Lessons from a Search Startup: Our Journey Through Two Rounds of VC Funding
Let me start off by coming clean and admitting that I’ve been dying to contribute to the WordStream blog since it debuted about a year ago. As CEO, I certainly could have posted any time I wanted (“it’s good to be the king”) … but I also have to admit to being intimidated due to the substantive nature of most of our posts and the corresponding readership. So I couldn’t make just any post my first post—it had to be good.
I figured the recent announcement of our successful capital raise provided as good an opportunity as any to make a meaningful contribution to the blog and our community of readers. Having raised more than $70 million for four start-up companies over the past 20 years, I have some clue as to what I'm talking about. (Not to mention I did a brief stint on the “dark side” of this game as an investor in 1995-1997, during which time we invested nearly $20 million into seven different companies.)
There are any number of great posts out there about raising money from venture capital, but if you are interested primarily in search and not necessarily the VC game I’d point you to Rand Fishkin’s fantastic post from earlier this year Rand does a great job providing background on his firm’s experience during the process, and I can say that much of what he wrote is consistent with my own experiences, and in the case of WordStream is specifically comparable, particularly because we had both already raised some outside capital and were both looking to bring in what is known as “Series B” financing (where Series A is an initial round of investment).
So rather than retell the WS story much along the same lines as Rand, I figured I’d try to advance the discussion a bit by bringing two new story lines to the table:
- Seven things I “relearned” during the last few months while raising capital for WordStream, and
- What talking to 20 venture capitalists about the search marketing industry tells me about where we are in the evolution of our industry.
Let’s start with a quick timeline of our financing history.
- August 2008 - Founder Larry Kim raises $4 million from Sigma Partners in a classic Series A financing.
- September 2008 - Adler (me!) named as CEO, joins as 5th full-time employee.
- January 2009 - WordStream launches its initial product, WordStream for PPC.
- January 2010 - I develop my “pitch deck” for Series B financing and work with existing investors to refine the story.
- February 2010 - I begin to have first meetings with a select group of possible investors. Eventually I’d meet with 20 investors altogether.
- March 31, 2010 - We get our first (of several) term sheets for the Series B round of financing.
- April 7, 2010 - The WordStream board votes to accept the Egan term sheet.
- April 30, 2010 - Da money is in da bank! (Series B financing closed)
7 Lessons Learned from the WordStream Financing Process
Lesson # 1—The market you are in is the market you are in, and there ain’t nothing you can do about it. While certainly better than what Rand faced in June 2009, the funding market is still a far cry from the halcyon days of 1998-99 (the ultimate in cheap and easy capital for entrepreneurs) or even the relatively robust environment of 2006-07. Certainly it was not a market that I’d have chosen, and we debated as a board whether to seek short-term financing from our existing investor in the form of a bridge loan in order to enable the company to raise moneyin six to nine months, in what most anticipate will be a better market, while at the same time enabling the company to put some more results underneath itself to better state our case. In the end, we decided that we had a great story to tell, there was no guarantee what the markets might look like in the future, and we wanted to put fundraising behind us if at all possible and focus on further developing our products for our market.
Lesson # 2—It is easier to sell the dream than the reality, AKA “Why raising B rounds sucks!” You see, venture capitalists love A rounds. They love that the company/idea is early in its formation, and they love feeling like they were in on the “discovery.” And when raising A round capital, there isn’t a lot for the investor to object to—typically results are sparse and mostly consist of “positive indicators” in a world where everyone knows that past performance is hardly an indicator of future success—otherwise the VC hit rate on investments would look a lot more like Shaq’s free throw percentage (58%) instead of A-Rod’s batting average (27%).
In evaluating Series A opportunities, VCs focus on things like:
- How much they like the entrepreneur.
- How exciting and filled with potential the market is.
- How cool the technology is.
- How much they can help build the company by bringing to bear their knowledge of the industry and how to build teams.
So what do investors focus on when you are raising a B round? Well, in our case, they looked closely at our first 15 months of performance, as well as our plan for growth looking ahead. There was plenty of hard data to examine too, in the form of clients, canceled clients, prospects who were confused with our offering—data that, despite being very positive, still showed us as having a few warts.
Do you see the problem here? When you need to raise money (and the only time you really need to raise money is when cash in the bank isn’t sufficient to cover future anticipated cash requirements), investors have all these data points to confuse them as to why they shouldn’t invest, and you’ve lost all that raw appeal of being a sexy virgin. Almost every VC would rather own 30-40% of an early-stage Series A deal than 15-20% of a further developed Series B deal, regardless of what their track record/returns might be from Series A vs. Series B.
Lesson # 3—It's not just the stock market that is focused on short-term results. This is kind of a corollary to Lesson #2, about how B rounds suck. We hear all the time about how Wall Street is too short-term focused and companies are forced to focus on today’s earnings rather than investing in tomorrow’s opportunities for growth. This may be true. But this is no different than venture capital investors during a B round financing. Every investor wants to see your business plan/model for the year, and if they have any interest at all that interest will absolutely be affected by how your business performs during the months they are considering investing in you.
One reason WordStream was able to secure financing was because our team kicked ass during the first four months of the year. We beat plan, and beat it handily, every month (a trend I hope will continue—so far it has!). But I laugh when I hear VCs talk about investing for the long term and how they love to build companies. True to a point, but only for a handful of VCs. When it comes to Series B investments in particular it is RESULTS that get you funded, and any slip in results bites you three times as hard in the price concessions you may need to make in order to get funded. Results matter in Series B growth companies as much as public companies.
Lesson # 4—You can’t push a rock uphill, particularly if the rock has any weight to it. And by rock I mean venture capitalist. And by weight I mean ego. So it is likely that most rocks you try and push on when raising money at least think they are heavy. And you need to treat them as heavy. Which means if they don’t “get it” in the first meeting—by which I mean get who you are and what your company is trying to do—then it is unlikely that they will invest. This doesn’t happen quite as much in A rounds (although it still is generally true). But in B rounds, they simply won’t waste their time looking into a company/industry/technology that they don’t understand, because that would take a lot more work than a comparable investment might require in an area that they do understand. And investors aren’t so different than most—they don’t want to work too hard, they want to succeed, and they want to succeed by taking as little risk as possible. I’d be very surprised if many B round investors toss their lot into a company/industry that is foreign to them.
Lesson # 5—Investors suck at “customer service.” So I can forgive a little bit of the laziness that goes with wanting to invest in people you know and industries you know. In fact, you could argue that it's a reasonable recipe for success and there is nothing wrong with it. But being unresponsive in follow-up … well, to me that is inexcusable. While rare, there were some investors who I never heard from again after our initial meeting and my subsequent follow-up. Not a voicemail, not an email, not even a message passed back through our existing investor or whomever might have helped broker a meeting in the first place. How hard is it to send an email? It doesn’t even have to be true—just humor me and tell me you are too busy or you’ve got other priorities right now but you wished you had more time, or you only like to invest in A rounds, or anything other than a black hole of no response. Out of 20 meetings, five investors literally never responded with a concrete position on their interest.
Lesson # 6—Venture capitalists are people, not firms, and it is an individual who makes each investment. Who you “pitch” matters. Why? Let’s say there are two partners at the same firm who might be interested in your company—one who has made three investments in the last six months and currently sits on 11 boards, and another who just sold two companies and as a result of that focus hasn’t made a new investment in six months. The former is in no position to consider a new investment unless he views it as a slam dunk, and even then he won’t have much bandwidth to do work on the investment, let alone invest time once the check has been written. But the other individual does have capacity, and therefore is a much better target. And if you pick the wrong partner, it's not as if he says, “I’m too busy, but talk to Joe.” See, Joe wants to find his own deals, not take over something pushed his way by his partner. So if this does happen you’ll already start with one foot in the ditch with Joe. As an entrepreneur you need to really think through who you reach out to for that first meeting, as the wrong initial contact could potentially derail a great fit.
Lesson # 7—Last but not least, who you have as your Series A investor is really important when seeking a new investor. Yeah, yeah, I know what you are saying—I’m just kissing a little ass with my Series A investor Paul Flanagan from Sigma. And to some extent you are correct—hey, after all, he is my boss. But in all the companies I’ve either invested in or raised capital for, it always comes down to people, most importantly the people in the company who do the work. But it also matters who is behind the company, how they are perceived, and what they are willing to do in order to support the company. Potential investors want to feel like true partners in the company, not just with the CEO and team but also the previous investors. They want to feel like they are joining forces with smart and reasonable people who they trust will do the right things on the company’s behalf down the road. Paul was a huge asset to WordStream in this regard—he is engaged so he really knows what we are all about, and he has tremendous enthusiasm for what we are trying to accomplish. He never made himself or Sigma the dominant issue as WordStream pursued its financing. And trust me, that is not always the case and is a very big deal. We may have gotten our deal done without someone like Paul, but I know it would not have been as easy.
Final Thoughts on VC Funding and How VC Firms View Search Engine Marketing
So those are some takeaways from the fundraising process that I thought might add to the insights Rand provided based on his experience last year. Before I sign off, I want to share what I learned about the search marketing market after talking with the VC community during the course of Q1. In summary, I’d say:
- VCs all recognize the power of online marketing, and even have some perspectives on both paid and organic search. But they really don’t understand how it works, or why it works.
- And interestingly enough, very few of their portfolio companies understand search marketing either. You’d think that many of the great start-up companies receiving VC funding in the last three years would be all over search, but that is not the case. And to me this was a really exciting observation. If search marketing isn’t viewed as a primary competency for most VC-backed companies, it still is nowhere near the market penetration it will eventually achieve. As big as search is, there are still hundreds of thousands if not millions of businesses that have yet to really scratch the surface with this “new” marketing medium.
- They are all scared of investing in a market seemingly controlled by Google, but they don’t know much about Google or what they are really about. Of course part of this might be a result of my principally meeting with Boston-area firms, not firms based in the valley.
- They view the market for search as crowded and one where there have yet to be many success stories. Given how hard it is to convince an investor to change their perception (see Lesson #3 above) I didn’t argue much with them, and not-so-secretly will say that I hope they continue to believe this—that will mean less competition tomorrow for us to worry about!
Thank you for allowing me to share my thoughts and observations. I look forward to any comments or questions, and will happily respond to any and all.