SUMMARY
Amit Somani said that while it’s difficult to comprehend what the unit economics of an early stage startup will end up looking like in the future, he looks closely at the plan that a founder has regarding how the funding will be utilised
From the perspective of an impact fund, AWE Funds' Seema Chaturvedi said that apart from traditional methods of evaluation to ascertain a startup's potential in terms of revenue and investment returns, it’s also essential for her that the company shows promise in making a social difference
Early-stage VCs recognised that certain businesses such as SaaS naturally gravitate towards higher margins, but the expectation generally is that the threshold is greater than zero to begin with
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The Product Summit boasted a series of successful tech startup founders such as OYO’s Ritesh Agarwal, Zoho’s Sridhar Vembu, Zerodha’s Nithin Kamath and Pallav Nadhani of Charts.com and Fusioncharts fame and other stalwarts of the ecosystem. While many of them spoke of how not focussing on fundraising helped them build products with greater freedom, we can’t discount the huge enabling role that VCs play in the startup ecosystem, especially at the early stage when products need fuel for development, testing, iteration and releases.
A burning question for early-stage founders, product managers at Series A and below startups and aspiring entrepreneurs, is what exactly convinces a VC to invest? What are the metrics that matter in early-stage investments and which are just vanity metrics that don’t need to be chased?
In a session moderated by Sanjay Mehta of 100X.VC, Indian investors — Sajith Pai of Blume Ventures, Seema Chaturvedi of AWE Funds, Amit Somani of Prime Ventures, Ritesh Banglani of Stellaris Venture Partners delved into what makes a startup tick from a product metric perspective.
Measuring Traction In Early Stage Startups
Mehta set the ball rolling asking his fellow VCs what would make a startup stand up in terms of traction — he quipped about how this would also help him educate his 100X.VC portfolio at the pre-revenue and super early stage. He set the stage by asking what are the most fundamental metrics for early-stage startups.
A lot of tech startups use metrics such as daily average users, monthly average users but the most important marker of traction that can yield value, in the long run, is user engagement.
According to Amit Somani, it’s crucial to ask if there’s a proxy metric that shows user engagement with respect to the core pain point that the startup is trying to solve in a particular market. But he also cautioned that it’s not useful to go metric shopping just for the heck of it as reading too much into a wide array of numbers might be futile for an early stage company.
“If a metric doesn’t change the way in which you want to run the business, don’t worry about it,” the Prime Venture Partners investor said.
From the perspective of an impact fund, Seema Chaturvedi said that apart from traditional methods of evaluation to ascertain a startup’s potential in terms of revenue and investment returns, it’s also essential for her that the company shows promise in making a social impact.
According to the veteran capital markets investor, one should also look at what kind of strategic partnerships a company has set up. “They can become a sample good housekeeping on the product, service or technology that the company is offering,” she added.
“The best source and the best validation you can get is a paying customer. So for us revenue is important and we are also open to the idea of looking at proxies,” — Seema Chaturvedi.
Ritesh Banglani of Stellaris jumped in at this point saying that there are three questions that need to be asked of an early stage venture — Is there a problem that the customer base wants solved? Next, do you have a solution that could potentially solve the problem? And the third, is this the right team for executing that solution and scaling?
“I think none of those have good answers at the seed stage and so we look for proxies to those. In our case, the level of traction has very little value. It is very hard for us to say, at any point, what level of traction is the right traction to invest in that business”, he said.
According to Banglani, the three important metrics that could be looked at before committing to investment are — conversion rate from free to paid as it shows that customers are actually responding to the solution that the startup is offering; the net promoter score, which shows how favourably a customer recommends a product to others; and customer retention.
Sajith Pai echoed Banglani saying that his fund also reaches out to customers at times to gauge what they think about a product. He said that apart from customer obsession, it is also important to get a view of how narrow the problem that a startup is trying to solve as it gives an idea if the product can be expanded in the future.
Taking A Margin Call On Burn Rates
While traction is the factor that VCs look for to determine how well a startup is solving a pain point, the rate of cash burn is what tells them if the company will survive long enough to get them their returns on investment.
Somani said that while it’s difficult to comprehend what the unit economics of an early-stage startup will end up looking like in the future, he looks closely at the plan that a founder has regarding how the funding will be utilised. “If you’re going to go raise a million or a million and a half and you’re going to be burning a couple of hundred thousand a month, that’s not really going to be all that great, irrespective of whatever business you’re in,” the investor explained.
There may also be times when the company doesn’t have clarity on its business model and cash flows — even though VCs would take a bet sometimes on those startups, it would be rare to invest in a venture with negative gross margins, according to Somani.
Another crucial factor to note here in this regard is the percentage of gross margins that an investor deems good to go with varies with respect to the sector. VCs recognise that certain businesses such as SaaS naturally gravitate towards higher margins in the range of 80-90%, but Somani says the expectation is that the threshold is greater than zero to begin with.
Sajith Pai agreed with both the points, saying “Fundamentally, all of us are investing in businesses where you can acquire the next customer at very little cost. So gross margins do become important to evaluate.” He added that if a SaaS startup has a 30-40% level of gross margin and there’s no plan of increasing it by scaling up or marketing, something is terribly amiss.
Banglani offered a different take, saying that investors should also look at the nature and the degree of burn rather than bucketing startups with similar rates together. “I think we need to look beyond the simplistic notion of burn and really assess what the burn is going towards,” he explained.
For instance, if the burn is a consequence of funding negative gross margins, then it means that the customer will not buy the product unless he gets it at below cost. However, if a Series A company is spending for its cost of product development, marketing, and operations, that’s not a cause of concern.
“If a company is burning to acquire customers and the customers become profitable in a few months time, that I would argue is a very good sign and the company would have a queue of investors in front of their office,” said Banglani.
At this point, Chaturvedi jumped in to remind the panel of the 1990s and the turn of the millennium, when the dot com boom was at its peak and investors were easily convinced that eyeballs would translate into returns in the future.Having been through many such market cycles of boom and bust, she stated that it’s important that even an early stage startup shows a path to profitability. Additionally, in her position, she calculates how long the cash runway would be if the burn rate persists and tries to gauge the ability of the founders to raise more capital after that.
“We are not excited about high numbers that just keep increasing. You cannot make money eventually by shipping losses and hoping to make it up in scale,” stressed the veteran investor.
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Reading The Tea Leaves For Growth And Scalability
What’s the difference between growth and scale? This was the first question that popped up as the floor was opened toThe Product Summit’s members, seeking clarity on the common conundrum of ramping up operations on the back of more resources vis-a-vis leveraging technology and existing user base to reach more consumers.
Banglani fielded the query, saying that at the early stage scale doesn’t matter at all — rather it’s the slope of the growth curve that’s important to look at. “I think both the first and the second derivative are important to us. Of course, we look at scalability a lot more closely than we look at scale,” he said explaining the distinction.
One way to judge the scalability of a product is to ascertain if there’s any barrier to the market size — if the value proposition is applicable only to a small segment of the market it would mean that there’s not much headroom for adoption even though there might be user growth in the short term.
The second factor is the ease of onboarding — if a product requires the startup to go through 10 different processes before delivering to a customer, it is very, very hard to scale processes, according to Banglani. In the absence of metrics for pre-revenue companies, these two indicators act as proxies for scalability from a market point of view and a perspective internal to the company.
Adding to the second point, Sajith Pai said that it is also important to note if the product involves a system of record — where customers need to transfer their database — as that would mean higher switch-over costs and hence might be a problem in scaling up fast.
In a lot of cases, VCs realise these roadblocks to scalability and growth after having made the investment already and that’s when they push for pivots in the product or the business model.
Making The Decision To Pivot
Sanjay Mehta, who was an angel investor in OYO, recounted that the hotel room aggregator started as an Airbnb listing called Oravel Stays before going through two pivots to arrive at the business model that has made it so successful.
“Investor value addition to drive growth has to be in the form of monthly monitoring rather than waiting for things to happen,” said Mehta. Banglani echoed this sentiment, saying that “I would actually argue that most companies have almost a monthly pivot, as they discover newer and newer things.”
The investors were concurrent in the view that pivoting doesn’t necessarily have to mean a 180-degree turn — it could also be in the form of constant changes to the business plan. “A product roadmap in a Series A or pre series for beyond 18 months is not credible because it should depend on what the market is telling you about the product,” said Banglani.
Apart from market feedback, the size of the audience could also be a reason for pivot as segments that are too niche might be hard to scale. Pai illustrated this with Little Black Book (LBB), a startup that Blume Ventures in. At the time of making the bet, LBB was a content company that was trying to build a layer of discovery to help people identify places to dine and avenues for entertainment.
The startup later realised that monetisation through advertising wasn’t working out very well in terms of the pace of growth. That’s when LBB decided that it would also need to aid businesses in selling to customers and pivoted to an ecommerce marketplace for small and quirky companies.
“That’s actually a good example of not only monetisation, but also the drive to pursue growth”, said Pai with a hint of pride.
This article is part of our coverage around The Product Summit 2020 by Inc42, which took place on October 10 & October 11. TPS 2020 was supported by Amplitude, AWS, Dell Technologies, and DigitalOcean.
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