It’s been less than a quarter that I switched from the buyside to the potential sell-side, or the “Other side of the table”. And you immediately start to realize something: Most VCs don’t get VC.
I will give you an example. Let’s look at X Co. Potential market size in the next 20 years around 1 billion in revenues – looking at the category. Place for around 2-3 companies based on industry dynamics and where the category sits in the global supply chain. Luckily, not a winner takes all market. More likely 15 relevant and good companies start entering, 5 go bust or are bought by the new players. 7 get bought by large enterprises. Established enterprises take 15% of the market share to diversify their business but don’t get the market as a core segment. 85% for 3 players.
Assuming okayish CAGR for the next 15 years (industry life cycle of the category) and some consolidation happening after. Conservative 7x Revenue multiple, there is a value of approx. 6 billion dollar in market cap. So who will take this category/market?
I don’t have to tell you if I give you t his:
Company A raises 5 – 40 – 100 – 300 – 400 – 500 from Seed to IPO
Company B raises 1 – 6 – 10 – 80 – 120 – 250 – 300 to IPO
Company C raises 2 – 8 – 12 – 40 – 80 – 100 – 250 to IPO
So we look at A, B, C revenue market shares of 50%, 24%, 16% and revenue multiples of 12, 7, 5, giving them 6, 2 and 1 bn approximately in market capitalization.
Now the Seed investors even if diluted to equal 10% of their initial 10% stake, get 12, 16, 4 times money on their initial investment. IRR wise, looking at the many rounds that C raised, number 4 was below industry average. company A seed investor made a bet, went out okayish on IRR and helped the company get a substantial market share. Company B did it best, got the highest multiple, waited maybe one more year to IPO and get a decent IRR for it.
Now here comes the gist of it all. The above numbers don’t make any sense. Given the above funding, company A is going to have 60% market share. Company B is going to end up with 17% and company C is getting 8%. Yes, probably company C doesn’t even IPO. ANd even if everything goes well, C has a multiple of almost 1, B is at 10x and A is at 18x. If you assume dilution to 15%, they have a multiple of 27x.
So all funds invested had the same assets under management – 100m – and wasted 5%, 1% and 2% of their fund into the investment. If they made a 1x on every other investment, fund 1 made 1.2x money, fund 2 made 1.09x money, fund 3 made 0.9x money.
Now apply this logic on all investments and you can see that there is one thing driving the fund performance. Allocating the higher tickets to the winning guys. All believed in their investment and let’s say all investments were equals in the beginning. That is a reasonable assumption, because no 3 – 10 guys in a company will make much of a difference with what they already have. It is all about two things:
- Who gets more money
- And who is seasoned and smart enough to use this money to win the market
Blowing 10 – 40 million at some lamers in a Seed round sure is a bad thing to consider. But blowing a mere 1 million at a winning team with a winning product in a winning market is a death sentence to that company and the investment you make as a fund.
So the ultimate answer here for the fund manager is:
- Forget your risk profile. the risk of ruining your fund and losing your LP relations. If you are not ready to select winning teams with winning technologies in a hyper growth market, not ready to put the capital it takes to get a huge market, then you are just not suited for the risk/venture capital business. Go back to dry cleaning. And maybe re-think why you entered the game in the first place. You don’t have to be a venture capital investors. I say this clearly, because I have seen first fund and second fund behaviour, and there is a clear pattern for new fund managers in this industry to completely ignore the rules of the g ame, because you want to establish yourself with a solid risk reward pattern. That is the way a pension fund wants to look at you maybe. But not the way an activist investor, wealthy individual, or government entity fueling the growth engine wants to look at you.0
For the entrepreneur:
- If you are a winning team, with a winning product, with a market that you believe to lift off, you sure as hell get all the help you need to nail your first valuation. And if that doesn’t work out, get that valuation corrected by the second time you raise money.
- Whenever an investor says your traction and performance isn’t on par with the valuation you demand, leave that room immediately and never talk to that investor again. There are only a few reasons that warrant an investor to not give you a good valuation. Either he doesn’t get the game, or his boss doesn’t get the game. Or his LPs don’t get the game. Or they don’t understand and believe your market.
- Understand valuation as a shit test. If the entire discussion rests on your performance, the investor isn’t really honest an open. Nail him down on why you believe he doesn’t trust you to take more money for a similar share. Either he tells you your team is bananaes. Or he doesn’t believe in the market. Or he sees difficulties he does not know how to support you with. If his answer isn’t actively focused on what your challenges are and why he sees a real risk in allocating so much money into you despite believing your market story, he is simply not caring enough about your story to continue dealing with him,
Opinions are my own. If you like to take a critical look on venture financing and why it might not be the best option, check out my series on my blog