One reason you’re not being funded — VC Math explained
What return potential are VCs looking for when assessing startups and why?
Firstly, let me get the ‘what this post is not’ bit out the way. It’s an example, not a playbook. Also, I’m generalising quite a bit and have deliberately removed some parts of the equation (more on that later). And I will not be covering anything on non-institutional investors (eg business angels and corporate/strategic investors). They usually view this differently based on their structural setup. So first rule — knowing which kind of investor you’re pitching to as an entrepreneur is crucial.
The math is as straightforward as this question: what is a VC looking for in terms of return potential when they assess a startup investment? And the place to start finding the answer is in the background of this kind of investor structure. Institutional investors have raised money from external fund investors (LPs) — meaning we’ve promised to deliver some level of return to these fund investors and that’s why we invest in startups. This also means the number of portfolio companies is important. In order to spread the risk, VCs will usually invest in around 20–30 companies from a single fund in order to get a solid risk/return balance.
In this example, I’ve chosen not to consider management fees, the ownership in the portfolio companies, the number of follow-on rounds that a VC can make into a portfolio company or liquidation preference stacks which are all important parts but would make the example way too complicated in this forum.
So let’s say a VC raises a fund of $100m. Usually they will have told their LPs they can deliver around 20% IRR annually and a fund is usually 10 years. This means in essence that the fund needs to deliver 6.2x return ($100m * 1.2^10 = $619m). However, since IRR is only calculated when the money is actually deployed and that depends on when you invest during the 10 year period and for how long you hold that stake. If we assume 6 years holding period on average — the multiple needs to be 3x instead ($100m * 1.2^6 = $299m). In this example the VC will also invest in a total of 20 companies from the fund.
According to research from the European Commission, 50% of all startups will fail and will therefore, most likely, not yield any return for investors. This is therefore the number I’ll use in this example — a 50% failure rate. That means that $50m of the $100m is lost and the remaining $50m need to not only recoup for the losses but also generate the return VCs have told LPs they will generate. In other words, the remaining $50m will have to generate $300m in returns. Assuming that each the VC invested the same amount of capital into each of every 20 portfolio companies, 10 portfolio companies will have to return $300m with only $5m investment per portfolio company. This leads to a multiple of 6x for these 10 companies.
So VCs job is to pick at least 10 companies that will return, on average, 6x. Not easy. Fred Wilson has, in a known blog post (see link below), stated that at USV they aim for 1/3 of companies returning the invested capital, 1/3 generating the majority of the return and 1/3 failures. I think a lot of VCs are aiming at the same if they’re investing in early stage startups.
There is a higher likelihood that you will invest in one company returning 30x ($150m) and another one returning 10x ($50m) and the remaining 8 companies returning around 2.5x ($100m) than investing in 10 companies all returning around 6x.
What does this lead to? It leads to that institutional investors look for companies that can yield at least 10x return but preferably a lot higher than that — 30x or more. In the example above, say the 30x investment only became a 10x investment, the VC will not reach the return level they’ve said they’ll deliver to LPs (they’ll only reach $200m instead of $300m). They might therefore struggle with raising a new fund.
Obviously, it’s quite hard to assess how big a company can be and the return potential in an early stage. VCs try to assess this by looking at a number of factors. Again, I’d need another post to explain in detail but some of the important bits are; revenue potential, total addressable market (TAM), how fast can it grow (i.e. scalability) and profitability potential. Another important piece is the comparison with similar companies who have been acquired or gone public.
To sum it up, the underlying math could be one reason why a VC decides to pass on investing in your startup. They just don’t see enough upside potential in your startup and the potential of delivering a large part of the return needed in order to be able to raise a new fund. In other words, has the investment in your startup the potential to be the defining investment in a portfolio if a large portion of the other companies fail?
Therefore, if you’re an entrepreneur raising money from VC’s, make sure you know who you’re pitching to and that the VC understands that an investment in your startup can yield the return the VC expects and needs.
Hopefully this can clarify a bit and let me know if you agree or disagree.
Worth mentioning is that a lot of people have written about this topic before and if you want to read more about the topic, I’d suggest reading this one from Fred Wilson (@fredwilson), this one from Seth Levine (@sether) and another good one here from Martin Mignot (@martinmignot).
Published in Startups, Wanderlust, and Life Hacking