On Startup Metrics and Picking The Right Investment

Controlling the right metrics is one of the indispensable features of a great founder. Management by numbers is key for growth, and critical in adapting a startup operation along its quantum leaps of scale. However, we can’t predict when your path as an investor will cross the path of a founder who have already reached that maturity… so the question becomes: since scale is the trigger for better metrics, how can we detect a precocious number orientation in a pre-growth startup?

Numbers don’t lie

You may want to read Semil’s recent take on how investors should spray and pray versus be picky. It’s a very good article, and this particular quote had me wondering:

So, is it just “spray and pray?” No, that is too easy. It’s about branding for deal flow, about securing the perimeter for coverage, about staying close to your companies and helping out, and having the financial access, right, and flexibility to follow along into subsequent rounds as the best companies emerge

The best companies emerge, he said. As an investor, how can you be there before it happens? This situation reminds me of Mark Zuckerberg right after the IPO, when asked about Facebook being overpriced. He said the company stock was undervalued and that it was a great opportunity for people to double down before it went up. Only he and the Board had the real glimpse of how Facebook was going, and that was because only they knew the key growth metrics. You can only price well what you measure well.

The deeper and faster you get into the metrics of a potential investment before closing a deal, the better are the odds to make a good decision. This looks like an obvious conclusion, but you’d be amazed that many investors don’t know which metrics to analyze. Doubling down is significantly de-risked with real numbers (even if they’re still small), and this is why I’m picky on metrics and dedicate long hours to make them right. Good metrics are a collateral benefit of a good strategy.

Startups are a tool to build scalable businesses, so you’re not looking at a “role model startup” if you don’t get the numbers – and role models are the only ones worth investing in. Even when there’s not enough operation history, the proper metrics are mandatory and key for a VC to evaluate the business evolution.

Using a simple analogy, startup founders who don’t know their metrics are like slow drivers on the fast lane: they should either go faster or pull to the right. The ones who drive faster and measure their way are still on the race; the slow drivers who don’t measure performance are thinking about something else than the race – and startups are all about winning that freaking race.

How to pick them?

Instead of focusing on the metrics themselves – because they vary according to the business model and there’s extensive online content on that matter – this is how I assess founders and startups with a simple framework and four levels of metrics maturity:

  1. they have no idea (or are uncertain) of what are the right metrics for startups
  2. they know the fundamental principles for startup metrics, but don’t know which ones to pick
  3. they know which metrics are the best for them and do perform measurements, but didn’t create a routine evaluation process
  4. they implemented an automated dashboard and the business is constantly refined according to the right measurements

This way VCs can easily prioritize the deal flow with one single objective criterion, instead of looking in the mirror every morning and pinching themselves thinking how unbelievably good they are when picking investments. Startups scoring 3-4 should be looked into before others. The higher the investment round, the closest they need to be to 4.

One might argue there may be excellent investment deals out there who operate under the radar, run kick-ass products but still didn’t figure out the right metrics. Well, considering the amount of information on the subject, that would be as condescending and contradictory as listing good VCs who don’t guide their strategies relentlessly and insanely by their own performance metrics.

We’re constantly being reminded that seed-stage valuations are reaching all-time highs. Check out the Q3 2015 Halo Report to understand why. I believe the proper intepretation of metrics reduces venture capital waste – but you need to be sharp on which ones to look into.

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Herd Behavior in Venture Capital: The Rise and Fall of Everything

Venture Capital is based in the expectation of returns, and that involves mainly two things: trying to predict future scenarios for a particular company, and comparing that future with other company futures to determine which to pick (if any). The fact is that some will become global, others will die miserably, some will gradually rise or graciously fall – and all that is like the birds and the bees for founders and investors.

Nevertheless, even after unveiling the mists of venture capital intercourse, most entrepreneurs take some time to notice a simple truth… that not all investors are bright, but most think they are.

Herd Behavior

To understand how good and bad decisions are made in Venture Capital, let’s segment investors under two simple criteria… how much they really know about the VC market, and how pretentious they are about that:

  1. those who don’t know much, and are aware about that
  2. those who don’t know much, but think they are wise
  3. those who are wise, and recognize their own wisdom
  4. those who are wise, but know there’s so much to learn

Group 1 is the Conscious Herd, mostly formed by angels and wealth managers who invest in startups to diversify and experiment, not necessarily expecting a massive return. A lot of novice LPs and executive-angels also fall into this first category. Recognizing their limitations and low expectations is key for their survival since they have no wish to risk more than they should – and that’s why they intend to follow the market and bet on information symmetry.

People in group 2 form the Unconscious Herd. They are following whatever venture capital trends published by media or celebrity investors, so they can mimic their bets. “Clean tech is the new bubble” and “50M is the new series A” are remarks they use that end up driving the market sideways and creating a zero-sum game. Those VCs sometimes are the ones who provide easy money for bad founders (since great founders tend to avoid them).

The Elders are in group 3. They look from afar and wait because they can’t run too fast. Most billion-dollar funds and experienced investors are in that category and feel no need to move fast because they’ve been there and done that (and that is millions/billions in return).

Founders should always be good friends with the VCs in group 4. They know their kung-fu, but know they can never be too fast. Their gut feeling and experience play an important part in deciding who will get a term sheet, but they also know data, experimentation, and sometimes pure luck and serendipity, carry a lot of meaning. They are The Leaders, and that involves leaving elders and the remaining herd behind if they can.

So what?

When people are looking for problems where no problem exists, I use an old Brazilian saying: “You’re looking for a horn in a horse’s head.” In the VC world, it might just as well mean that you shouldn’t search startups for future unicorns… but a lot of investors think they’ll bump into one.

Venture Capital is a strange industry because some of these groups act and interact for emotional reasons. There will rarely be a bubble in a market when there are only Leaders and the Conscious Herd; bubbles are caused by Elders (in the higher atmosphere) and the Unconscious Herd (who agree to inflated valuations in early and seed stages).

The rise and fall of everything in venture capital start with a herd behavior of those two groups. Either a small trend that suddenly escalates, a specific snowball effect that changes habits in 1-2 years or a strange move that seems good at first but rationally makes no sense. Here’s what happens next:

  1. The Conscious Herd experiments more or follow the Leaders
  2. The Unconscious Herd will stay behind and moan their dead
  3. Elders co-invest with larger bets
  4. Leaders lead because there’s no other way

Groups 1 and 2 generate waste. The ones in group 3 don’t care about waste (but may change their minds when the market turns). Lean VCs are mostly in group 4 because there’s no worse vision than waste in capital. Being conscious about your limitations as a VC – regardless of past wins and losses – is a fundamental feature of a lean investor.

The secret is to make a move, no matter where the market is going. There’s no bubble for startups that grow fast and strong, and for VCs that ignore the herd.

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