“Top Drivers of Digital Product Value” – Episode 2: Building Digital Product Value Through Early Strategic Investment

Last Update: 20.05.2024

In today’s digital age, the value of digital products and solutions has skyrocketed, transforming industries and creating new market leaders. These digital innovations—ranging from mobile apps to cloud-based services—have reshaped how we interact with technology, offering unparalleled convenience and functionality. Understanding what makes a digital product valuable is crucial for anyone involved in the tech industry, whether as an entrepreneur, investor, or business leader.

The value of digital products results from several factors. One of the key elements driving their exponential value growth is strategic investment. The way in which exponential value is unlocked is, in our observation, a know-how that more traditional businesses and entrepreneurs selling physical products struggle to incorporate.

As we observed that this is a rather new topic for many  of our clients, who are looking to digitalize themselves, building digital value, in this article, episode 2 of our series “Top Drivers of Digital Product Value”, we will provide here a nuanced understanding of how strategic investments can significantly enhance the value of digital products.

The Role of Fundraising in Value Creation

Introduction to Fundraising

Fundraising is the lifeblood of innovation and growth in the business world, especially for startups. It involves securing capital from various investors to fuel the development and expansion of products or services. The process typically begins with seed funding, which provides the initial capital to turn an idea into a viable product. As the company grows, it moves through several rounds of funding, including Series A, B, C, and so on, each with specific goals and milestones. Investors in these rounds can range from angel investors and venture capitalists to institutional investors and, eventually, the public through initial public offerings (IPOs).

Fundraising for Physical vs. Digital Products

When it comes to physical products, the fundraising process often revolves around tangible assets and direct revenue generation. Investors typically look for evidence of market demand, production capacity, and clear revenue streams. Conversely, fundraising for digital products is primarily driven by potential, scalability, and user growth metrics rather than immediate profitability. It is very important to understand these differences between the fundraising strategies for physical and digital products as they seem to be at odds with each other. First-time founders often struggle to understand what investors are looking for in the digital product category and loose valuable time.

The Mechanics of Investing in Digital Products

Investing in digital products involves a different set of criteria and expectations compared to physical products. Here’s why:

1. Valuation Based on Potential: Digital products, such as software applications or online platforms, often have low marginal costs for adding new users. This scalability allows for rapid growth in user base, which can significantly boost the company’s valuation even if the product is not yet profitable.
2. Initial Investment for Value Creation: Early investment is crucial for digital products. It helps in developing a robust product, acquiring initial users, and establishing a market presence. The value of the product is often set by these early investors, who base their valuations on the product’s potential to disrupt markets or create new ones.
3. Perceived Value and Market Confidence: The trust and confidence of early investors play a pivotal role. When influential investors back a digital product, it sends a strong signal to the market about the product’s potential. This can attract further investment, creating a positive feedback loop that enhances the company’s valuation.

Investment Rounds and Their Implications

Investment rounds are structured to support different stages of a company’s growth, each with typical investment sizes in the U.S. for digital products.

Seed Funding

Average Investment Size: $500,000 to $2 million

Seed funding is the earliest stage of investment, aimed at developing the basic product and conducting initial market research. This funding helps startups validate their business model, build a prototype, and gain initial traction. While helping the startup to gain initial traction, it also can create early on a perceived higher valuation on the market, simply based on the seed funding amount and investor profile. Profitability is not the goal during this stage.

As described by Y combinator, one of Silicon Valley’s premier startup accelerators, founders should try to “give away as little as 10% of their company in their seed round”. However, they mention that most rounds require up to 20% dilution and founders should try to avoid more than 25%. Read the entire article here to dive deeper into the best investment practices for Startups.

Series A

Average Investment Size: $2 million to $15 million

Series A funding focuses on optimizing the product, scaling the user base, and generating revenue. At this stage, companies typically have a working product and some user engagement. The goal is to improve the product based on feedback, enhance marketing efforts, and establish a stronger market presence. As the company is focused on its revenue growth and product improvement, profitability might still not be the main goal at this stage of funding.

Series B and Beyond

Average Investment Size for Series B: $15 million to $50 million
Average Investment Size for Series C and Later Rounds: $50 million to $100 million or more

Series B and subsequent rounds support large-scale expansion, entering new markets, and enhancing operational capabilities. These rounds are crucial for scaling operations, adding new features, and positioning the company for long-term success. Profitability can, if part of the strategy, be put from here into the focus of the company’s activity.

How to strategically increase Valuation of the Digital Product

With each investment round, a company’s valuation typically rises to reflect its progress and growth potential. This increase is often driven by projected future earnings and market dominance possibilities, rather than current profits.

The dynamics of this process can sometimes resemble an unsustainable financial strategy, where initial investments create a perception of value that attracts subsequent funding rounds. This perception is often fueled by ambitious projections and market potential rather than tangible financial performance. In extreme cases, this can lead to a cycle where valuations are disproportionately high relative to the company’s actual financial health, creating a pyramid scheme.

Yet, this system forms the bedrock of the startup ecosystem. For newcomers to this environment, it’s helpful to draw comparisons, such as with the art market, to deeply understand these structures.

At Arckipel, we advise our clients to rethink the definition of “value.”

Consider the Mona Lisa: its creation might have cost only a few hundred dollars, but its worth is exponentially greater because society and investors attribute immense value to it. While one might argue the real value is just a few hundred dollars for a small oil painting of a smiling woman, the world recognizes the Mona Lisa as one of the most important and expensive paintings due to its perceived value and the substantial sums required to acquire it.

The real value lies in itself in the valuation of the Mona Lisa, attracting thousands of tourist to see her each year.  This is precisely how valuations work for digital products in the startup sphere. The value is created through perception and the amount of investment it attracts, setting the stage for future growth and success. It is the potential of “thousand of visitors” that make up the value of the digital product in investors eyes. There might be only clues, yet no proof to confirm the valuation.

Why is the first investment into a digital product the most important one?

The first round of investment, often referred to as seed funding, is particularly critical. This first injection of capital is crucial as it lays the foundation for the company’s valuation and future growth. Early investors typically receive equity at a lower valuation, which can lead to significant returns if the company is successful.
Not only do they provide the necessary funds to get the company up and running, but they also set the tone for future investor confidence and valuation growth. Therefore, a strategically managed first round of funding is critical to long-term success as it mitigates the risks of inflated valuations and ensures sustainable financial growth.

Especially for early-stage investors, it is possible to see immediate returns after the next financing round. By investing early and helping to increase the value of the company, they immediately increase the value of their own investment. If the valuation of the company increases in later rounds, the value of their initial investment will also increase, leading to a potentially significant return.
Such a strategy is often used within the startup scene to generate quick profits.

Case Studies in Digital Product Fundraising

Spotify

Spotify is a prime example of a company that has significantly raised its valuation through successive funding rounds without being ever until today, entirely profitabel. Despite having a history of negative balance sheets, Spotify attracted substantial investment due to its potential to dominate the music streaming market.

Investment Summary:

• Seed Funding: Raised approximately $1 million in 2006 to develop the initial product.
• Series A: Raised $21 million in 2008 to scale the user base and enhance the platform.
• Series B to F: Raised over $2 billion across multiple rounds from 2010 to 2018, including $400 million in Series F in 2015.
• IPO: Went public in 2018 with a valuation of $26.5 billion.

Despite still not being profitable, investors saw value in Spotify’s large and growing user base, innovative platform, and market leadership, which justified continued investment. As of 2023, Spotify has not consistently reported annual profitability but has shown profitable quarters, emphasizing its strategy of growth and market expansion.

From an outside perspective, it may seem rather outlandish to invest billions of dollars to increase the valuation without the company being profitable at all. It is perhaps also worth mentioning that the founder Daniel Ek founded this company without even knowing what a business model might look like. (We advise everyone interested to watch the Netflix series “The Playlist”)

However, their investment history proves that investors are convinced of the strategy of constantly increasing valuations and achieving market dominance.

Uber

Uber has navigated multiple funding rounds to achieve a high valuation, fundamentally changing the ride-sharing market.

Investment Summary:

• Seed Funding: Raised $200,000 in 2009 to develop the initial app.
• Series A: Raised $1.25 million in 2010 to launch in San Francisco.
• Series B to G: Raised over $15 billion across various rounds, including a $3.5 billion investment from Saudi Arabia’s Public Investment Fund in 2016.
• IPO: Went public in 2019 with a valuation of $82 billion.

Uber’s ability to attract substantial investment reflects investor confidence in its long-term growth potential and market disruption capabilities. As of 2023, Uber has achieved profitability on an adjusted EBITDA basis (that means to exclude certain non-recurring, irregular, or non-cash expenses and incomes) but has not consistently reported net profitability, focusing instead on scaling and operational efficiency.

Airbnb

Airbnb has also achieved high valuations through successive funding rounds, revolutionizing the home-sharing market without the need to be profitable until 2022.

Investment Summary:

• Seed Funding: Raised $600,000 in 2009 to develop the platform and acquire users.
• Series A: Raised $7.2 million in 2010 to expand the user base and improve the platform.
• Series B to F: Raised over $5 billion across multiple rounds, including $1.5 billion in Series F in 2015.
• IPO: Went public in 2020 with a valuation of $86.5 billion.

Airbnb’s ability to rapidly expand and innovate, coupled with strong market demand, justified continued investment despite periods of unprofitability. As of 2022, Airbnb has reported net profitability, marking a significant milestone in its growth journey.

Takeaway

Now, what does the stories of these startups tells us when we look at digital products and their valuation?

Fundraising for digital products is a complex that hinges on potential, scalability, and market confidence. By understanding the intricacies of investment rounds and the dynamics of investor trust, startups can strategically navigate their growth journeys through investment. Through examples like Spotify, Uber, and Airbnb, it becomes clear that immediate profitability is not always the primary driver of valuation. Instead, the promise of future market dominance and innovative disruption plays a crucial role in attracting investment and boosting company value.

Investors expect their returns from the significant increase in company valuation through successive funding rounds, leading to lucrative exit opportunities such as IPOs or acquisitions. This dynamic allows companies to grow without immediate profits, focusing instead on long-term market positioning and value creation. The stories of these prominent startups highlight several key insights for emerging digital products:

1. Vision and Potential: Investors are drawn to startups with a compelling vision and the potential to disrupt industries. Demonstrating a clear path to market leadership can outweigh current financial performance.
2. Scalability: The ability to scale rapidly is a critical factor. Startups must showcase their capacity to expand their user base and operations efficiently, leveraging technology to drive growth.
3. Market Confidence: Building and maintaining investor confidence is crucial. Transparent communication, consistent performance, and strategic pivots in response to market demands can enhance trust and attract continued investment.
4. Innovative Disruption: Startups that offer innovative solutions and challenge the status quo tend to attract more attention. Emphasizing unique value propositions and staying ahead of technological trends can set a company apart.
5. Strategic Partnerships: Forming alliances with established players in the industry can provide credibility and open new avenues for growth. Partnerships can also facilitate access to new markets and customer segments.
6. Long-Term Vision: Focusing on long-term goals rather than short-term profits allows startups to invest in research, development, and customer acquisition, laying the foundation for sustained growth and valuation appreciation.

By internalizing these principles, emerging startups can better position themselves in the competitive landscape of digital products, generating investor interest and driving their valuation to new heights. 

Want to read the rest of this series to learn how to create a valuable digital product?

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