Artko Capital, a US-based special situations micro fund, recently tweeted about how the venture capital (VC) firm Eniac Ventures had, it seemed, “discovered” gross margins.
How?? How are these real people that manage money?! How is this a real paragraph? https://t.co/tMuureVF0j pic.twitter.com/zBo7PsJGEz
— ArtkoCapital (@ArtkoCapital) October 11, 2019
They reiterated rather savagely:
I can’t get over this. This VC firm just went on record to say they’ve never looked at gross profits for their companies. What?!?
— ArtkoCapital (@ArtkoCapital) October 11, 2019
The entire thread by Artko Capital and the comments, in response, are fascinating.
The reaction, however, reflects the severe lack of understanding of how the “VC world” functions. Yes, gross margins matter, but not at a certain stage. At the seed stage, it is relatively less important to other metrics.
A crash course in VC landscape
The VC sector isn’t a single monolith. It comprises several different entities who invest at different stages across the startup’s lifecycle. The progression is thus: angels –> seed VCs –> Series A –> Late Growth Capital (Series B and C) –> Hedge funds (of late). Each of these investors is a specialist at a certain risk level, and focuses on how they can get the startup in 12-18 months to the next level.
Eniac Ventures is a seed fund. It is effectively taking a bet anywhere from idea to early customer validation but almost always at the pre-product market fit stage. At this stage, you don’t want to put undue stress on gross margin. What matters here is product-market fit (PMF)!
Stressing unduly on gross margin at this stage can force the startup to focus on the wrong things: not experimenting, not focusing on engagement, taking product risks in pursuit of traction and growth.
You don’t want to give up experimentation early and climb the wrong hill! If seed-stage VCs drove profitability and gross margins, then we would be undercutting the growth potential of these rocket ships by starving them of the experimentation required to identify paths to scale.
Each stage has a risk specialist
In fact, Limited Partners (LPs), who give money to funds like Eniac Ventures, have clearly demarcated allocations to funds at different stages. So each fund, at varying stages, understands its place in the ecosystem and learns to play by the rules of our stage.
For Eniac Ventures, or Blume Ventures, where I work, the goal is to get a third to half (many startups will die along the way sadly, and that is the nature of the industry) of the portfolio to PMF with solid traction and thereby bring on a Series A investor.
It is at this point, or Series A, that the startup begins to (post-PMF and with solid growth underway) focus on costs. At this stage, the big experiments are over, PMF is achieved, and the goal is to use the Series A capital to get to positive gross margin—or even EBITDA positivity by reigning costs, ramping up and scaling what is working, and setting the company on course to grab late-stage growth capital.
Just as the seed fund understands the risk at the early stage, similarly, Series A and B, C investors understand the risks for their stage. Each of us drives focus on certain metrics needed to get to the next stage. That is the way the industry works, and it works well.
In bubbly markets, when you know that fundraising is not tough, seed stage investors tend to focus far more on growth than on other metrics (cash is relatively cheap). However, when tough times portend, seed funds start to worry about what would happen to the portfolio companies if fundraising started slowing.
Eniac Ventures is on the right path
And that is why Eniac Ventures is wisely looking at gross margins and reigning in spends. It is wise to do it now rather than earlier. If they had focussed on gross margins last year or even before that, they would have set their portfolios for failure.
It’s not that VCs are stupid or don’t get it, we understand the rules of financial gravity as well as anyone else. But we also understand very well what our multiple stakeholders—founders, LPs, next stage VCs—want, and optimise the solution that satisfies them all.
Perhaps Artko Capital was being sarcastic, maybe not. Either way, my objective was to drive greater understanding of each others’ roles, and the underlying motivations for our behaviour.
This post was originally published on LinkedIn. We welcome your comments at ideas.india@qz.com.