that historically 90% of investment companies break even or lose money. This leaves on 10% of investments to achieve all of the returns. As such, these 10% of companies must achieve a rate of return of 20-30 times(x) the initial investment. This generally works out to produce the minimum desired level of return to keep limited partners of the venture capital fund happy.
The difficult job of the venture capitalist is to find and invest in startups (portfolio companies) that will or have the potential to produce the desired return on investment. This is perhaps the most important function of the venture capitalists. The limited partners of the VC fund believe that the venture capitalists have the ability to identify and invest in winning companies.
What Metrics Investors Look for in a Series A Investment
Investors rely on company metrics to identify companies with the potential for rapid growth and the ability to achieve the desired rate of return. The metrics desired by a VC firm will vary depending upon the nature of the company and the industry. Below are some of the metrics highly valued:
- Product-market fit – This is when a company identifies a minimum viable product to meet the demands of an identified market segment. A business generally begins with an identifiable target market. Too often, the intended target market does not embrace the product or service. As such, the business must pivot to meet the identified need or want of the target market or to meet the needs or wants of a completely different market. Thus, having achieved product-market fit is an important metric for a VC in a venture capital investment.
- Business Model – Investors want to see a scalable and repeatable business model. This means that the company has a method and clear trajectory for creating recurring value. Depending upon the nature of the business, this could be through increasing sales, new users/viewers, customer/client acquisition, growing subscriber based, etc. For example, a brokerage would need to demonstrate monthly sales along with a growth metric. A social media platform would need to show a broad and increasing user base.
- Strength of Demand – How much does a customer/client value your product or service? What is the customer/client acquisition cost? What is the expected value to be realized from the average customer. The metrics associate with this in SAAS and E-commerce will often be expressed in terms of monthly recurring revenue. Anything near:
– $1 million of mostly revenue for e-commerce,
– $500K-$1million in monthly revenue with 20% month over month growth for brokerages or marketplaces;
– $50 -150K for monthly subscriptions for SAAS is a good metric.
– 50K daily users and 25% month-over-month growth for n consumer apps, are strong metrics.
- Competitive Advantage – The market for the product or service may be crowded and competitive. What gives the company a competitive edge? This could be intellectual property protections, first move advantage, brand recognition, team talent, etc.
LawTrades Knows Venture Capital
Undergoing a series A venture capital transaction is a major undertaking. You will need professional assistance from a number of service providers. The legal professionals at LawTrades can meet all of your company’s legal needs.