How VCs look at business ideas?
It is not a secret that VCs receive hundreds of pitch decks each month. They have to wade through and dig into huge amounts of data to find the next unicorn. But what exactly are investors looking for? Is there any scheme of analyzing a startup?
Good news: yes there is!
That’s exactly what we lectured on at the recent event organized by Inovo for Founder Wannabes. The main goal of the event was to connect people with different backgrounds, who are looking for a co-founder and by the way show them the investor’s point of view on a business idea.
If you would like to join the next event in Poland, register here.
VCs look for 100X returns [“Fundmakers”]
To understand the investor’s approach to a startup, we should first understand the math behind running a VC fund.
Let’s assume that the fund invested in 15 companies. At the end of the day:
- About 10 of them will go bankrupt
- 3–4 startups will make 1x or 5x return on investment
- Only 1–2 portfolio companies will generate 100x returns and pay off the entire fund
This it the famous “Power Law” , and this is why early-stage VCs are not interested in startups promising: “only 3x return on investment but almost guaranteed”. Each of the investments VCs do, should have the “Fundmaker” potential.
What happens if a VC doesn’t find this 100x return portfolio company? They will most probably go out of business and won’t be able to raise the next fund.
VCs are searching for Fundmakers, and this usually means “at least Unicorns”
This is obviously a rule of thumb but is based on simple math.
As a Founder, you can guess what are expectations of VCs regarding required market size by knowing their fund size and their targeted ownership in portfolio companies.
- Let’s assume that the size of a VC fund is $50M
- Fundmaker for such a fund would mean selling their shares in a portfolio company for at least $50M
- The money they get at the exit can be calculated as:
value of the company at the exit times VC’s stake at the exit - If the VC gets 10% ownership at the moment of initial investment, their ownership will usually be diluted by followon rounds, so let’s assume ~5% at the exit
- Now you see that the required valuation of a startup at the exit is $1B. 5% of the unicorn gives the VC a “Fundmaker”.
Unicorns usually require $100M+ revenues
Actually we can do even more math [and assumptions] to get more insights how VCs look at your startup.
If you have a finance background, you are aware of how most of the valuations are done: usually using some “multiple valuation method”. It works like this:
- We look at some metric of a company, eg Revenues, EBITDA, Net Profit
- Then we look at a bunch of comparable companies with known valuations [eg listed on a stock exchange]
- Then we try to figure out the fair relation of the chosen metric to the valuation. As a result we get some average number “multiple” that we can apply to our startup’s metric.
Let’s say that we will use “Revenue multiple”
- Depending on your industry, margins, growth, geography, market conditions might vary from… 0x to 100x [check this out: 100x revenue club].
- Ok but for the sake of this post let’s assume 10x revenue multiple.
- This means that your company needs to generate at least $100M in annual sales
$100M+ revenues usually requires $1B+ market
Here goes the next assumption!
The revenues of a company are a function of the market size and market share. It’s near to impossible to own 100% market share. There are some industries in which “the winner takes it all”. Marketplaces are good example of this kind of startups but even Airbnb, one of the biggest winners, has “only” 20% of the vacation rental market share. Obviosly this market share also depends on how narrow or broad the definition of your market is.
- Let’s assume that as a top startup in your category you will get 10% market share
- This means that the minimum market size you target should be $1B
1% of a huge number from an industry report means nothing
The next question that naturally comes to mind is how to calculate a market size? And this is the problem faced by many founders.
What we see quite often in startup decks is:
- Founders look at the industry report from a famous consulting company
- They search for the biggest number in it
- And then they explain what would it mean to get 1% of this number
This method provides almost 0 insights. We have no idea whether such a founder understands the market, because understanding of the market is actualy about understanding your customers and their problem.
Talk to the users and understand them
At the end of the day one of the best way to impress VCs is to show how well you understand your users. Paul Graham has shared in one of his essays that the best advice for getting into Ycombinator is explaining what you’ve learned from users.
Understanding of the users will also make your market estimation more convincing for the VCs. Let’s do a market sizing for one of our portfolio companies. Jutro Medical runs primary healthcare clinics in Poland that provide superb patients’ experience. Most of the problems is solved quickly and online.
How would you estimate their market size? You can stop here and do your own calculations before reading further.
From our perspective, everything starts with understanding of who patients of Jutro Medical are.
They are people living in some distance of physical clinics, because from the time to time they will need in person visit. The next question is what is a rational assumption on the coverage that Jutro Medical might build in the coming few years. We believe that it’s feasible to open clinics in the biggest 20–30 Polish cities, and it potentially means market of ~8.5M patients.
The next question is how much the users are willing to pay for solving their problem.
In the case of primary healthcare in Poland the user and the payer are separate entities. Primary healthcare in our contry is financed by National Health Fund, and the medical doctors get ~$5/mth per each patient assigned to a given doctor. The payment doesn’t depend on the usage — it’s ~$5/mth no mater how many times a month you actually see the doctor [the number is just adjusted for age etc.].
From the math above we get $500M market size for Jutro Medical in Poland. This is less than we mentioned before, so why we invested?
There are many feasible ways in which this market size can be expanded:
- Jutro Medical can enter 1–2 more countries
- The company might expand their offering and add eg. speciality care on top of primary healthcare
The market size is not the only factor that we as VCs consider when investing. The team behind the company is equally important and Adam Janczewski is definitely one of the most impressive founders we’ve met in the recent years. How we look at startup teams is a topic for the next post!
Do you want to start a tech startup in Poland but you are missing ideas, validation, or co-founders? Apply to our community here and meet other ambitious individuals during face to face meetings in Warsaw!
Inovo Venture Partners backs early-stage, post-traction startups that can grow 100x. We partner up with ambitious founders like Stefan from Booksy, Maja from Zowie, or Marcin from Spacelift. We invest between €0.5–4m in startups from Poland and CEE region.
