Those Who Don’t Understand Venture Math are Doomed to Not Getting Investment
You have a great product that customers are clamoring for. The business plan looks fantastic. Now you just need funding to get the product to market.
You begin pitching to angels and VCs but aren’t getting any bites. Why isn’t anyone interested?
It’s all about venture math.
The business plan shows you reaching $20M in revenues in 7 years. You want to raise $2M now on a $10M valuation.
The business will generate $5M a year in profits, you predict. Isn’t this a fantastic opportunity?
Well…no.
If the startup does generate $5M in profits annually, regular accounting math says it’s a great business for the founders. But venture math shows why it’s a poor opportunity for venture investors.
*Venture Math Assumptions*
When investors look at your deck, they’re not looking for a good, profitable business. They’re looking for that needle in the haystack that will be the one investment in their portfolio that will return 100x or more and make their fund a success.
Venture investors (VCs and angels) invest in startups based on the following fundamental assumptions.
– Investments can’t be monetized until the startup exits
Unlike investments in public companies, real estate, crypto, artwork, race horses, or just about anything else, investments in startups can’t be sold or traded until either (1) the startup is acquired, or (2) the startup completes an IPO making the stock publicly tradable. Until that exit, which won’t come for many years, my investment is nothing but a line on your cap table.
– Venture funds have a 10 year lifetime
Money is collected at the beginning of the fund, investments are made over the first 3 years, and at the end of 10 years, the fund is shut down. Startups therefore need to be able to exit within 5–7 years of investment. Angels have more flexibility, but we’d like to see a cash return on our investment sometime before we die.
– 90% of seed stage investments fail
Out of every 10 startup investments, 9 will fail. Typically, 5 will fail completely, 2 give a partial return, and 2 return our initial investment. To make up for those 9 failures, the 1 investment that does succeed has to succeed spectacularly.
– High risk requires high return
If I can get an 11.6% average annual return from S&P index funds and cash in that investment whenever I want, why should I invest in startups and lock up my retirement savings for a decade? Basic logic says I need to expect a higher return.
– A successful fund has to beat its peers
The people who put millions into venture funds have thousands of funds to choose from. They’ll pick a fund from a venture firm with a history of the highest returns. It’s not enough to beat the S&P index, they have to beat their peers. There’s some debate about what that takes, but we’ll assume a return of at least 20% per year is needed to be considered a top fund.
– Acquisitions don’t happen under $50M ARR
Coca Cola doesn’t buy a new drinks company because they have a soda that tastes good; they buy it because the company has built a hot brand they have to get their hands on. Oracle doesn’t buy up a SaaS platform because it solves an industry problem; they buy it because customers are demanding it or switching. With some notable exceptions, high value acquisitions don’t happen until the startup has reached at least $50M in revenues. The bar for an IPO is far higher.
– Exit Multiples
Industry giants in hot industries desperate to get their hands on a quickly growing startup threatening to make them irrelevant will pay 5–10x a startup’s revenues for a strategic acquisition, even more if they get into a bidding war with their equally desperate competitors. Big companies simply adding complementary product lines and private equity firms extracting profits will typically pay 4x EBITDA, a much lower value exit.
*The Venture Math*
Based on those assumptions, we can calculate venture requirements.
– Simple return:
To generate a return of 20% per year over 7 years requires an exit at a multiple of 3.6x what was originally paid. If the valuation was $10M when I invested, I need an exit at $36M to be a good investment. That wouldn’t be too bad, but…
– Portfolio return:
If only 1 of my 10 investments succeed, for a portfolio return of 20%, I need my 1 success to return 36x what I paid. If the valuation was $10m when I made the investment, I need my one success to exit at $360M or more. Within 7 years. Gulp.
– Dilution:
If the startup needs additional rounds of funding, and almost all startups will, each round will dilute my ownership percentage, requiring a higher exit price to meet my 20% IRR requirement. If you need to raise 2 more rounds that between investment and an expanded options pool, dilute me by 1/3 each time, my investment as a percentage of the total company valuation is 45% of what I started with. I’d need an exit that’s 80x what I paid.
– Exit:
With a profits-based exit of only 4x EBITDA, there is no way to get to the required return. Exits to private equity or based on company profits aren’t quite failures, but aren’t successes either. If the exit takes longer than 7 years, or requires more that 2 additional rounds of investment, that 80x multiple goes up even further.
*Math Implications*
When VCs look at a seed-stage pitch, it starts with a glance at the numbers.
- Can the company reach $50M in revenues within 7 years, and ideally $100M within 5 years?
- Are there big acquisitions at high multiples in this sector? If the startup is in AI, MedTech, or SaaS, that’s not a problem, but other categories can be difficult to see a big acquisition at 80x the current valuation.
- How much additional investment will be required and how much dilution will that create?
– The Example
Let’s go back and examine the example pitch again:
You expect to reach $20M in revenues in 7 years and generate $5m in profits. You want to raise $2M on a $10M valuation. What’s wrong?
To start with, $20M is too small a business (unless you can prove otherwise) to generate a big acquisition. Without the possibility of a big acquisition, this isn’t a venture fundable-deal.
At a $10M valuation now, the exit will have to be at $800M. Is that feasible? Not likely unless you’re generating $100M in revenues and are in a hot industry where the giants will pay 8x revenues to get their hands on a new technology.
That $5M in profits per year? Irrelevant. Venture investors want you investing every penny in growth to get to $100M in 5 years instead of paying out dividends.
*Solution to the Venture Math Problem*
If you want to build a successful, profitable business, you can have a very comfortable life on $5M in profits every year. But you’ll have to find another way to fund it, because that doesn’t fit the VC model.
Of the thousands of startups that apply for funding each year, only a few get investment. That’s because for most startups, the venture math doesn’t add up. They’re great small businesses, but not venture rocket ships.
As founders, you have 2 choices. You can either accept that your startup doesn’t fit the venture capital business model and find another way to fund the business.
Or you can rework the pitch deck to highlight how you’ll reach $100M in revenue in 5 years, and have a line of big companies desperate to acquire the business at a high multiple.
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