\n<\/p>\n
You have a great product that customers are clamoring for. The business plan looks fantastic.\u00a0Now you just need funding to get the product to market.<\/p>\n
You begin pitching to angels and VCs but aren\u2019t getting any bites. Why isn\u2019t anyone interested?<\/p>\n
It\u2019s all about venture math.<\/p>\n
The business plan shows you\u00a0reaching $20M\u00a0in revenues in 7 years. You want to raise $2M now on a $10M valuation.<\/p>\n
The business will generate $5M a year in profits, you predict. Isn\u2019t this a fantastic opportunity?<\/p>\n
Well\u2026no.<\/p>\n
If the startup does generate $5M in profits annually, regular accounting math says it\u2019s a great business for the founders. But venture math shows why it\u2019s a poor opportunity for venture investors.<\/p>\n
When investors look at your deck, they\u2019re not looking for a good, profitable business. They\u2019re 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.<\/p>\n
Venture investors (VCs and angels) invest in startups based on the following fundamental assumptions.<\/p>\n
Unlike investments in public companies, real estate, crypto, artwork, race horses, or just about anything else, investments in startups can\u2019t be sold or traded until either (1) the startup is acquired, or (2) the startup completes an IPO making the stock publicly tradable.\u00a0Until that exit, which won\u2019t come for many years, my investment is nothing but a line on your cap table.<\/p>\n
Money is collected at the beginning of the fund,\u00a0investments are made over\u00a0the first 3 years, and at the end of\u00a010 years, the fund is shut down. Startups therefore need to be able to exit within 5\u20137 years of investment.\u00a0Angels have more flexibility, but we\u2019d\u00a0like to see a cash return on our investment sometime before we die.<\/p>\n
Out of every 10 startup investments, 9 will fail.\u00a0Typically, 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.<\/p>\n
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\u00a0and lock up my retirement savings for a decade? Basic logic says I need to expect a higher return.<\/p>\n
The people who put millions into venture funds have thousands of funds to choose from. They\u2019ll pick a fund from a\u00a0venture firm\u00a0with a history of the highest returns. It\u2019s not enough to beat the S&P index, they have to beat their peers. There\u2019s some debate about what that takes, but\u00a0we\u2019ll assume\u00a0a return of at least 20% per year is needed to be considered a top fund.<\/p>\n
Coca Cola doesn\u2019t 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.\u00a0Oracle doesn\u2019t buy up a SaaS platform because it solves an industry problem; they buy it because customers are demanding it or switching.\u00a0With some notable exceptions,\u00a0high value acquisitions don\u2019t happen until\u00a0the startup has reached at least $50M in revenues.\u00a0The bar for an IPO is far higher.<\/p>\n
Industry giants in hot industries desperate to get their hands on a quickly growing startup threatening to make them irrelevant will pay 5\u201310x a startup\u2019s revenues for a strategic acquisition, even more if they get into a bidding war\u00a0with their equally desperate competitors.\u00a0Big companies simply adding complementary product lines and private equity firms extracting profits will typically pay 4x EBITDA, a much lower value exit.<\/p>\n
Based on those assumptions, we can calculate venture requirements.<\/p>\n
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\u2019t be too bad, but\u2026<\/p>\n
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.\u00a0If the valuation was $10m when I made the investment, I need my one success to exit at $360M or more. Within 7 years. Gulp.<\/p>\n
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.\u00a0If 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.\u00a0I\u2019d need an exit that\u2019s 80x what I paid.<\/p>\n
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\u2019t quite failures, but aren\u2019t successes either.\u00a0If the exit takes longer than 7 years, or requires more that 2 additional rounds of investment, that 80x multiple goes up even further.<\/p>\n
When VCs look at a seed-stage pitch, it starts with a glance at the numbers.<\/p>\n
Let\u2019s go back and examine the example pitch again:<\/p>\n
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\u2019s wrong?<\/p>\n
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\u2019t a venture fundable-deal.<\/p>\n
At a $10M valuation now, the exit will have to be at $800M. Is that feasible? Not likely unless you\u2019re 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.<\/p>\n
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.<\/p>\n
If you want to build a successful, profitable business, you can have a very comfortable life on $5M in profits every year. But you\u2019ll have to find another way to fund it, because that doesn\u2019t fit the VC model.<\/p>\n
Of the thousands of startups that apply for funding each year, only a few get investment. That\u2019s because for most startups, the venture math doesn\u2019t add up. They\u2019re great small businesses, but not venture rocket ships.<\/p>\n
As founders, you have 2 choices. You can either accept that your startup doesn\u2019t fit the venture capital business model and find another way to fund the business.<\/p>\n
Or you can\u00a0rework the pitch deck to highlight how you\u2019ll reach $100M in revenue in 5 years, and have a line of big companies desperate to acquire the business at a high multiple.<\/p>\n
Ted Hara is back! The hapless, sake-drinking hacker has discovered a terrorist plot in a murdered friend\u2019s email, but the file is encrypted and only the dead friend has the password. Can Ted find a way to crack the file before the bombs start exploding? Find out in my cyberthriller,\u00a0Countdown to Decryption<\/a><\/em>.<\/p>\n Those Who Don\u2019t Understand Venture Math are Doomed to Not Getting Investment You have a great product that customers are clamoring for. The business plan looks fantastic.\u00a0Now you just need funding to get the product to market. You begin pitching to angels and VCs but aren\u2019t getting any bites. Why isn\u2019t anyone interested? It\u2019s all […]<\/p>\n","protected":false},"author":1,"featured_media":35218,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[12034],"tags":[2214,4210,6605,5715,17993],"dealstore":[],"offerexpiration":[],"class_list":["post-35217","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-angel-investor","tag-angels","tag-math","tag-pitching","tag-understanding","tag-venture"],"yoast_head":"\n