Meaningful VC Exits
Can your startup generate venture-scale returns?
The purpose of this post is, with the help of some venture math and a bunch of frequently made assumptions, to derive the size in term of revenues that a company has to achieve in a 5–7 years time window to be regarded as attractive for VC investment. We will do that for different fund sizes (micro $50mm-$100mm, traditional $350mm and mega $1b VC funds) and different startup business models (SaaS, marketplaces, e-commerce). This might also be helpful for the company and its investors to plan revenue targets and required growth rates for the years ahead, from first investment to exit.
Defining a Meaningful Exit
Let’s start with some venture math assumptions:
- An early-stage venture fund is going to invest in 20 companies
- The fund aims to get a 3x gross return (which, with the usual 2–20 fee estructure, translates into something close to a 2x net return and a 15%-25% IRR depending on the actual timing of the cash flows)
- The expected distribution of outcomes is: 1/3 losses (7 companies with 0x returns), 1/3 money-back (7 companies with 1x returns), 1/3 successes (6 companies with substantial returns)
- The expected distribution of the successful outcomes is: 1 home-run (a company returning the entire fund) + 5 meaningful exits (5 companies returning the amount required up to a 3x gross fund return)
Considering all the above, we are in the position to mathematically define a meaningful exit: a company able to return (3–1–1/3)/5 = (5/3)/5 = 1/3 of the fund.
Don’t get lost in the math: From our 3x target gross return I have subtracted 1x (the expected return of the home-run) and 1/3 (the expected return of the money-back companies) and then I have divided the result by 5 (the expected number of meaningful exits).
Determining the Size of a Meaningful Exit
Once that we know what a meaningful exit is, let’s introduce one more assumption: that the VC is going to construct a 20% ownership in a successful company over time, which, by the way, is not easy at all.
With that in mind, we are now equipped to tell for how much a company must be sold in order to be considered a meaningful exit, for different fund sizes:
For example, for a $50mm micro VC fund like ours, a company must generate at least $17mm in returns to be considered meaningful, which with a 20% ownership position for the VC at the time of the exit, means that the company has to be sold for at least $83mm. For the same $50mm micro VC fund, the thing gets a bit more complicated to achieve a home-run return: the company has to sell for at least $250mm.
Here you can also see the importance of ownership targets: if the VC had only 10% of the company instead of 20%, the company had to sell for $167mm instead of $83 just to be meaningful or for $500mm to be a home-run.
I hope that at this point it is also clear that, the bigger the fund, the bigger the exit required to be considered meaningful. Remember that when assessing the right investor for you and your company.
The bigger the fund, the bigger the exit required to be considered meaningful.
If you are following the reasoning through here, you might think that a way to reduce the size of a meaningful exit for a VC would be to increase the portfolio size. And you would be right: if instead of investing in 20 companies the VC invested in 30 (assuming the same outcome distribution), a meaningful exit would be (3–1–1/3)/9=(5/3)/9=0.19x the fund size. The problem with that is that the portfolio size is constrained, not only by the number of attractive investment opportunities the VC is able to find during the investment period of the fund, but also by the number of companies the VC firm is able to properly monitor/add value to (for instance by sitting on the board of directors).
Also, I think it is worth noting that there are two schools of thought regarding the best strategy for selecting VC investments (and both of them have been proven successful): some VCs will only aim at potential home-runs, knowing that some of those investments will most likely end up being “just” meaningful exits, and some VCs will mainly aim at potential meaningful exits, expecting that 1 or 2 of those investments will end up being home-runs. We are in the second camp.
Determining the Revenue Targets for Meaningful Exits
Before we can determine the revenue targets, again, we need some more assumptions:
- A SaaS company with 75% gross margin can be sold for 5x ARR
- A marketplace company with 15% take rate can be sold for 1x the last twelve months (LTM) gross merchandise value (GMV)
- An e-commerce company with 30% gross margin can be sold for 2x the LTM revenues
- In all cases, Net Debt (debt minus cash) at the time of exit equals zero, so Enterprise Value (EV) = Equity Value
- In all cases, the same growth rate is assumed
(Note: I hope you see the correspondence between the revenue multiples and gross margins above)
Now that we know the size of the exits we need for different fund sizes (e.g. $83mm for the $50mm micro VC fund) and the expected revenue multiples for different business models (e.g. 5x ARR for SaaS), we can determine the revenue targets for the different combinations of them:
This means that for a $50mm micro VC fund, a SaaS company has to be able to generate $17mm in ARR in 5–7 years; or $83mm in GMV if it is a marketplace; or $42mm in revenues if it is an e-commerce business.
Can I grow fast enough?
The next question is: “Given my current ARR/GMV/revenues, can I/how do I grow fast enough to become a meaningful exit, or even better, a home-run for the venture fund I am speaking to?”
As an example, let’s continue with the the micro VC $50mm fund and the SaaS company. Now consider that some of the best SaaS companies have followed the following revenue trajectory: T2D3 (triple, triple, double, double, double). It might also be useful to remember that to triple the ARR is equivalent to growing at a monthly compound rate of 10% and that to double it is equivalent to growing at a monthly compound rate of 6%.
(No need to mention that if you present a business plan in which you need to grow faster than that in order to become a meaningful exit/home-run you won’t get much credibility from the investor).
This means that, if your current ARR is $200k ($17k MRR) and you follow that revenue trajectory, you might become a successful exit for the VC. If your current ARR is $700k ($58k MRR) and you follow that revenue trajectory, you might become a home-run. I don’t think it is wise to assume that every company will follow that growth path, so adjust accordingly (e.g. decrease the growth rates and increase the starting required ARR).
Once you have your revenue target, budget the corresponding sales & marketing costs plus any other expenses required to achieve that goal and assess if the overall picture is achievable. Remember that everything seems possible (and even easy) in a spreadsheet but unfortunately it is not so in reality.
- Not every company can grow quickly enough to generate venture-scale returns. There is absolutely nothing wrong with it. But a VC should only invest in the companies with that potential.
- The fund size (and the venture math assumptions used) determines what a meaningful exit is.
- Some investors aim only at potential home-run exits. Others don’t. Both strategies have been proven successful over time.
- Your business model determines mainly your gross margin. Your gross margin and your growth rate are some of the most important factors to determine the multiple you get in an exit. Use that multiple to find your revenue target.
- Work backwards to find out the growth rates required to hit that target given your current level. Compare those rates to those of the most successful companies to have a feeling of its feasibility.
- There are many possible values for the assumptions used — although I think the ones presented here are reasonable. Adjust them to your liking and do your own math!
JME Venture Capital is an early-stage tech VC firm based in Madrid investing in the best Spanish founders everywhere. JME VC manages two venture funds with €60mm in assets under management. So far, JME VC has invested in 19 companies across two funds, including Flywire (formerly peerTranfer), WorldSensing, Redbooth (formerly Teambox), Jobandtalent, Minube, OnyxSolar and Playspace.