What it takes to be a venture-backed SAAS startup (hint: grow 13% per month for 7 years)
(What follows is a straight-up financial conversation, void of any of the soul and passion that are critical to being successful in any startup endeavor. To be sure, many VCs, including ourselves here at the Govtech Fund, also have deeply held, mission-oriented, decision parameters for their investments. In our case, we only invest in startups focused on innovating government and, for our first fund, US-based companies focused on the US government. We are very much real people who are empathetic to our founders’ challenges since we were founders once too. But math matters, and it’s important to understand the black-and-white of investing to understand some of the VC mindset).
The world of venture investing can often seem opaque from the outside and often entrepreneurs aren’t sure what the financial goal posts are. Most have heard VCs talk about investing in “Billion dollar businesses”, but what does that actually mean? To fully understand how VCs think, it’s important to first understand the basics of how a VC fund works.
VCs need to return a minimum of 4x the amount they’ve raised, which really means 5x.
A VC has raised their first $25M venture fund. Congrats - time to start investing in companies that are going to change the world! But if they want to be a successful VC and be able to raise their next fund, they’ll need to return their investors at least 5x their over the typical 10-year life of the fund. Why?
VC’s like all investment managers compete for their capital. Investing in a venture fund is a highly-risky asset compared to, for example, a government bond. So investors in venture funds look for a return on their investment that is significantly higher. Let’s assume 16% return per year for 10 years is the “risk hurdle” a VC fund investor would be willing to accept (though many VC fund investors would suggest this is still too low).
In order to generate a 16% annual return for their investors, our newly minted $25M fund needs to generate a total of $112.5M in returns over the 10 years, which actually translates to a 19% annual return that the VC needs to generate from funds actually invested. Here’s why:
First, VC’s don’t actually invest the full $25M committed by their investors. VCs generally earn an average 1.5% per year management fee over 10 years + 20% any returns after the first $25M.
The math over 10 years looks like this:
$25M fund raised
- $4M in fees over 10 years
- $1M in expenses (legal, formation, etc) over 10 years
= $20M in investible capital
So, a 19% annualized return on $20M on investable capital over 10 years equals $112.5M in returns, or 16% return on the the total $25M invested in the fund.
(This is all an approximation of course, and these calculations are before the 80/20 profit share, but the message is the same: VC’s don’t actually invest all of the dollars they raise ie. a decent chunk goes to other stuff.)
Great, so now the VC fund has $20M to invest. Let’s just say they make 10 investments of $2M each. Again most VCs might not construct their portfolio this way but, just simple for math. And let’s assume that each investment they own 10% of the Company.
(Btw, most VCs who see this are probably shaking their head right now as they know how difficult it is to consistently achieve such a nice distribution of outcomes. That is, exits are easy to model in a spreadsheet, but the reality of M&A is hard and the reality is that most VCs are increasingly dependent on the one or two really BIG public market outcomes to make their numbers work.)
So why do you care as an entrepreneur? Because your company is evaluated as the Billion dollar outcome in a portfolio of potential Billion dollar outcomes.
That’s right. See that company at the very top of the list in the enclosed Table above- the one in the pole position? Yeah, that’s how VCs are thinking about your company. Will this ultimately be the one? Talk about pressure.
So, what does it take to have a Billion dollar valuation? Valuations for public SAAS companies move around just like any other industry and largely depend on growth rates but for simplicity let’s use a trailing 12-month revenue multiple of 5x. That means in order to be worth $1B, your public company SAAS business needs to have ~$200M in revenues in the prior 12 months.
Since most VC funds have a 10-year life, most VCs are looking for an investment to liquidity timeframe of less, say 7 years.
So, how do you build your SAAS business to ~$200M in trailing 12-month revenue in 7 years? Grow at slightly more than 13% each month for 7 years.
Month 1 MRR: $1000
Monthly Growth Rate: 13%
# Of Months: 84
Month 84 MRR: $25M
Trailing 12-Month Revenue In Year 7: $170M (ok, not exactly $200M, but close enough)
So there you have it, yet another example of the power of compounding. Looks easy right? Wrong. Growing any business double digits every month for any period of time is really frickin’ hard. You’ve got to get your product right, hire the right team, have customers that love you so they don’t churn, fend off competitors, have some semblance of a personal life and lose a lot sleep worrying about all of it.
So, the next time you’re wondering what does it take to be a venture-backed SAAS business? Keep the answer simple: whatever it takes to grow 13% a month for 7 years.