Good business doesn't mean a fundable business...
I have seen many startups that I have personally found exciting, but have passed those opportunities to invest through my fund. What's the reason- they are not fundable. And why not- because they can't become really large companies in next 5-6 years.
An entrepreneur asked me this:
VCs are happy to put $100-200M in a company to get it to a $1B+ valuation, which is 5-10 times of the money invested. But, they don't put $1-2M, even if it gets a company to real profits and $50M valuation, 25+ times of the money invested and with significant better probability of success.
So, let me share a VC's perspective here
Does it move the needle for a VC?
It is about percentage return from an investment but it's more about absolute return from that investment, which significantly affects your overall fund performance.
"A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets." - Peter Thiel
I'll take the same example. Let's say I am a VC running a $300M fund. I invest $30M in the company I talked about, and I have a 10% equity when the company is valued at $1B. So, I got $100M returns i.e. 3X+ returns, but more importantly, I got $70M of absolute return. Or in other words, If i make 3 such investments, I'll return the fund value ( $100M X3 = $300M)
Now, If I invest $1M in the second option and get 20% equity. In the same duration, it gets to $50M Value and I get $10M. The returns are 10X, but absolute returns are only $9M. In other words, I have to make 30 such investments to return the fund value.
As a fund, I have to invest all my capital and generate returns on it in a given time frame. I also understand that not all of my investments will do well. Hence, it's a question of maximizing the absolute return on my fund though any investment. For a VC, portfolio returns follow power law (Y-axis is returns and X-axis is portfolio companies), which has a long tail and many investments do not return anything at all.
Why not invest in multiple small winners?
"The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined." - Peter Thiel
Now, the possible argument is- that I can invest in many "lower potential" but high % return companies rather than a risky "higher potential" companies for the same expected absolute return. But, here are the reasons why most investment funds won't do that:
Firstly, it's simply difficult to manage a large portfolio. It takes the same amount of work even if it is a smaller investment and most VC funds aren't designed for that. Going back to Power law, VCs are looking for winners for the fund. Also, it's difficult to get such opportunities (lower potential but higher % returns and less risk) consistently. So, doing only few such investments in a fund won't make sense for a VC fund.
Secondly, the true risk of such investments might not be less than higher potential investments. Investors can find few less risky opportunities on ad hoc basis but if they run it as an investment theme to increase the number of such opportunities, the risk wouldn't be less. Venture investment is inherently risky, and you would want to maximize the upside if you are taking the same risk.
"The unspoken truth is that the best way to make money might be to promise everyone help but then actually help the ones who are going to provide the best returns." - Peter Thiel
Finally, the exit can be tricky. Proper exit means real money and that can be offered through IPO, acquisition or secondary sale. A $50M valued company would have fewer options. Also, It might not be really valued at $50M in the absence of high growth. While a profitable smaller company is a good result for an entrepreneur, it might not be good for an investor.
What should an entrepreneur do?
Firstly, building a profitable company with average plus growth is a good result for an entrepreneur. The question is only if venture capital is available for your business. Statistics says that less than 0.1% of startups end up getting venture capital. So, venture funding addresses only minuscule of funding requirements. Venture Capitalists look for specific attributes in the business- it has to be become large and that too in 5-6 years. That's the constraint for any VC. When starting a business, an entrepreneur should know if the business is even fundable. And he can do a quick math:
- Figure out your best case scenario revenue (in 5-6 years) and try to estimate valuation at that time based on industry metrics. e.g., If you are building a SaaS company, you might be valued at 6-10X revenue.
- Understand the exit an investor will get at that time. e.g., they own 20-30% of the company so they will get proportionate value. While this value should generate good multiples for investors, it should also generate significant absolute return to move the needle. For a decent size fund, this value should be definitely more than $100M in optimistic case. Even for smaller funds, this value wouldn't drop dramatically, but may be around $50M or so, if they see a clear exit path.
- If you don't pass the test above, think of your business model and scale again. Also, think of alternate ways to raise money.
What are the alternate options:
- Look for industry focus or special vehicles by different VCs. Some VCs might be focus on that space knowing that not all companies will become unicorns, and would have allocated some capital with that understanding. They can be smaller niche investors or even part of large funds.
- Identify angels, smaller funds and strategic investors. For angels and smaller funds, the needle moves earlier, as long as they can see an exit path. Strategic investors aren't trying to make money by exiting but hoping to add value in their overall business. They also don't have time constraint to exit in 5-6 years.
- ~40% startups receive funding from friends and family. You can also raise this money on favorable terms. You can think of innovative ways to repay them rather than focusing on exit, if you are profitable.
- Finally, debt and related instruments are an option. It's not really simple especially in India, but this option opens up once you are in business for some time.
Capital can help you grow fast and scale big. But if your business isn't that scalable, you can decide not to burn money to grow fast. You can take additional time to reach the stable state and save that capital. Overall, building a decent size revenue company, which is profitable is a great result anyday if you can do that with minimal investment.
Raising capital is not a success, building a sustainable business is!
Founder- PCS Ventures, PROBLEM SOLVER I Fund Raising I M&A I Consulting I Board Advisory I Technology
5 年Very good insight...
Founder & CEO @ Schooglink | IIT Kanpur
5 年Thanks Dinesh for the insights.
Managing risks l Better understood, better protected l Progress happens when you feel secure l Insurance Consultant
5 年True. Also entrepreneurs should stop fooling themselves about the nature of business before fooling the investors. It is a “common practice” that when start ups meet a potential investor and when asked about their excel sheet they prefer dropping that investor!
Analyst ll Growth Strategy || Communication || Relationship Building ||
5 年Interesting to know... V good post