Are You Right For Venture?

Had a bunch of meetings with some interesting people the last few days.  I was perusing Twitter and I saw Hunter Walk tweet this:

This is totally interesting and enlightening. Why?

First some perspective. Hunter runs a seed stage VC fund in Silicon Valley.  I want to give you a window into how funds like this view the world.  To be clear, I am not making a statement about Hunter or his fund-this is generic.

They need to make $250,000 to $1M investments (depending on fund size) into companies that will return money to their investors.  The average person might see a $20M fund size and think, “If they return $60M to their investors, they are successful.”  Sort of.  But, not really.  There are two other incentives behind that investment.  First, we know that most seed investments don’t work out.  By “don’t work out” I mean they fail or don’t return any money to investors.  If you ran a $20M fund, the maximum amount of companies that you could reasonably do is around 15-17 depending on initial and follow on check size. If 90% fail or don’t return money, only 1-3 companies are going to return money.  That means the fund needs to return its entire net on one check. 

Most seed stage fund managers want to manage larger and larger funds.  They don’t want to manage a series of $20M funds.  It’s not just about the money and management fees.  It’s because of the risk.  It’s hard to find that one deal.  For example, Hunter published his funds statistics the other day.  They looked at 1600 deals to find the very few they wrote a check for.

Now, suppose you are an entrepreneur and you think you are building a pretty cool business.  Customer growth is escalating, and you feel like you are getting traction.  You think, “If I could raise a round of VC money, I could put the pedal to the metal and really grow.”

You do some research, and you put together a deck.  You know full well that no one is going to fund you unless yo have a billion dollar opportunity because that’s what it says in the blogs.  But, more importantly you should know they aren’t going to write a check unless they think you can get there because of the math I alluded to above.  You build your deck highlighting how massive the market is and you show how your business will get it.

The problem is, deep in your heart you know your business is probably more like a $40M-$60M business based on the niche you are going after.

Don’t get me wrong.  It’s a great business.  You are creating value for people.  But, even though it’s not a “cash flow” business, it’s still not an investible business by the metrics used by venture capitalists.  They can’t afford to write a check for a business that will exit at $40M even though they will make some money.

What should you do?

Pick your investors correctly.  Don’t pitch larger seed stage venture funds.  They want to hear your pitch to help their statistics-and also to learn from you.  But, most won’t write a check because of the exit problem.  You might get some stub funding from them but they aren’t going to support you like they will other companies in their portfolio since the other companies offer more bang for the buck.  (Again, I am not talking specifically about Hunter’s fund I am making a generic statement)

Pitch angel groups and individual angels that have a network which can help your business grow faster.  Pitch a family office that made their money in your industry.  Pitch friends and family.  Pitch your existing customers and see if they might want to invest.  There are also a very small network of funds that look for investments like yours.  Joe Dwyer runs a fund like that.

The alternative is grow from revenue.  That’s tough.  But, that will benefit you the most in the future.  You keep the majority of equity.  As your company grows, you can have control over when you want to sell it and who you want to sell to.  As time passes and the way your growing company changes, you might want to sell it at $20M and move on.  If you raise VC money, that option is totally off the table.

 

 

  • Seph

    Good post. It’s important to distinguish expectations for exit of an entrepreneur versus those of VC. This distinction is not apparent unless one is paying attention and thinking about the incentives of each party. Or unless someone with more experience in the arena points it out.

    A couple of weeks ago, I read a blog post from Jason Lemkin where he makes the case for a 10x rule of thumb. That a liquidity event should return 10x to an investor. Having this as a guidepost would allow the entrepreneur to anticipate what kind of exit path is necessary to deliver a 10x return.

    https://www.saastr.com/the-10x-rule-what-raising-1-of-venture-capital-really-means/

    (Tip of the hat to @Nick_Moran:disqus and his Venture Weekly mailing for the link.)

    • Agreed. Great post, Jeff. Founders need to be aware of investors expectations going in. ‘Exit goal congruency,’ as John Huston calls it, may not exist between all stakeholders. But awareness should.