Are you special enough to get funded?

If you read the tech press regularly, you would be forgiven for thinking that it’s easy to raise capital these days. Every day is filled with new funding announcements. Rounds are getting bigger and happening faster.

However, the sad fact is that most companies that look to raise capital will not be able to. Why? Because they are just not special enough. Let’s unpack this sad truth.

First, let’s divide investors into two camps, early stage (VC) and late stage (growth/ private equity).

Early Stage Venture

Early stage investors are looking for outliers. Those rare companies that could make a fund. It is accepted wisdom that for every 10 investments a venture fund makes, only 1 or 2 will deliver significant returns. Several others will create nominal returns or just return capital. The balance will be complete write offs, worth nothing.

What this means is that when a VC is looking at your business, she is not just trying to assess whether you will be successful, but whether you have the potential to be so wildly successful that your outcome can pay for all the investments that fail.

Let’s do some math. A $300M early stage fund invests in your company. To hit their target returns to their LPs, they want to turn that $300M into $900M over the life of the fund.

Now, let’s say they invest in your company. They own 20% of it when you sell for $100M (BTW, $100M is a pretty rare outcome. Most exits are well below this level).

You’re feeling pretty good about achieving a rare exit. For the fund this outcome gets them 2.2% towards their planned target value. i.e. this exit totally doesn’t matter to them.

The sad fact is that the $600M in gains that this (small) fund needs to achieve will come from a handful of companies. Let’s say five (though in reality it may be fewer). Sticking with that 20% ownership target, those five exits need to be for a cumulative exit value of $3B. So, basically each and every investment opportunity will be judged through the lens of whether it could achieve a $600M outcome.

Let’s put this $600M outcome bar in perspective: Since Jan. 1, 2016 (i.e. almost 3 years ago), 18 SaaS companies in the US sold for more than $600M. That is a very small subset of the SaaS exits that have happened in that time.

Will you be one of the 6 SaaS companies per year that sell for this amount? That’s the bar against which you will be judged by VCs. Maybe not in the beginning (after all, what data could that be based on). But definitely over time. That’s why the VC funnel is so steep. Less than 1/2 of seed funded companies raise an A. Half of those raise a B and so on…

Source: https://www.cbinsights.com/research/venture-capital-funnel-2/

Late Stage Funding

Now that you’re totally depressed, let’s move on to the late stage segment.

The late stage game is very different. For one thing, late stage investors expect to make a return on almost every investment they make. This is a good thing for founders. It means you have a high degree of alignment with your backers and a high probability of everyone making money.

However, as you would expect not every company is capable of generating a return. Late stage investors need to cast a very wide net, looking at as many companies as possible to find their investments.

Insight Venture Partners offers a great case study. They have an army of analysts who are outbound. These analysts touch 30,000 companies per year. In 2017, Insight made 58 investments, including existing portfolio companies. Basically, they fund 0.2% of the companies they touch in a given year.

Why is this?

For one, they want to make money on every deal. This means finding totally de-risked companies. Companies that have a great team in place, pursuing a massive market opportunity, with the right product and with the customer acquisition, expansion and retention recipes already nailed. A sausage machine. Totally repeatable.

Also, because they pay a lot to get into these great companies, they need to back category leaders. In B2C and enterprise especially, being the market leader matters. Most of the value in a category will goto the leader of that category. Knowing this, growth investors will talk to every company in a category then try and get it into the one that they believe will be the leader. They have no interest in funding the also rans.

Early stage VCs typically own small stakes (20% and below). They do this because they invest at the earliest and riskiest stage. So, they need to spread their risk across many bets.

The big outcomes are rare (remember there are basically 6 SaaS exits per year north of $600M). To achieve their target returns, late stage investors need to own a lot. 20% of $600M isn’t that much for a giant PE fund. As a result, these funds are often looking to take a majority (> 50%) stake. This often has them gravitating towards capital efficient, largely founder-owned companies that have hit scale. These are few and far between. Generally speaking, companies raise significant capital before getting the level of scale and repeatability that growth investors need.

I hope this gives you a better picture of why you need to be truly special (at every stage) in order to get funded. The bar is high.