As you may know, most investors orientate themselves along an investment framework to evaluate start-ups. In other words, they look at certain factors in a company to evaluate the growth potential. Possible key factors for an investment decision could be the market development, competitive landscape, defensibility, traction or even a steep learning curve of the founding team. Further, there exist investor specific criteria such as funding size, target group, leverage effects or strategic fit that usually play a role as well. Nonetheless, a simplified approach could be a framework like this:
- Unit Economics
Today investors evaluate each of these components, but rarely tell you how they do it. One of the reasons for that is that investors such as venture capital funds receive inside information in form of a pitch deck, business plan or financial plans. Those usually are confidential and should not be shared or discussed with the general public. Also, most investors don’t want you to understand their thought process to hinder you from arguing about it.
Now to get a better understanding of investors thought process we will orientate us along the mentioned evaluation framework above and discuss a possible case. This case involves assumptions I take from the outside and not from the inside of the company since none of these companies have provided me with any information.
Accordingly, the assumptions I take are probably inaccurate. However, the goal of this analysis is to understand how to identify the key drivers of a business model and create an investment rationale. In the end you try to answer if the drivers of the business model validate your investment rationale.
Selecting a product and market
One of the products that were discussed a lot in the last years was the bedding market. So, the company we will look at is a vertically integrated bedding producer. A vertically integrated company is a company that owns the entire value chain and thereby saves a margin on the middleman sitting in between. In other words, vertically integrated companies order their own material, design the product in-house and sell to consumers via their website or store. A common example is Warby Parker, a vertically integrated eyewear brand.
Problem & solution
Orienting us along the framework we start with the problem and solution. Take a minute or two to think what could be the problem this product (mattresses, pillows, etc.) should solve. Try to be precise and determine the exact problem in this case. Do you understand the problem? Yes, no, maybe? I recommend starting with a basic analysis from your own perspective creating assumptions on the go.
So, what do I know or remember about mattresses? When were the last time you or your friends bought one and what was your/their experience? Every one of us has to buy a mattress at some point.
Lately, I personally had to buy a mattress myself and had a lock around at the different products available in the market. I remember that I was wondering how a foamy thing could be so expensive, a couple of hundred euros, plus they had so many different price levels and transportation was a hustle. The process of ordering bedding products is still a pain.
What did I want to have? A cheaper mattress that I knew the quality was good enough so that I would sleep well.
Problem: Expensive, intransparent buying process of mattresses with logistical hustles.
Solution: A simplified, cheap online purchasing process plus hassle free shipping to my doorsteps.
Obviously you could provide different answers to the same problem. A super smart mattress that cools down your body and increases your deep and REM sleep efficiency , would also be a nice thing to have. Than, however, it rather targets the problem of better sleep and not the problem I experienced when having to buy a normal mattress.
So always ask yourself: does there exist a real clear customer pain or benefit? In other words, is there a compelling reason to buy for your customers? The more critical your product is for your customers the better. There exists a nice analogy of vitamin pills and aspirins. Some products are nice to have for customers and businesses, but they do not solve an immediate problem. Painkillers as aspirins do. This is would I define from an analytical viewpoint.
Next, I like to look at what would my emotional response would look like to the solution of the problem. Can I imagine users to be excited about the product? In plain English, can the boring process of buying a mattress change into a lifestyle product to make me look forward to receive it? If you can imagine really exciting customers they will tell your friends, create vitality and stay longer with the company or product. On top of that marketing costs decrease and customer lifetime value increases. Overall, I can imagine myself to have a positive response to a nicely designed mattress and a good experience having it delivered to my doorstep.
As we know by now the bedding market is a mass market – you, me and everyone buys one. As some investors have a preference for consumer and others for B2B products this could already be a knock out criteria for us. On the contrary, having a mass market might be important for a potential media investor (TV ads & Radio) since only mass products appeal to large audiences. Image if you looked at a B2B business, TV and radio ads would have very high losses due to the high media spread (reaching a lot of people but not your customers), making a media investment unreasonable. Therefore, a B2B investor would disqualify the investment opportunity. Luckily, we are a media investor and our bedding company fits our strategic direction 😉
Nevertheless, what else do we know about buying a mattress and its implications? Probably I buy a mattress every 10 years. This indicates that subscriptions or frequent purchases are rare. The lifetime value of a customer is low. Further, I know from a personal experience that consumers have very little know-how about the mattress market.
Before I started researching it didn’t know the difference, advantages and disadvantages between spring core mattresses and foam mattress. It’s very intransparent for me as consumer what a good mattress is. I didn’t really know any mattress brands, either. In contrast, if I think about another common consumer good as headphones. I can tell you 4 companies that right away that come to my mind: Sony, Bose, Sennheiser, Philips. Little brand awareness offers us the possibility to create a brand.
Establishing a brand, means being able to sell at a higher price point, have higher margins, making a business more profitable (higher EBITDA). An intransparent process and expensive product offer high gross margins potential by cutting out the middleman and high basket sizes.
Unit Economics and profit model
In order to evaluate the financial perspective of our product and business, lets look at the unit economics. Unit economics give us an idea about gross margins and contribution margins, but also about fixed costs, expensive for delivery and warehousing.
So, an average mattress costs around 700 EURs. Assuming a high gross margin of 70% (no middleman as vertically integrated company) we pay 210 EUR COGS. Also, we have to pay 19% tax in Germany and include that Paypal fee of around 2%. Minus the fulfillment and the packing. Shipping the huge mattresses costs us maybe 50 EUR on average.
Further, we must subtract some cost for possible returns. Normal, E-Commerce stores have a high return rate, but bringing back a mattress and shipping it back might be a big hassle for consumers so, lets assume 35 EUR for returns. Finally, we add some marketing costs. Most of our marketing is done online.
Now, lets say that a click on Facebook costs us 1 EUR and 0.735 of the people that clicked our ad buy a mattress. This would indicate that we spend 136 EUR on marketing per sale. Accordingly, our contribution margin equals around 122 EUR. This means that our company has a first order profitability. Nonetheless, do not forget that the customers buy a mattress every 10 years and have low reorder rates. Therefore, we must rely on a high Net-Promoter-Score or increase the LTV through a wider product variety (pillows, covers, blankets).
In a real case we would check our assumptions in a cohort analysis or the financial plan to see how customer cohorts develop.
Market – Size and Growth
The founders of Bedding Group X told us they have a huge market. Lets see what we can find out about the market ourselves. The size of the mattress market is round 1148 million in Germany. It´s expected to grow to around 1153 million in 2020. As you probably know investors like large markets, but what else is there. So, think about which markets or products the company could potentially expand into. Can you imagine the company selling bedding products, sheets, covers, box spring beds, and so on? I do. Than you quickly have a market worth 7-8 billion.
Next, look at the dynamics of the market. How is the market behaving? Is there strong seasonality? Some verticals such as fitness, real estate, travel or ice cream products experience strong variation throughout the year. Conclusively, YoY figures provide a more accurate picture to the actual growth than MoM do. Further, what kind of percentage is done online and would kind of percentage would you expect to be online in 5 years (trends). Look at industry reports or Statista or Eurostat and get an idea of the growth. Approximately only 2.5% is online right know (57,4 Mio. EUR). It is expected to grow to 230.6 Mio in 2020 – a good opportunity.
Finally, market timing. You never now when is the right timing for a new idea. But are there indicators as shifts in consumer behavior, new regulations or trends? There exist general trends into increasing online buying behavior and consumer value life-style products more.
The competitive landscape you should look at involves old as well as new players. In this case I differentiated the competitor along the online and offline segment as well as a high product and low product expertise. I choose the product expertise as second axis since as we discussed a product expertise will result in a strong product, which seems to me to be essential to increase the net promoter score. I think clustering the competition give a quick overview and the shows the strength and weakness of the companies. Further, by looking at EBITDA margins of competitive established players you will get an idea of what is possible with the business. This might be especially important later on when valuing the company. Also, find out how large your competitors are in terms of revenue, employees and growth. Every company has a public record, which can provide good insights.
In our case, we have several old economies player and a bunch of new Internet startups rising up. Competitive markets can be an opportunity for some VCs and not for other VCs. Some VCs have built up lot of knowledge in SEO and SEA other focus on media power. Putting media power (TV & Radio) into a competitive market e.g. can make some SEA profitable for a company since media core is to build a brand and establish trust. Trustworthy products perform better in SEA. Therefore, you might outperform the competition by reducing CPAs. Most TVs are not cost efficient or only with online marketing. Anyhow, do you think the company will be dominant and growing 3 years form now? I am not certain about our Bedding Group X, but I believe that there exists an opportunity for category leader.
Valuation and company structure
A capitalization table (short cap table) provides us with the basic understand of the company structure. Bedding Group X is looking for its Series B round and had some business angels and seed investors investing in the first round. By looking at the company register, we find that they are currently making 20 Mio. Also, we know that the previous round was at 3 Mio. revenue. Assuming a 2x multiple the company was valued at a Series A valuation of around 6 Mio EUR. Now, the current estimated Series B valuation of 40 Mio. is based on 20 Mio. revenue and looking for an 5 Million EUR investment. Quiet a nice development for the company.
After having a quick look as investors I ask myself some of the following question before diving into the evaluation process. First, is the company offering a high enough stake (10%+)? Since as a venture investor I will have a small portfolio, I want to focus my time and energy on the possible outcome that will provide the most return for me. To get the 3-5x return that most venture capitalists target 10% of their portfolio need to return 10x+. In our case the company offers a 12.5% equity stake in company, good enough. Second, are the founders incentivized to grow the company further? Far too often, entrepreneurs or key employees (e.g. CTO) have a too small share. As good investor I can still offset this negative incentive structure by creating an ESOP or letting the founders rebuy share. Never forget though that the founders will dilute further in the follow up rounds decreasing their stake in the company. Third, does the company have a clean cap table? In our case it does, however, lots of companies have a wide range of investors, especially crowdfunded companies. The owner of the shares will have certain rights and may be a possible to control the company. As new investor I most likely want to take a board seat in the company and discuss the issues with as few people as possible. Fourth, are there trusted co-investors investing into the company? Having known partners help in reducing upcoming problems in the future.
Fifth, what are potential exits? Will the potential acquires pay a premium? I assume that companies such as Steinhoff, Roller or other brick-and-mortar bedding companies would pay a premium to buy online experience and place themselves in a new growing market, in which the retail-focused traditional stores a little knowledge. But would they pay 400 – 500 Mio. to achieve my 10x return? Sixth, determining a valuation is probably the most difficult part. Some investors will perform a DCF analysis and multiple comparisons. Nonetheless, most valuations are fixed by experience of the investor and negotiation with the founders. Nonetheless, you should think what metric would it be valued by a potential acquirer? Revenue, P/E, EBITDA multiples, number of customers, growth. Also, strategic acquisition e.g. gaining new knowledge or access to a new market that could not be building with the internal team is mostly paid with a premium. Finally, we look at burn rate. How long will the company last with the 5 Mio. Maybe 6 months, 1 year, 2 years or even more?
- Quickly scalable business with the ability to create a category leader in a new online segment
- High margins, larger baskets, high mass consumer relevance
- High achievable EBITDA margins of 10-15%, 15%-20% in long-term
- First order profitability
- Strong branding opportunity – brand can reduce online marketing costs
- Product expansion and potential cross-selling opportunity can increase LTV, provide economies of scale in warehousing, manufacturing and logistics
- Vertical integration of supply chain increases delivery speed (delivery to customer), quality control (since you own and control entire chain), product know-how, little inventory complexity, independency from other manufacturer (pricing and logistics)
- High competition increases online marketing costs like Google Ads or Facebook Ads
- Low LTV requires a really good product to achieve a high net-promoter-score (referrals)
- Profitability driven trough referrals, cross-sales and performance marketing
- Activate customers to increase reorder rates
- Working capital intense compared to drop shipping
- Logistical scalability (but lower backorder risks)