Practical Founders Podcast

#19: Practical VC seed investor explains the institutional funding game – John Francis

John Francis is a general partner at Stout Street Capital, a  venture capital fund based in Denver, Colorado. Stout Street has made 70 small seed and pre-seed investments in software startups outside the big tech centers in North America. 

Unlike big Silicon Valley VCs, almost half of Stout Street’s investments are in more practical software companies that have reasonable valuations, sustainable growth models, and won’t need more outside investment before they exit. 

In this in-depth interview with a “practical funder,” John explains the ROI math of professional investors and how they think about investing. John also has great insights on how founders should think about raising money in the first place.

Best quote from John:

“There are so many things that can kill a business. And running out of money is probably the number one reason.”

The potential for a 10X return is reduced if they don’t have enough money to survive for the next three months. The potential goes down to maybe even less than 1X, so we can’t invest.

“Even though we love the founders and we love the idea, we have a fiduciary responsibility to our LP investors when we are investing their money. It’s heartbreaking sometimes to say no, but that’s the reality of it is we just can’t do that.

Full-text transcript of the Practical Founders Podcast interview with John Francis of Stout Street Capital.

Greg Head: And we’re live with John Francis of Stout Street Capital. Hey, John, welcome to the Practical Founders podcast.

John Francis: Hey, Greg. Thanks for having me.

Greg Head: It’s going to be a really interesting conversation, another one of our practical funder discussions. I really appreciate you as a professional venture capital investor coming on. We haven’t met in person, but I know you do a lot in Phoenix and I know a lot of founders in Phoenix, so we know hundreds of people in common. You’re very active. Why don’t you tell us briefly about Stout Street? And this isn’t going to be about selling venture capital. We’re going to explain how you do, at one end of your investing, practical institutional capital. There’s a practical side to it, and we’re going to talk about the venture capital game and what it means for practical founders.

John Francis: Stout Street is a pre-seed and seed-stage investor. We are based in Denver. We invest across all regions in the US. We tend to avoid, I’d say, coastal cities like San Francisco and New York, and Boston. Outside of those cities, we invest anywhere else. Right now we have about 70 portfolio companies. Our investment thesis is primarily around productivity gains. So any company that improves efficiency and existing processes is what we’re looking for. Investments, ideally we are looking for investments in rounds that are at least a million in size and companies that are at least doing some revenue. So anywhere between 15 to 20K and monthly revenue is the threshold that we start looking at companies. We are sector agnostic, we are region agnostic in terms of scale. We’re looking at companies that can grow to anywhere between $20 to $30 million in revenue to all the way up to $100 million in revenues per year.

Greg Head: Okay. So we’ll pick that apart here. And again, we’re not recommending venture capital drugs to practical founders out there. Every founder should understand it. Every VC I talked to has a 90-second speech like that that says, Here’s exactly what we do, Here’s exactly what we focus on. Every venture capital fund professional investor has a focus. So let me ask you a few questions about that. First of all, you say pre-seed and seed, right? So those are confusing terms because they mean different things. And so you’re at the beginning, the first tier. What are your typical investments when you see companies you want to invest in?

John Francis: If we take the standard definitions of pre-seed, or I’d say nonstandard definitions of pre-seed, and see how we look at ourselves as we invest in companies less than $10 million in valuation. So pre-money valuations of less than ten are usually our entry points. So our average is around 6 (million pre-money valuation). But we, we have invested in companies with valuations of 3 and we’ve gone up to ten. So it’s a blend, but we can talk a little bit about how we look at those and why entry points matter.

Greg Head: You’re investing a million or investing half a million or a few hundred thousand or how does that what does that look like? A couple of different ways?

John Francis: So right now, again, it depends on the stage of the fund. So we just kicked off fund three. So one thing to understand with funds is the different life cycles of the fund. So we’re in the very early stages of the fund. So we are still raising money. So we did have our first close, but we are still raising money. So we don’t know what our fund size is. We are looking to raise a $30 million fund right now at $15M. So our initial checks, the first two years of this fund cycle, we’re going to be writing slightly smaller checks because we don’t know what the fund size is. So and the way the reason why we do that is so once we know what the fund size is, then we can go back and maybe follow on in future rounds. So right now our check sizes are around $150K. And with the fund size that we are looking at, if we fully subscribe to that 30 million, our check size is going to be close to 300-350K first check size. Ideally, we want to get to about half a million in check size. So the last year where we have no option of following on, like the fourth year will be our biggest checks. So we’ll be writing half a million dollar checks sizes and that will be the single check.

Greg Head: So you’re an early-stage startup investor and if you go to Silicon Valley where they have big billion-dollar funds, they’re not investing $150,000 a time. Somebody who just got $30,000 monthly recurring revenue, you’re doing practical valuations and early checks with lots of companies. You’re not on the board of 70 companies. John, are you?

John Francis: Know, we’re on the board of six.

Greg Head: So you’re a check, right?

John Francis: Yes.

Greg Head: And a little endorsement and probably some therapy and help along the way. So that means you generally don’t lead the round. Take the biggest check and the board seat, which is kind of an adult supervision role in startups. You’re joining with other investors who you know, and writing checks when they lead and need to fill out the round. Is that mostly how it’s done?

John Francis: Yes, we syndicate every single deal. We’re not a single check writer where we take the whole round. That’s not our style of investments. So we work with at least 300 to 400 other VCs all across the country. So that’s what we bring to the table. So we bring our network, in terms of syndicating rounds, in terms of how founders should look at us, we’re a network node. So we are connected with a lot of different people. So if you’re looking to connect with customers, you’re looking to connect with other entrepreneurs or founders or other regions. How to look at expanding to other regions. Those are some of the things that we can help with. We work with state entities through the UNMET conference. So there are a lot of things that we add outside of just the check. But the check is sometimes the most important thing for founders because most of the founders that we invest in are bootstrapped founders who have at least spent three or four years building their company before raising their first institutional check or at least looking to raise money from an institution. And I would say at least 30% of our founders are founders who never raise another round. So the round that they raise with us is the last round, and that kind of gets them to profitability or breakeven and they’re looking at exit offer that or they’re trying to build that business organically without raising excess capital.

Greg Head: So I’ll call that the practical funding side of your business. And I know some of the founders you’ve invested in and I’ve watched them have an idea and build something out of their savings and service businesses and say, Gee, do I think I need funding? And then start to show up and get funding? And they say, I just need a little bit and then I can keep growing. Can you differentiate that, let’s call that practical funding, where they’re raising a little bit and they’re not going to raise forever? They’re not totally addicted to the funding drugs. They’re not going to raise series A, B, C, you know, tens of millions or hundreds of millions. Can you differentiate that one-and-done kind of funding from traditional VC, which is big funding? Lots of it. Shoot the moon unicorn. Like there are different tracks. And yes, for founders to know what track they think they might be on if they’re actually talking to investors.

John Francis: Right there, completely different characteristically, companies that or founders were looking to organically grow their companies. They are trying to build a sustainable business. They’re not trying to outcompete, they’re not trying to outspend their competition. And most of the time they understand their business better than anyone else, and they’re focused on an extremely strong niche. Yeah, usually that boils down to market size the urgency to go to market urgency to solve that problem. So a lot of times with venture scale companies, the problem is acute that there are a lot of people trying to solve that same problem and the solution is expensive, right? And also there’s a cost to being slow. So if you’re slow to attack that problem and if you don’t have enough money behind you, you’re like the whole concept of being first to market or winner take all or grow that all costs, all of these are a subset of that sort of thinking where without money you’re going to lose out. And a lot of founders can get pigeonholed in that thinking where they where they feel like, Oh my, my idea is so good that other people are going to copy and other people are going to do this. And that’s why I need venture funding. And a lot of times, if the problem is not big enough, again, you’re talking about red oceans and blue oceans. Blue oceans are like your new markets for taking, and if you don’t move faster, you’re going to lose. So most of the.

Greg Head: Okay, so let’s put those in context here. So on one side is practical funding, practical valuations, one round and then will be organic (growth) and that’s a lot of vertical markets where they can be efficient. We’ll sell the company because you invested in it because you’re going to get paid back when they sell the company at a bigger valuation. They’re going to sell the company, but it doesn’t have to be a $1,000,000,000 valuation, right? They’re slower and steadier and more efficient: practical and have a little bit of funding. Like if they do the funding. Versus the traditional VC funding: big VC funding, high valuations, big rounds of venture capital, go fast, shoot the moon, create the market, do it expensively. I’ve done that before too. So and you do a little of both of those. Do you do practical funding and traditional and shoot-the-moon VC funding?

John Francis: Yes, 30 to 40% of our investments, I would say, are on the practical side, on founder-scale investments. So usually the reason why we do that is founder-scale investments and bootstrapped companies tend to be a little more predictable on the exit side. They tend to be a little more capital efficient, even though they are not going to be a $1,000,000,000 company or they’re not hoping to be a $1,000,000,000 company. A lot of times they have very practical exit expectations and a lot of times people even know that a $30 or $40 million exit could be life-changing for founders. So and with our entry points and $3 to $4 million and we are not diluting a lot. We are not we are still a minority holder. Most of the investors will be minority holders in those cases. And you know, the $30-$40 million exit, we are still getting venture-scale returns for the fund.

Greg Head: So your 10X, right?

John Francis: So or even like 4x to 5X in a, in a three-year window or three or four-year window is the same as a ten X on a ten-year window.

Greg Head: Right.

John Francis: Time is of the essence in terms of exits and getting a good IRR (Internal Rate of Return). So how we look at it is a lot of our founder scale investments help us recycle into the fund because if you look at the fund mechanics, yes, there’s a quick cycle. So most of our early investments tend to be on the founder scale, which allows us to exit quickly, and recycle that money into the fund. So we have a four-year investment period, like most funds. If you have an early-cycle fund with an early-cycle investment that gives you money before the investment period, you’re able to recycle that money into new investments. So that allows you to stretch your IRR, which allows you a better investment return. So there’s a lot of practicality in doing those kinds of investments where you’re not waiting for 10, 15 years for an exit, but you’re still investing early, getting good IRR and you’re still using that money to go invest more, in more companies and also getting better IRR for your LPs.

Greg Head: So IRR is the Internal Rate of Return. And then there is the multiple of invested capital. So let’s talk about what’s on your side. You have your customers who are the people who invest in your funds. So now you’re on fund III where you haven’t been doing this for 30 years. You’re still a newer generation, but you’re on fund III, which means you’ve had some success and your funds are getting bigger and you’re getting investors. Let’s talk about what you’re trying to accomplish. Because if a founder says, I need money and you say I need it to fit my model, if those two can’t overlap, then there’s no funding. So when you say I’m on fund three, we raise $15 million of $30 million, and those are the people I work for. And I go invest that money to pay them back 2 or 3 times what they put in. Right? Right. That’s the multiple of invested capital (MOIC). Who are those people that are your limited partner investors and what do they expect from you that you need to deliver through investing in founders?

John Francis: I mean, our LPs are mostly high net-worth individuals, family offices, and we have a few institutions as well. Most are either state entities like pension funds or state investment councils or committees. So again, they have their own requirements. Most of them don’t mandate a certain amount of return, but there are certain expectations. So because of the amount of risk that is involved in venture capital right now. I feel like the last two years have been aberrations where expectations have been.

Greg Head: We’ll talk about that, too. Yes.

John Francis: I feel a lot of times it’s very much like your mortgage rate depends on what the Fed rate is. The expectations for venture capital returns are dependent on what S&P is doing. So if the S&P is yielding you 20% for the last five years, then they’re not happy with a 10% IRR for your venture fund, even though that would mean if you do a 20% IRR for your venture fund, which in a ten-year fund, that’s a 5X on invested capital, right? So it’s incredible to get 5x multiple returns. I would say there’s no one on this planet who’s consistently gotten a 5x return fund over fund. You always have like a few funds outperforming other funds lose money too.

Greg Head: So your game literally you’re talking to thousands of founders at Stout Street and you make, I don’t know, a dozen investments a year, something like that, and you’re putting money in. What expectations do your investors have from your fund? They could invest in the stock market, but they think you’re going to be better. Let’s play this game and you’re obligated to go make those returns.

John Francis: And because of that expectation, I think VCs tend to take riskier and riskier bets. And that’s something that we have seen in the last couple of years is to get those returns, to kind of drive those returns, you need to take riskier and riskier bets. You need to go invest in NFTs and crypto and all these fringe sometimes and sometimes frontier tech companies. In terms of LPs, that’s what they’re expecting VCs to do and that’s what VCs will do or that’s what they’re obligated to do. So as fund managers, we fall closer to being conservative in terms of how we rather go towards predictable returns rather than unpredictable returns. So what’s what we are expecting at Stout Street is a 3x to 5X return on capital, and on the low end being at 3X, And when we do that we are looking at a very risk-mitigated approach to investments. And in terms of your question on what we are expecting from founders: for each company, we’re expecting at least a ten X on money-on-money, from an X from a potential return, not an expected return.

Greg Head: And that doesn’t always happen. That’s why 5X on average or 3X on average, right? So you actually have some of the power law math, which is we’ll make 60 investments, and half of them won’t pay back, some of them will and some of them will pay back pretty well. But you’re not as skewed as Silicon Valley, where they’ll invest in 100 and as long as they get one mega of decacorn ($10B exit). You’re a little bit more flattened there. This is something every founder should understand and it doesn’t always work out. And VCs try hard to choose wisely and help you along the way. But what percentage of companies in your portfolio do you think will not pay back and not make it?

John Francis: The two ways to think about it are will they pay anything back or they go to zero? Yeah. So in terms of going to zero, I would say at least 10% is what we are tracking right now across funds that go to zero, which I think historically we’re doing better. It’s lower than other funds which are closer to 30% I would say that is where they go to zero. But in terms of your singles and doubles, that’s where we can make the most and at least get to that 2x multiple, right? In terms of the fund. So let’s say out of the 40 companies, we can split that into 16, 16, and eight, let’s say. So if there are 16 founder-scale companies, 16 venture-scale, and 8 you’re shooting for the moon, right? And reason 8, is that you do also have companies that don’t meet your mandates that might be extraordinary. You do see some of those companies where valuation doesn’t matter or the metrics don’t matter. You just want to be part of the deal. And and there are some opportunities like that where we do need to keep ourselves open for those opportunities as a venture fund, purely because if you’re not, then you’re not going to see those opportunities in the future.

Greg Head: So I know you’re a super engineer and super math guy investor. So you’re actually kind of taking a portfolio approach. We’ve got some big swings over here. We’ve got some 3-5 x and 3-5 years, quick wins. And something in the middle and you’ve got a blend of these.

John Francis: Yeah, and that’s partly because of my background. So I was, I was a quant doing energy trading. So that was the first thing I did after my MBA out of Tulane. It’s not common in venture capital to see a lot of discipline in the portfolio construction side, especially for the fund managers, Most fund managers are selling access to LPs because it’s still such a closed ecosystem where your losses are discounted and your events are celebrated, right? So that’s something that’s fairly common that you don’t see a lot of finance guys doing venture capital. So it’s definitely got a lot more art to it than science. But I feel like that that is changing slowly.

Greg Head: It’s also extremely early, pre-seed. It’s like a sense of smell about a market and a founder and the numbers are not true yet. Let’s move to talk about the kinds of investments in the practical bucket, not to shoot the moon, be a unicorn, traditional VC, that we all read about, and that’s for a small group of software companies. But for a bootstrapper who’s got an up-and-running business and is thinking about a little funding to accelerate and someday I’m going to sell it, which means you’re going to sell it for more than you thought you were because now you have investors that you have to pay back too.

John Francis: Practical founders are looking for just one round of funding to get them to the next level. So they’re well positioned for an exit or they’re well positioned in their own market that they’re selling into. So there are a couple of different ways to look at it. Or get even to profitability, right? So if they’re already profitable, I would suggest debt being a better option than VC.

Greg Head: My goodness, a venture capitalist not recommending funding drugs! You said if you’re already profitable and growing, debt is the most practical option for founders is what you said.

John Francis: Absolutely. And that’s true from mom-and-pop businesses to tech businesses. There is no there’s no change in that mindset because it is the cheapest way for you to grow your business. And if you can’t grow faster than the interest rate, then you shouldn’t be seeking venture funding. Right? (laughs)

Greg Head: So give us an example. I’m $500K in revenue or a million in revenue. I’m burning a little bit of cash and I could use just $1 million or $2 million to get past this phase and grow faster, accelerate a little bit, and make some investments. Is that the kind of typical deal or does it look different than that?

John Francis: Yeah, I mean, there are so many different flavors of it, right? So in terms of practical founders that are looking for just one round of funding or just getting to that next level, venture capital is is a good fit if you have the ROI for that investment. So if you already have some product-market fit, it’s not like you’re trying to validate product-market fit with this new money. You already know what the CAC numbers are, your customer acquisition costs are. You already know what their lifetime value is. This extra million dollars is going to get you the marketing budget that you need to grow that business from $1,000,000 business to a $5 million business where you have a 5x in value. The momentum of that growth is what drives your exit, right? So if you’re growing slowly to get to that five, so you take your growth rate, right? If you take three years to get to that $5 million versus going there in 2 years, there’s a big difference in growth rates. So if you can get that, you’re getting a better multiple at exit. And that’s what venture capital investors are looking for, the pace and the growth rate. If you’re growing slowly with that money, that also depresses your return. So that way you’re losing more money on exit as well. And the thing to understand is most VCs would have liquidation preferences. So if you have a bad exit outcome, it can bleed into your ownership or it’ll eat into your return as well. So as founders, the key thing that is different when you take venture capital money versus like growing, growing the business on your own is if you don’t grow fast enough, you’re going to be on the losing end.

Greg Head: So it’s and it’s an acceleration investment, not an experiment investment. So let’s talk about that product-market fit and traction and experiments game that a lot of founders are confused by. Meaning, I see an opportunity, I’m struggling out here, I’m running out of money, I need money to run some more experiments, I’m sure it’s going to work someday, I know it’s going to be big–is way different than I know who the customer is, we got a product, there’s a little factory building here, a little bit of momentum: Traction. Right. And heading towards product market fit. A lot of founders will say if you wait till I build a factory and I have product market fit and it’s just adding water to make it go faster, then there’s no more risk. Why do I need you–a VC? Because when you invest at 425K or $50K MRR They haven’t figured it all out yet, right?

John Francis: Yeah. So the points that we are investing in, they’re still figuring out product-market fit, but a lot of times some of the money is going into developing new channels. So some at 25K-30K you have some established channels, but those channels are not going to get you to. Let’s say a million in MRR.

Greg Head: Those are sales and marketing channels. I have direct sales and I want to add partners.

John Francis: Right. Yeah. So you want to channel, you want to add resellers, you want to integrate with new partners. When we invest, we are investing in product development on the integration side. So where they’re already working with, let’s say one integration partner and they are selling through that integration partner or they already have one. So let’s say they have one region, so they’re selling in Colorado or selling in Phoenix, but they’re looking to expand to like two new markets or three new markets.

Greg Head: And there’s more of an expansion story, not a creation story.

John Francis: Absolutely.

Greg Head: And you can see clearly and it’s a less risky bet, but even then, it’s not completely risk free.

John Francis: It’s not. There’s always competition, change in regulation. There’s so many things that can that can kill a business. I feel like that will be like a whole new episode on. Oh, yeah.

Greg Head: Yeah. Founders are aware of that.

John Francis: Yeah. And running out of money is probably the number one.

Greg Head: Well, let’s talk about that. There’s a lot of running out of money right now. Some sectors of the economy are contracting, buyers are less active and they’re slowing down their their buying. Investors are less active. The stock market’s down. For some reason, the valuation of tech stocks at a public market makes early stage investors contract, there’s less funding. Half as much early stage funding compared to last year, albeit a crazy time. What happens when companies run out of money? Do you invest in companies that say, I need your money because I’m running out of money?

John Francis: No, but it’s…

Greg Head: One of your portfolio companies says, I’m running out of money and I need more funding, what do you do there?

John Francis: It’s a different story when it’s a portfolio company, right? So you do have interest. So you definitely pull every last trick out of the bag to save your own portfolio company. But when it’s a new company and if you don’t have a sufficient runway, you’re not going to find institutional funders.

Greg Head: Isn’t that interesting? And the founders would say, I only get a loan when I have enough money, you know, to pay it back. But there’s something in between there that’s founders should hear from a professional investor.

John Francis: Yeah. The reason is, again, it depends on who you’re talking to. Investors like us, we syndicate every single round, So we’re not the only Yes you need. You probably need ten other Yeses to get enough money to survive long enough to to get that return. And when we are investing or writing our first check, if we don’t see the potential for that 10X, which would be depressed if they don’t have enough money to succeed for the next three months, then that potential goes down to maybe even less than a 1X, right? So the idea there is it doesn’t fit the mandate or like we won’t be doing justice to our LPs, even though we love the founders, we love the idea, we do have fiduciary responsibility to our LPs on when we are investing that money. It’s heartbreaking sometimes to say no, but that’s the reality of it, is we can’t do that.

Greg Head: Well, let’s talk about it. How do you tell founders No. Founders are frustrated out there that they talk to investors and it’s always “get more traction and maybe we’ll talk later.” Founders are not always that helpful or friendly when they hear a no from an investor. So investors have learned not to say no, but how do you tell founders it’s not a good fit or not right now or you probably shouldn’t raise money.

John Francis: For for us there. I would say they fall into three categories. One is they are way past our stage. So that’s the easiest no for us where we say like.

Greg Head: You’re just “too good.”

John Francis: You’re too good. So that that’s the easiest No Where we say, Sorry, we can’t do it because you’re past our stage. But that’s also part of the mandate where we can’t go beyond an entry point. And then the other end of the spectrum is they’re too early where they don’t have traction, they don’t have a product, they just have an idea. So in those cases, it’s not an easy No, but a lot of times what we are looking is to build a relationship with founders where, let’s say if we do like the idea, that’s something that we would invest in, in the future, we would be very respectful. We would try to give them some advice or guidance or try to be helpful by connecting them with other people. That’s something that we do offer when we say no. The hardest no’s are the ones that would fit like 80% of the mandate: it checks all the boxes except one or two. Let’s say they’re not growing fast enough or they don’t have enough revenue, or they’re in a in an industry that historically has not seen any exits.

John Francis: Those are some of the things. Or that there are no buyers, right? So you might be building a great business, but as we see if if you don’t sell it, we don’t survive on dividends, We had to find an exit point. Those are some of the reasons why and it’s really hard to say no sometimes when when they fit all these criteria. Ideally, we are really open when it comes to those things. We do tell them, Hey, we like everything you do, it’s just we couldn’t get it past the line. And a lot of times those things are hotly debated in the investment committee and the partners and everybody involved in the deal. So we get pretty passionate about opportunities that we feel strongly about. But those are fairly hard no’s and and a lot of times we try to get a soft landing because we know these founders are going to be successful no matter what. But so we are trying to build that relationship as well, even though it’s a no.

Greg Head: So I’ve been part of software ecosystems for 30 years and the classic venture event where there’s a crowd of 300 founders in the room and there is a panel of venture investors up front, different stages with their story in their math and the stage. And as I look about the room, all the founders are there because they need funding and they’re have a big dream. But I know that the VC investors in there could maybe invest in ten people in that room. And so there’s ones that create businesses, or maybe they shouldn’t create a business, but they’re not going to get funding. It wouldn’t be the best fit for them. They’re practical founders. How do those appear to you? Do they not get a meeting with you to have a conversation, or is your door open to have a conversation? And you say, Well, you’re not that level yet. I don’t see the 10X return multiple, you don’t don’t have traction or whatever. You’re the front door to the institutional capital.

John Francis: Right.

Greg Head: How do how does it work at the front door.

John Francis: We’re definitely having more than a thousand conversations per partner in our firm (per year). Last time we tracked or last year, we saw over 3,000 opportunities just from the top of the funnel for us.

Greg Head: So founders should also hear that, right? I have a good idea. I really need money. They’re competing with 3,000 other companies that are lined up to talk to you.

John Francis: And it’s and that was just part of it. So we’re not even including our accelerators and incubators and others that are open. So those are just founders that reached out to us directly or somebody referred it to us out of that 3000. I think the quick no’s we were about 2200 of them were quick no’s. So so we had about 700 of them where we actually took a meeting. About 200 of them got into second meetings. So from 200, we ended up investing in 10 companies. So about 30 of them made it to investment committee. So and from an investment committee, that investment is 1 in 3 chance.

Greg Head: I’d say similar proportions exist at larger venture capital firms that invest bigger dollars. But you’re at the early stage, and that’s a lot of volume there for a small team. Yeah, and a small fund. .

John Francis: So the reason for us that we can we can manage all this volume is because of our quantitative approach. Our initial filter is very quantitative, so we’re looking at thresholds like valuation thresholds. We are looking at revenue thresholds geographically, if they’re not a fit, because we do see a lot of San Francisco and New York based companies as well.

Greg Head: And so why would San Francisco be a disadvantage? A lot of smart people in San Francisco and so forth, but you know, automatically their valuation expectations are going to be different?

John Francis: On the valuation front, it’s more psychological, to be honest. So we feel there are certain regions like San Francisco, New York, Boston, I would probably add Austin and Salt Lake to that as well. They’re very well-funded ecosystems, so where they have a really good critical mass and diversity of VCs and institutional investors in those regions. So we view it with a little more skepticism when we see opportunities coming from those those regions, because like, Hey, you can get funded locally, why would you go pitch in Denver? So there’s that survivor bias or whatever the opposite is of that bias is. .

Greg Head: Before we talked about exits in the 10X. Meaning if if you invest at a certain valuation and you own a piece of the company, you’re expecting that company to grow and sell and pay you back for at least ten times what the valuation was that you put in, right? So you put in 100,000 and you get a million back, ten times, right?

John Francis: Yes.

Greg Head: And hopefully more.

John Francis: Yeah. I mean, at least the potential of it. Like it’s not that they have to return it, but at least on paper or at least when we’re looking at them, it’s not what they put on, like, oh, our TAM is 10 billion. Usually we take a number out of that, we take a zero out of it. But whatever is realistic after our analysis, right, where we can say, okay, realistically, sure, they’re saying $16 billion TAM, realistically this is at least a $200 million TAM and three other competitors in the space. And they could probably realistically get to about $20 million if they do a good job. So and if they get to about $20 million, they could probably sell at a 6X or 7X multiple on exit, let’s say at $100-$120 million exit. So yeah, even if you’re entering at a $10 million valuation, you know you’re getting a potential 10X on it. So that’s how we tend to evaluate it. .

Greg Head: Founders should hear that expectation right. And the moment you decide to raise capital is you just moment you decide to sell your company.

John Francis: Right.

Greg Head: Which is different than a practical founder that builds a few million dollar annual recurring revenue SaaS business a $2 million and sell it for $10M or $5 million and sell it for $30M or $50M or something like that, depending on whether it’s 2022 or 2021.

John Francis: Right.

Greg Head: Those multiples on exit, that’s kind of founder scale, but that’s the low end of what you would be considered interesting for venture investor.

John Francis: Yeah, I mean we have had exits like anywhere from $30 to $100 million on the founder-scale. Yeah, a lot of times founder-scale companies or founders even tend to be like, Hey, I wish I waited longer. And you also see a wide range in terms of multiples as well. So it’s not that everybody is getting a 10X or 20x or 30x.

Greg Head: What’s the lowest multiple that founders would sell at and everybody would kind of be happy. I mean, that’s obviously a multiple of revenue, not a multiple of EBIDTA or profits. What’s what are you seeing out there?

John Francis: I would say it depends on the nature of business. I would say a recurring revenue business is obviously sell upwards of 7X. But if you’re more on the services side and again, gross margins, less than 50%, I would say like we have seen 3-4X as well.

Greg Head: And is that tech-enabled services with recurring contracts and repeatable higher margin than an agency services or something like that.

John Francis: In pure yeah, hardware inventory dealer distributor model businesses, there are some of those as well, but those are usually on a 2-3 X, not more than those. So again, it’s a nature of business. It’s a nature of like what the margins are and how repeatable those business are.

Greg Head: And do you play the timing in the market? I know you tried to resist big valuations last year in 2021, as every investor did. And now we have lower multiples of exits for those that are actually exiting this year. There’s less M&A, mergers and acquisitions. Is there M&A happening this year? Companies selling and doing reasonable or is this like the doors closed? Like there’s no IPOs and there’s not many exits for your kind of practical founder-scale companies?

John Francis: Yeah, in terms of like the portfolio game or the portfolio construction for us is we try to invest in countercyclical industries. If you look at real estate and fintech, they’re closely tied. And if you look at financial services or if you look at so we invested in a couple of companies that are countercyclical to real estate. For example, there was this company on the debt collection side, which is counter-cyclical to when the when the economy is doing really well. So we we tend to balance out when you’re looking at building a classic hedge fund, you’re investing in companies that have kind of cyclical trends. So that’s one practice that we do follow in Stout Street is we tend to invest in companies that have the exact opposite systemic risks. When some companies do really well, for example, during COVID 19, we had a good number of companies on the health tech or the teledoc side that did extremely well. And we also had a few on the the remote working space that did really well.

Greg Head: So we’ve been talking about funding here. Founders could always use a little bit more cash, but now we’ve kind of learned a little bit more about how a professional early-stage investor thinks about their clear criteria for investing.

Greg Head: When should a founder not take venture capital investment?

John Francis: In terms of venture capital, I feel like the industry is fairly unorganized, is probably the right right way where there’s no simple way to get into or get an investment from an investor. And sometimes it’s hard to tell who is a serious institutional investor versus who is not or who’s a newbie. So I know we talked about what are the red flags. Or when should you not take venture capital? So sometimes you can tell if you’re getting a non-standard term sheet, if you’re getting if you’re getting weird liquidation preferences or if you’re getting weird clauses in your term sheet. And this is something that you can always look at through your NVCA model docs and that’s something that’s public that you can actually look at.

Greg Head: I’ll put a link to that in the show notes there, John.

John Francis: Cool. Yeah. And that can give you a good idea of if somebody is trying to do something that’s out of the ordinary or if they don’t have any experience. So usually with what we see investors, most of the time people understand the risk. People understand that the companies can go to zero or companies may not succeed. So if you do have investors that don’t think like that or they’re trying to wrestle the company over from you or try to run the company themselves. So clauses like that where you’re giving up control or they’re like extraordinary warrant clauses added on to your to your term sheet.

Greg Head: So if you’re getting these really aggressive vulture capital offers and terms and such, it’s a sign that you should back off and not take that deal, which is very difficult for desperate founders that are running out of cash. So it’s a trap that founders can fall into if they’re not very efficient about it. I need the capital and I got to do this deal. But when what you’re saying is, if a deal doesn’t look good for the founder, like standard for the founder, then it’s a sign.

John Francis: It’s better to walk away on those terms. And also in terms of exit expectations. The other side of it, you do find a VC who is willing to fund you, but your exit expectations don’t line up or match up with their exit expectations. That’s another thing. There’s a lot of temptation for founders to kind of agree with the VCs and say, Oh yeah, that’s the exit that I’m seeing as well. But if that’s not what you truly want for yourself, you shouldn’t you shouldn’t take VC money because that’s what they’ll come to you for. They’ll keep you accountable for that, for that exit.

Greg Head: John, we’re finishing up our interview here. And I got one more question. You know 66 of these founders that you’ve invested in, you’ve talked to hundreds of founders. Of the ones that have taken venture capital, your Stout Street and your other investors that you work with, what is the biggest thing they have learned a year or two later after taking the capital that you wish founders would understand before they got that far? And there’s a lot to learn about this process. And all founders are usually first timers to funding, and you’ve been doing it over and over again. But what can you say from the other side, from a founder perspective, that would be most useful for founders, either considering someday getting VC funding or they’re kind of desperate or I want to stay off the drugs. What is the thing that founders learned that surprises them the most?

John Francis: I feel like being honest about how the company is. A lot of times this is a very, very hard thing for founders to do, is communicate the reality to the investors. At least professional investors know the risks of investments. So if the company is not doing well, there’s this natural tendency with founders to just kind of internalize those things and try to…

Greg Head: To not talk about it.

John Francis: Not talk about it. So the really successful founders that we have come across are very open about their troubles. They’re open about asking questions and figuring out a way to solve it because it is a team game. So and VCs are playing the same slide. If you’re taking their money, they’re on the same side as you are, so they’re not going to go after you if you do something wrong or if it was an honest mistake or if your company is not doing well or let’s say one of your experiments is not working. So it’s it’s easy to internalize that and not really tell the honest truth of what’s going on with the company. So that’s the biggest lesson or the biggest expectation that we would have is like having an open channel or communications. That’s something that I would implore every single founder to follow is to be very communicative. Like, even if even if the updates are bad, just send it. Because if you don’t send updates, for sure, you’re not getting follow on funding. But if you do get updates, even if you’re in trouble, VCs would know ahead of time and they could plan for it. They could line up new investor intros because they can help. They can help. So that’s something that to keep in mind for is it’s not all bad. You’re bringing on more help. But yes, it comes at a cost. But there are pros and cons for for bringing venture capital on.

Greg Head: John, anything else you’d like to add for practical founders out there from your perspective?

John Francis: I know the last couple of years have been a little crazy, so it’s hard to put a baseline for people who are starting off. 2019 and even prior to 2020, 2021, which which have been two crazy years in venture capital. I think the perception about venture capital has changed quite a bit. 2022 we’re kind of gravitating back to 2019, 2018 era. I feel like people who survived the last two years or this year, they’re going to see more stable venture capital. It’s not going to be as crazy as some of the things that you’ve seen in the last two years. But yeah, we are always on the cutting edge of things. We’re always like taking the next big risk. We understand that founders and ideas come in all shapes and forms. Don’t limit yourself. There are a lot of practical funders like ourselves who are looking to fund practical founders, so feel free to reach out.

Greg Head: And how can people reach you, John, and get to the front door and have a conversation and see if there’s a fit? How can they reach you and learn more about Stout Street Capital?

John Francis: You can reach me at my email. jfrancis@stoutstreetcapital.com. You can send me an email. I respond to all cold emails. . Or you can find me on LinkedIn and try to connect to me on LinkedIn.

Greg Head: We’ll have links to all of that in the podcast, show notes on the web page for that. John I really appreciate it. This great conversation allowing me to channel the questions that founders have and and put you on the spot as it venture investor. Thanks for all you do for serious founders out there to change the world with practical funding and sometimes impractical funding that when they’re even going bigger. But you’re part of the game here of changing the world with this crazy tech that we do. And thank you for being on the Practical Founders podcast today.

John Francis: Thank you so much for having me. Greg I really enjoyed the conversation. I come here. I can’t wait to hear the podcast once it’s out. Awesome.

In this episode, John explains:

  • The basic investment math that a seed-stage venture fund manager needs to deliver the expected return to their “limited partner” investors
  • What kind of investment valuation and eventual exit outcomes are required to raise institutional capital
  • When a practical founder shouldn’t raise VC funding and how they should be thinking about taking outside investment capital
  • How “practical VC investing” is different than traditional moonshot VC investing and why founders need to be clear about which kind of funding they want
  • What’s happening in valuation for investment and acquisitions in 2022 compared to 2021

Stout Street Capital Company Facts

  • Founded: 2017
  • Description: Stout Street Capital is a seed and pre-seed venture capital investment fund that actively invests in practical software startups with sustainable growth models
  • Number of Employees: 9
  • Location: Denver, Colorado

Links

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Greg Head recorded this on episode on October 28, 2022 for the Practical Founders Podcast see all of the episodes.

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