Venture Capital is not the only or best financing option for most companies
But it is perfect for a select few. Think Intel, Facebook, VMWare. If you must fundraise to keep the lights on and/or to fuel growth, then it’s best you understand the return profile of the investors you are soliciting. For the majority of companies starting out, taking VC money is a mistake. Let’s do a quick dive into Venture Capital, the business.
Venture Capital Funds are made of General Partners (GPs) and Limited Partners (LPs). The former run the firm on a day-to-day basis and thus are active investors. LPs are the institutions and sometimes individuals that provide capital for GPs to deploy as investments and are thus passive investors in the fund. For the interested, LPs are typically endowments, public pensions, sovereign wealth funds and other institutional asset managers.
VC Math
LPs in early stage (think series A and B) Venture Capital Funds, look for a 2.5x net return over 10 years. VCs generally deploy the capital raised over 3–4 years and manage those assets for 10 years.
Say you’ve a $200MM fund (not uncommon for an early stage venture firm). You’ll need $4.2B in enterprise value at time of exit to generate a 2.5x net return. See Fred’s post here for how the math works. This return must come from the 20 or so investments you’ll make per fund.
The odds of investing in one $1B+ is rare each year (and I mean 0.14% rare). To generate $4.2B, you’ll need at least one or two $B exits, keeping in mind that great funds lose their entire investment 40% of the time. Not so great funds lose their entire investment up to a staggering 80% of the time.
Market Size
In my experience, the #1 reason entrepreneurs are not able to raise venture capital is because a VC (in/correctly) does not deem the market large enough to someday realize their desired outcome. A VC’s goal is to have the company she invested in IPO. Very few M&A deals yield the sort of outcomes VCs would consider meaningful.
The thing is, we don’t all need/want to be building the next Google or Amazon. Building a 10, 20, 30, 50 or even 100 million dollar net revenue business is a massive undertaking and achievement. All the while, many series A/B VCs will likely pass on these businesses due to size.
Yogi Berra once said, “it’s tough to make predictions, especially about the future.” He isn’t wrong. Assessing the market size of a business 10 years or more down the road is preposterously difficult or impossible because we are far too often fooled by randomness. And even with my incomprehensible love for spreadsheets, Bryce is right in that you can never size a market in excel.
So if not VC, then what?
Building a business is really (really really) hard and often takes (a lot of) time. There are many different ways of funding your business and VC is just one. Past savings, borrowing from aunt Malika or uncle Olivier, Angels and Jersey gangsters are all options to help get your business off the ground.
An alternative and nowadays seemingly less popular path is what Gary Vaynerchuk suggests. Once you’ve proven viability of your business but haven’t reached profitability yet, Indie.vc might be a good fit for you.
There are various financing options available at different stages of a company’s life cycle and I plan to share more on the topic in the future. For now, I hope this helps better align early stage entrepreneurs and investors.
Stay hustlin’ my friends.
