Why VCs require Hypergrowth

Since it was first used in the April 2008 issue of the Harvard Business Review, the term “hypergrowth” has come to represent an important part of the VC investment process. Defined as “the steep part of the S-curve that most young markets and industries experience at some point” it is essentially the point “where the winners get separated from the losers.”

The S-Curve shows the growth trajectory of a startup, and gives investors a way to understand the potential a startup may have. In the figure below, the x-axis represents time, while the y-axis typically represents either revenue growth or market share. Most startups that are ultimately successful experience growth along this type of an S-curve. Often times, you’ll hear that VCs do not invest in “lifestyle” business, where the product or service is a good idea, and the company may eventually make substantial revenue, but the VC is concerned the company might not get big enough to generate enough return. Put another way, these “lifestyle” businesses typically don’t experience hypergrowth.

To understand why most VCs require hypergrowth in order to invest, we need to take a closer look at VC portfolio theory. For starters, VCs typically have a set fund size. A small fund may be $50M, a medium size fund may be a couple hundred million, and a large fund can be well over $1B. The VC deploys this fund into a set of startups (the portfolio). The VC generates return on the investment at exit, when the startup is acquired or IPOs.

For a VC to actually profit on an investment, there must be a clear exit strategy. And it’s extremely tough for a startup to get to an exit. Let’s look at the VC funnel:

Put simply, the failure rate of startups is incredibly high. Out of 1000 hypothetical startups that raise a round Pre-Series A, only 40 of them will actually make it to a Series A. Out of those 40, only 10 will make it to Series D. Out of those 10 that get to Series D, only a fraction will get to an exit.

VCs are aware of the high failure rate, and on the low end will budget for half of their investments downright failing and producing no return at all. CBInsights data shows that only 5 out of 1098 startups catalogued exited at unicorn status. That’s 0.45%.

However, on the other end of the spectrum, a single successful company can provide massive returns. For example, Accel Partners led the Series A round in Facebook at a pre-money valuation of $85M. Facebook IPO’d at $65B. According to WSJ, Accel’s stake was worth $9B. That’s a 105x return on invested capital. Considering Accel’s fund size was $440M, they were able to return 20x the fund in a single investment. For reference the average return multiple for a fund that size is about 1.8x.

VC returns are not normally distributed, and rather follow the power law. For example, in a portfolio of n companies that highest performing company (company 1) will generate the same return as the rest of the companies (company 2 through company n). Company 2 will generate the same return as company 3 through company n. Company 3 will generate the same return as company 4 through n, and so on.

This is where the idea of hypergrowth comes in. Because of the high failure rate of startups, VCs need their winners to not only make up for multiple losers, but also provide adequate returns themselves. In other words, they need to hit home runs, not singles or doubles. The best way to predict a home run is to look for a company that is likely to experience hypergrowth.

So what does this mean for the founder? It’s important to realize the growth trajectory that VCs are looking for. By taking VC money, you should be aware that the VC:

• Wants you to aggressively pursue and prioritize growth
• Wants you to exit at some point (acquisition or IPO)
• Wants you to exit at the right time — they need their winners to win. That means exiting for at least a 5x return and ideally higher than 10x.

What should you do if your vision for the company does not align with the VC funding model? Don’t worry, there are a couple alternative funding options:

Revenue: If you are able to generate steady revenues to get to cash-flow positive, then following a slower, steadier growth trajectory through efficient, existing operations may be beneficial. Plenty of successful companies have followed this path without ever raising VC money: MailChimp, Shopify, Shutterstock, Spanx, Craigslist, Github. Other companies took this route and raised VC funding later on in their lifecycles. For example, Wayfair was profitable from its first month of operations and raised its Series A when it was 10 years old.

Venture Debt: Venture debt is a form of debt financing for venture equity-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. Venture debt can reduce dilution, extend a company’s runway, or accelerate growth with limited cost to a business. This pathway is better suited to companies who are generating revenue and where the debt payments will not amount to a significant portion of operating expenses (~20%).

Revenue Sharing: This is the most feasible way for a pre-revenue company to get non-dilutive funding from a VC. In it’s most basic form, revenue sharing is essentially venture debt with a couple differences. One being that the repayment schedule is flexible and typically will start a few years after the funding is given. This allows a pre-revenue company ample time to start generating revenue. The second major difference, is that the repayment amounts are not fixed, but rather a percentage of revenue in that period. This is huge — if the company has a down month, the payment is lowered down as well to not place unnecessary burden on the company. This model also guarantees return for the VC. Typically, the revenue share will continue until the VC has gotten 2–3x its money back. While this return is lower than what VCs typically shoot for, it is still attractive given that it is much lower risk as it does not require the company to achieve hypergrowth and an exit.

I’d like to see more VCs experiment with revenue sharing models as it opens up the potential universe of companies that can receive VC funding. If more companies are able to get funding, more problems are able to be solved. Check out a simple revenue-sharing template put together by Exponential Creativity here.