FUND SIZE AND RELEVANT MARKET SIZE — Why Fund Size is Critical when Fundraising
Recently Samuel Gil, CFA from JME Venture Capital wrote an interesting article on fund size and how that affects the attractiveness of a startup.
The article uses some common VC assumptions and some basic VC math to show how different revenue scenarios for exists are correlated to the size of the fund.
I want to take this one step further, with a simple example, to explain how this relates to startups, and a common mistake that founders make when attempting to fundraise.
But first, let’s review the assumptions that Sam makes:
— 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 structure, 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)
So, according to Samuel, a $50M fund would function something like this, where the “meaningful exit” is the number to solve for:
Assuming (like Sam), that the VC share is 20%, then the actual expected returns for the “Meaningful exists” and the “Home Runs” looks something like this:
In other words, a $50M VC fund will be really interested in a startup if they see a $82.5M light at the end of the tunnel.
Looking at this over a number of find sizes:
The bottom line is: The bigger the fund, the bigger the exit required to be considered meaningful.
So now let’s take a real world example from a former client and make this practical.
Imagine a smartphone platform for ticket sales to events over Twitter, utilizing those with a lot of followers to push ticket sales and getting a cut in the middle. For example, if I have 1000 Twitter followers and I tell my followers that I’m going to the nearby Run the Jewels concert, some small portion of my followers may also want to go. They could buy a concert ticket through the platform, increasing ticket sales for the venue. In that case, the platform (the startup) gets a small commission, and I, as the originator of additional ticket sales, get a small commission as well. Everybody wins.
This is a clear mass-market play.
The founders pitched to investors that events in the US represent a $25B market. Let’s say they can capture 5% of all of that over 7 years, or $1.25B GMV. At a 20% share, the VC is looking at $250M, which, for a marketplace platform, would signify a “meaningful exit” for a $200M fund.
BUT!
All too frequently founders misjudge the relevant market.
Of the $25B market for events, 60% of it comes from food and merch. In addition, of all the concerts and events out there, the company is targeting a select demographic group that is only interested in about 50% of all the possible events out there.
So real relevant market is: $5B! And capturing 5% of that is equal to $250M, which is equal to a VC share of $50M, which isn’t meaningful even for a $50M fund!
So what to do?
1. Founders give up more equity.
In the scenario above, the company can reach “meaningful” status for a $50M fund by giving the VC a 35% share.
2. Go to a smaller fund.
A $50M exit, at a 20% share, is meaningful for a $30M fund, for example (but be prepared for a smaller investment).
3. Get the business right and increase the potential size of the relevant market, or find some way to capture more of it.
This is the hardest part and involves actual business strategy, long term planning, a clear and coherent go-to-market strategy, and growth strategy. (All the things that we can help you with)
So what’s the point?
As I said before, TAM, SAM, and SOM are not good enough, and should not be relied upon.
Founders need to be honest with themselves about their relevant market, and approach funds that have a commensurate size.
It is PERFECTLY FINE to have an amazing idea for a smaller, niche market. But don’t be surprised if bigger funds turn you down. So be proactive and save yourself time/effort by approaching appropriately sized funds.
