Posted by randfish

Prelude: I’ve long promised blog readers a detailed accounting of my experiences raising capital over the course of last summer and into the fall. My apologies for the long delay, and to those seeking more SEO-focused content. This entry is lengthy, detailed and designed to share as much as possible, so hopefully you’ve got a good 20 minutes to read it :-) We’ll be back to SEO tips & tricks tomorrow.

Sections in this post:

Introduction to our Process & Venture Capital

In this post, my goal is to walk you through the process we used, the feedback we received and the final results and decisions. Fundraising is a demanding, lengthy, emotionally charged process and something that challenged me personally more so than any other single part of my life in the last 5 years. I hope that by sharing my experience I can help others who start down this road and give you an idea of what to expect. The more knowledge you have, the less fear can hold you up; that’s what this post is here to accomplish.

First, I’ll try to provide some context around why we went to raise money in the first place, how we constructed our "pitch deck," how we got introductions and meetings to a large number of VCs and the progress from initial meetings to partner meetings to final decisions.

SEOmoz started the VC process in June 2009, in possibly the worst climate for fundraising since 2001. You can see the stark contrast from our timing with the previous round in, arguably, the best environment since 2000.

VC Invested 2007-2009
Graph of Venture Capital Invested by Quarter (via NVCA)

Ventue capital is "expensive" money, not just in terms of the price paid in equity, but in the obligations and requirements that come with it. In our Series A, we took money more like a seed investment – Michelle & Kelly saw potential and wanted to see what could happen. Raising another round meant aiming to hit the "home run." For those who are unfamiliar, the startup world has built an entire lexicon around the "seriousness" and exit-size focus of a company that ranges from "lifestyle" businesses that don’t try to achieve multi-million dollar scale to "home runs" that exit for $1billion+.

Note that there’s plenty of criticism of this model from both the venture side and from entrepreneurs and operators. Lots of other blogs have talked about the imbalance in interests between founders and investors and current market conditions vs. expected VC portfolio returns. I won’t re-hash these, but as a broad overview, most venture funds have 100s of millions of dollars from their LPs (Limited Partners – folks like large endowment funds, pensions, government entities, extremely wealthy individuals, etc). In order to provide significant returns, they follow a model of investing in a few dozen startups, most of which will go bankrupt and, hopefully, 1-3 of which will provide most of the profits in billion dollar+ "exits" (an acquisition or IPO).

This somewhat odd scenario means that VCs are often investing in "long shots" to be huge, rather than low-risk bets for more reasonable exits (for example, an 80% chance of exiting for $150 million is not nearly as interesting as a 10% chance of exiting for $1 billion). As an entrepreneur, particularly a first-time startup guy who has $3,000 in his checking account, an orange scooter and a small apartment, the incentive is completely the reverse. Fred Wilson wrote a bit about this disparity in his post on Swinging for the Fences.

In order to be appealing to a venture investor, especially those with larger fund sizes ($300 million+), a company must be able to show a credible path to that $1 billion+ exit. Since the average VC-backed exit is actually something under $100 million, it’s a bit of a "wink, wink; nod, nod" game. Both parties recognize that a more likely outcome is something far lower, but the "sell" has to include the envision-able path to hundreds of millions in annual revenue that can yield those tremendous exits. Again, I’ll point to Fred, who wrote about the Venture Capital Math Problem (and a Part 2).

Building the Pitch

You can read a lot more about the catalysts for fundraising on my post – My Startup Experience: VC, Entrepreneurship, Self-Analysis & the Road Ahead – so I’m going to dive right into the process for creating a pitch deck.

We started with a lot of great advice and direction from entrepreneurs who’d been down this road before and also got terrific help from the partners at Ignition, for whom we delivered a "mock" pitch and collected feedback that helped push us in some smart directions. As a base, we used the model promoted by VentureHacks and sprinkled in bits liberally from Dave McClure’s excellent How to Pitch a VC deck and Guy Kawasaki’s – Perfecting Your Pitch (PDF).

The process itself involved sheets of paper affixed to a large wall, which we’d then swap around, tear up, mark up with pens and generally treat like a post-it-note fight. We started with blank paper that we’d draw on, then began creating real slides in Powerpoint. It was fun – exhilirating and stressful, yes, but also exciting. We were going to raise millions of dollars, put that money to work and build incredible product and an amazing revenue stream.

Before we did that, we had to get beaten up a bit first. I mentioned that we gave a test-run pitch of the deck to the board at Ignition Partners (our first-round investors). We also privately delivered the pitch to a handful of CEOs and angel investors, hoping to garner feedback and assistance (these weren’t serious attempts to raise money, as we weren’t seeking an angel-type deal). The great part is, we really did get beat up. I have pages and pages of notes from meetings where I showed the pitch to other entrepreneurs and got feedback ranging from "this is almost perfect, just tweak X" to "you need to start completely from scratch, and here’s the deck I used to raise $XY millions in my last round."

I’m going to come back to this again below, but the generosity of time, energy and prior work (even stuff that’s usually very private) from other startup CEOs and entrepreneurs was absolutely remarkable. I found none of the closed-door mentality or brash indifference I expected, especially in Silicon Valley. Founders and CEOs, who had multi-million dollar businesses to run would take hours out of their days to have lunch, walk through the deck, and introduce us to VCs they knew. I’ve rarely known so much goodwill from people who have so many demands on their time.

The Pitch Itself

Let’s get to the meat and potatoes, as I’m sure by now you’re hungry :-)

The "elevator pitch" sounded something like:

SEO is huge – every site on the web is doing it or wants to be. But the process is broken – it’s hard to learn, hard to measure, hard to know what’s working and far more art than science. We are going to build software that helps transform SEO into a mainstream marketing activity, the way analytics software (Urchin, Omniture, etc.) did for web visitor reporting or email software (iContact, ExactTarget) did for email marketing.

Unfortunately, I’m not going to share the exact deck we used, nor all the details from it. Transparent though I love to be, there’s a lot of information and data points that aren’t fit for public consumption. It’s less that I believe any of this data could be used to materially harm us and more that we’ve made promises to our investors and board to keep this stuff internal for now. I will say this – while I believed strongly in the deck when we first created it, that confidence was somewhat eroded by the end of the process. In late September, for example, I think I could have done a far better job crafting and delivering the pitch than when I gave my first one in July (only 60 days before).

Below, you’ll find a modified version of the original pitch deck (we later crafted many customized versions with slides particular VCs wanted to see). It doesn’t include things like a P&L statement or specific customer retention/churn/lifetime value metrics, but hopefully it will still be valuable and interesting.

Since I didn’t include revenue/profit numbers in this deck (and it’s hard to get a sense for how a potential investor might perceive this without it), I’ve included some non-specific growth charts below, illlustrating the top-line numbers in a profit-and-loss statement:

SEOmoz's Revenue Breakdown 2007-2009 

I’ve also left out some portions of our very large appendix. The appendix, in fact, was one of the most interesting parts of the deck. When we started the process, it was 5-6 slides with additional information about market size, importance, some detailed stats on membership, lifetime customer value calculations, etc. A month into the process, it was nearly 30 slides, attacking every question, problem or issue that had been raised in meetings where we didn’t have an immediate solid answer or data point. I really believe that the VC process is all backwards in this fashion. The pitching company should:

  1. Have an introductory call to see if there’s interest
  2. Attend a sit down meeting with a partner or two, some associates and a dilgent notetaker to get all the questions, concerns and issues on the table
  3. Go back home, make a great deck that addresses the things the VCs care about
  4. Come back and give the formal pitch

Instead, many pitch meetings at the beginning made us feel like amateurs and it was only at the end of the process that we felt more comfortable tackling any question thrown our way (mostly because we’d heard nearly all of them before). In my opinion, venture capital shouldn’t be about who has the most experience pitching, or who can deliver the best pitch, but about who has the most exciting, interesting company. In the current model, it feels like 80% sizzle (pitch) and 20% steak (company).

Then again, what do I know about the VC process? I got lucky in my mid-twenties, landed a bit of capital, and have never invested or even studied the venture model the way the professionals have. Perhaps ability to pitch and success of company are well correlated metrics or at least, indicative of company performance. I’ll leave that to those more knowledgable on the topic.

In any case, now that we had this story to tell (the pitch deck), we needed an audience.

Getting Introduced to Venture Capitalists

I initially presumed that our investors (Kelly & Michelle) would drive this process of introductions and networking, but in reality, this is apparently a suboptimal methodology. Michelle explained (and many others concurred) that entrepreneurs themselves provide the best introductions. Thus, it was my task to find other founders & CEOs who would provide positive connections to the investor community. Outside of Ignition, I knew virtually no one in that sphere, so this would be my first formidable challenge.

Thankfully, the entrepreneur community was incredibly kind – generous to a fault, actually. Busy CEOs of important startups took time away from their jobs to sit down for coffee with me, buy me lunch, take me to dinner, review the pitch deck we’d built, give advice and make introductions to a very impressive set of folks in the VC world. In exchange, I did the best I could to help them with SEO, and we hosted a number of great companies at our offices in Seattle for hour-long SEO reviews. It will be hard to thank everyone here, but I’ll do my best:

I’m indebted to all of these great folks and I can only hope that the SEO help we provided to many of them has returned some of that.

However, this part of the process is also where we made our first big misstep. Explaining will take a bit of background.

SEOmoz’s business model is what’s generally called "self-service SaaS." Similar to most SaaS companies, we sell software in a subscription/licensing type of model and, as has become common in the last few years, do it "in the cloud" (meaning we don’t install software; everything’s run remotely over the web). However, we’re very different from traditional "SaaS" in that we have no sales team. There isn’t a single person at SEOmoz whose job title or description includes sales (though, technically, if Gillian and I had descriptions, "sales" might be part of that).

Our business model and margins might result in an acquisition price (sale of the company) of between 3-6X trailing revenue, depending on the market circumstances, growth rates, strategic importance, etc. This is massively favorable to consulting revenue, which typically garners 1-1.5X. Put another way:

  • An SEO consulting business sale price (assuming $5 million in trailing revenue) = $5-7.5 million
  • An SEO self-service SaaS business sale price (assuming $5 million in trailing revenue) = $15-30 million

It’s no surprise that investors are far more interested in these "scalable" business models that have higher exit multipliers. This is a big reason why you rarely ever see venture or angel capital flowing into consulting firms. The margins on a consulting business hover between 40-55%. Margins in software get closer to 80%+ and scale isn’t proportionally tied to cost (in most consulting businesses, the more you want to make, the more consultants you need to hire). 

In our situation, a VC in the B-round would be likely to get something between 15-20% ownership in the company (depending on valuation, amount in, etc). Let’s look at a chart that helps explain why we messed up from a strategic standpoint in the introductions process:

VCs Level of Interest Based on Levels of Outcome

Doing the math, even at the high end of the revenue/exit numbers, the VC is making 15% x $450 million = $67.5 million. If you have a $300 million fund and invest in 20 companies, you need at least 6 and hopefully 7-8 of those to hit in that range. The odds say that 10 of those companies will go under, 8 will have much more modest outcomes and 1-2 will return the lion’s share. Thus, big fund VCs are going to be seeking portfolio investments that address multi-billion dollar markets and have a shot at that massive IPO/acquisition.

A smart entrepreneur would look at this ahead of time and specifically chase venture capital firms with small-moderate fund sizes. Unfortunately, we didn’t plan ahead intelligently on this, and thus talked to many folks with funds between $100-500million. At those levels, it’s the 1/20 or 1/50 billion dollar+ exits that bring all the returns for the VC. They’re not seeking a reasonable bet on a company that has an long-shot, outside chance at a $500 million exit. They want 20 or 30 companies with 1 in 20 or 1 in 30 chances to go all the way to that billion dollar acquisition or IPO.

Our introductions came streaming in very unstrategically. I met with lots of entreprenuers and people in the tech community, who put me in touch, usually via an email introduction, to a partner at a firm. We’d exchange a couple emails to set up a time to talk, chat for 15-45 minutes (sometimes longer) and then schedule an in-person meeting for the next time I was in their area. Those introductions didn’t come all at once – in the first 30 days of actively pursuing introductions, I had ~10 calls. Then, over the next 40 days, more and more introductions would roll in from people I’d connected with in the past couple months, and those would turn into calls and meetings.

I talked to entrepreneurs who were much more strategic and exacting about their introductions process (and plenty who followed a similar pattern to what I did). In hindsight, it wasn’t perfect, but I did get to meet a tremendous number of very impressive investors and get their feedback.

The Meeting Process

During our fundraising experience, we connected with a lot of VCs. I’ve taken a screenshot of the the firms we talked to below (from my Google spreadsheet file on the subject), though I won’t go into more detail about who from each firm we talked to or how far along we progressed with each of them. I think there’s an expectation of privacy most VCs have, and I want to respect that. BTW – I’m not listing every single firm we talked to, but this is a more-than-representative sample and hopefully fulfills our core value of transparency.

List of VCs

Initially, we were very excited and I’ll try to explain why. When starting out, our expectations (thanks to both advice from other entrepreneurs and via blog posts/articles the web) were that 10-20% of phone calls would lead to first meetings , a few of these might turn into partner meetings and we’d hopefully get a term sheet or two at the end. Instead, the funnel looked like this:

VC Conversion Path

As you can see, we had phone calls with 40 firms, and had a surprisingly high conversion rate to first meetings, which had us initially enthusiastic. VCs are notoriously busy, and scheduling time with them is often a massive challenge. To have such a high percentage of firms interested in such a dour climate made us believe we could buck the trend. Unfortunately, it also meant lots of time we needed to invest in preparing for, and in most cases, flying out of Seattle for in-person meetings.

The entire process from the first call I had with a partner (on June 18th) to the time we stopped actively pursuing funding (September 30th) was 93 days. In that time I made 5 separate roundtrips to San Francisco, which adds up in hotel, airfare and car rentals. Raising money takes time, resources and a tremendous amount of energy, not just from the founder/CEO, but from the entire team. Adam & Matt were consistently pulled away from day-to-day and strategic work to create and refine the product demo. Sarah, Christine & our accountants labored to provide detailed financials. Jeff often had to postpone critical work items to make custom queries against our members database to pull an obscure metric about recitivism, churn or usage.

The meetings themselves are fascinating. I’ll be honest – the first few were completely intimidating and overwhelming. Like most times in life when you’re nervous, it wasn’t until I stopped worrying and (very nearly) stopped caring, that I got good at the process.

You arrive at a non-descript, but very well-adorned office building, almost all of them on Sand Hill Road in Menlo Park. An assistant, who is nearly always young, female, very attractive and somewhat cold (though there were a number of exceptions), greets you in the front room and will offer a beverage. I typically waited only 5-10 minutes, though a few times it was 20 minutes or more, after which I’d be escorted into a meeting room with a place to plug in my laptop to a projector or screen. VC offices provide free wifi (though I always brought my AT&T aircard just in case) and are designed to impress – expensive furnishings and artwork, placards showing the successful companies they’ve backed and the massive IPOs/exits those companies had.

The VCs themselves ran the gamut, from friendly, approachable and jovial to overly serious, harsh and distant. Intentionally or unintentionally, they all have some emotional walls up, which I believe are out of necessity and certainly don’t begrudge. If you’re meeting with dozens of entrepreneurs every week, you can’t get personally attached or build close relationships with even a fraction of them, especially if you’re not going to make an investment. It’s a very different experience from the many hundreds of other meetings I’ve had in my professional career, where establishing rapport and working in a mutually positive fashion is the norm. VCs need to drill down on specifics, call out your flaws, explain what they don’t like and gloss over a lot of positives in the process. A typical partner meeting lasts precisely one hour, and in my experience, that rarely deviated (a few times we ran over, and more than a few times things started late).

Second meetings are often pretty similar in format, though there’s typically more than one partner from the VC firm in attendance, as well as an associate or two. I also found that it was extremely helpful to bring Sarah Bird (SEOmoz’s COO and a guru when it comes to our financials) as well as Nick Gerner and/or Ben Hendrickson (who convincingly play the role of "way smarter about technology than anyone else in the room") to these meetings. They’d sometimes be a bit longer, and would almost always request a much greater degree of detail, as well as significant "objections" ot the investment, which were frequently presented as challenges we were intended to conquer using slides, data and verbal acuity.

Following both first and second meetings would be the impossible-to-parse "thanks, we’ll be in touch." We’d take guesses about which VCs were actually interested and would follow up vs. those who’d email to say "no thanks" or simply never communicate again (the latter bothered me at first, but once you realize it’s just part of the accepted cultural practice, it’s fine). Surprisingly, we were never good at this. We’d often mistakenly think one VC was interested when they weren’t and vice versa. They’re a notoriously hard-to-read bunch, perhaps intentionally.

I have a much tougher time presenting a representative partner meeting, as we only had two. They almost always take place on Monday, though, and you’re often back-to-back scheduled with pitches from other entrepreneurs. A larger, board-style meeting room will be filled with all of the firm’s partners and you’ll present the same pitch you made to the first partner to this group. Questions can get a bit strange if my experience is any guide – tangents and off-topic discussions come into play and it seems to be up to the entrepreneurs to keep things on track. I think this happens because in any given partner meeting, a good number of the partners won’t be familiar with your industry, company or technology, and may not even be interested. I imagine that if you specialize in clean-tech investments, listening to an SEOmoz pitch can get a bit boring, and you might, naturally, focus on the one or two areas you know something or have heard something about.

I will say that my experience with the vast majority of VCs we saw was not nearly as negative as what Fred Destin wrote about in his posts for VentureHacks – The Arrogant VC: Why VCs are Disliked by Entrepreneurs and Part 2. Certainly a few of these traits came out, but by and large, I felt these were responsible, talented, experienced individuals doing a hard job the best they could and putting forward both a serious effort and respect for me, my company and my time.

For a completely alternate perspective on what it was like for my wife, who accompanied me on 2 of my 5 fundraising trips, check out A little more than 24 Hours in Palo Alto and San Francisco. I do wholeheartedly recommend someone who loves you unconditionally and pretends to be unable to identify a single flaw in you, your company or your pitch, supporting you in the VC process. It can get very lonely and emotionally turbulent.

What Worked & What Didn’t

When it came time to analyze the results, we tried our best to aggregate feedback, both positive and negative, for our board meetings back in Seattle. Early on, we focused on refining the pitch, but we were (I think uncommonly) stubborn about changing our business plan or product roadmap significantly to suite investors’ opinions. We felt (and feel) strongly about the direction we want to pursue, and that may have been perceived negatively by some (though I know it was a positive to at least one investor who talked to us afterwards).

Following any "no" response, including a "no answer" within a couple weeks following the meeting, I’d email and ask for a phone call to discuss. 60%+ of the VCs we had met in person took those calls and explained to us some of their reasons for rejecting the investment.  I’d specifically ask what they liked, what they didn’t and what they recommended for us to improve. I was both impressed and grateful to receive a number of thoughtful, honest answers, and encountered only a couple of folks who clearly didn’t remember our pitch or company well enough to provide a cogent response.

Some of the things the VCs generally liked:

  • The Self-Service SaaS Business Model – although there were a few dissenters who thought we should pursue a more classic SaaS business with tele-sales would be better, most were supportive of the self-service methodology.
  • The Community & Userbase – that’s you! Great work, gang :-)
  • The Marketing/Sales Funnel – investors tended to like the freemium/content model that attracted potential customers at a low marketing cost
  • The Technology Achievements – nearly all of the VCs with technical backgrounds were impressed by what we’d achieved with the Linkscape web index and ranking models work, particularly on such a small amount of capital.

Unfortunately, there wasn’t a clear winner in the reasons VCs didn’t want to make an investment. I did, however, make a quick chart noting which reasons were most frequently given by the investors for why chose against us:

Reasons VCs Didn't Invest

It’s important to note that many of the VCs who said no that we followed up with gave multiple reasons for the decision. Some of these we found very reasonable and agreed with, others we struggled with. The most perturbing by far were the few folks who came back and said they didn’t like to back the consulting revenue model and would be more interested once we were more product-focused. When I’d explain that we had 80%+ of revenue for the past three years coming from the self-service SaaS product, awkward silences would follow. Still, these are investors who likely talk to hundreds of companies each year, so it must be incredibly challenging to keep things straight – and it speaks to our need to move away from consulting in our branding and perception.

The Final Outcome

It’s likely very obvious at this point that we didn’t receive term sheets or offers to fund. In actuality, that’s not technically the case – we did have firms interested, just not a the relatively high pre-money valuation numbers we sought. As you can see in the graphic above, there were a number of VCs who may have offered us terms at a lower valuation, though it’s hard to say for certain.

The reason we went in with a high valuation "ask" goes back to the very beginning of the post. From the founders’ perspective (and those of employee shareholders), an exit has to be judged through the lens of ownership percentages. If I or Gillian or Sarah owned, for example 50% of SEOmoz’s shares (none of us do - this is just an example), in a $20 million exit, we’d make $10 million. If venture capital comes in and dilutes that to 35% ownership, that number drops to $7 million in the same exit scenario. Hence, every owner of SEOmoz shares has a vested interest in seeing the final exit price reach the highest possible figure while maintaining the lowest possible level of dilution.

My understanding is that it’s very unorthodox to present a minimum pre-money valuation to investors prior to a term sheet. I believe this is because you’re potentially "laying too many cards on the table" and you may actually be hurting yourself if the VCs planned to offer a higher pre-money figure. We did it both because we like to be transparent and because we hoped to prevent ourselves from wasting time with investors who couldn’t meet our minimums. Our hope was that by giving that number in the first conversation (over the phone) and in the initial pitch deck, we’d achieve similar results as those we had in the past by publishing our prices for consulting – reduce the target market size and improve the quality.

I tell this story about our VC experience to a lot of people – it seems to be a subject that attracts great curiousity and I, of course, love to share. Most of the time, folks follow up by asking "are you disappointed?" and my answer has been the same since October. I’m not disappointed we didn’t get funded. In fact, the more time passes and the more I think about the pitfalls that could have come with another round of investment, additional board members and pressure to reach $75-$100 million in annual revenue, the more I’m glad we didn’t. However, I do regret the decision to seek funding – it cost our team countless days and weeks of productivity, took our eyes off our primary goal of delighting our members and customers and, in the end, was a learning experience with a shockingly high cost.

That said, I do think we learned a tremendous amount and really helped clarify the vision internally and to our existing board members and investors about where this company is going and what our roadmap looks like. We had dozens of smart, analytical, experienced investors reviewing our plans and ideas, and we received a lot of very positive feedback. Nearly everyone we encountered had positive things to say about the business’ future, regardless of investment, and I’m glad we were able to be in a situation where we could turn venture funding down. I have friends here in Seattle and in the Bay Area who didn’t have that luxury – who HAD to get funded, no matter the cost, because their company’s future and employees depended on it. That’s a burden I don’t wish on anyone, and I hope more and more startups are finding ways to live lean and do more with less.

So, it’s 3:45am and I’ve been working on this post on and off since before the holidays. There’s so much more I want to add, but I think I’ll leave that up to you. If you have questions I can answer, PLEASE post them in the comments and I’ll do my best to incorporate that material into the post as it makes sense. Thanks for all the support, kindness and patience – I hope this has been valuable.

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