In the New Venture Finance class that I teach in the MBA program at UC Berkeley, the conversation at the beginning of each semester often starts with how to raise venture capital – jumping right past the questions around the suitability of venture capital financing for a particular startup idea. As a venture capitalist, I believe there is a valuable place for the skills and resources of venture capital when it comes to building great companies from ideas. At the same time, I regularly see startup ideas that I don’t feel meet the metrics required to be venture-financeable. In my own operating experience, I have built a company with a global presence from cash flow with no outside investors, and I have started a company that was venture-backed from the outset. So how do you know if you are a viable candidate for raising venture capital?
This post is part 1 of our “Roadmap” guest series for entrepreneurs by Allegis Capital’s Bob Ackerman.
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To answer the question, it’s essential to understand how venture capitalists look at potential investments. Tasked by their investors with generating internal rates of returns (after expenses) of 25% or more, venture capitalist are looking for opportunities where they can (1) build a sizeable company over (2) a number of years where there is a (3) balance between the capital required to build the company and (4) the eventual value that will be paid for a company in an M & A transaction or an IPO. The “sizable company” factor is often the first mine in the field – venture capitalists make a distinction between innovative ideas that are “features” or a “product” and a “company.” There is a place for all three, but VCs are focused on building companies – standalone entities that can build, support, and defend their own customer base on an ongoing basis.
There is a lot of judgment involved in looking at this distinction, and a business can evolve over time. TIVO started as a product and morphed to become both a feature and company. In approaching a venture capitalist you will need to defend your ability to build a sustainable company with a product line sufficient to grow to $100M in revenue in 6 or 7 years. Smartphone apps shed some light on the distinctions: an iPhone-Android app that reports the weather is very useful but unlikely to hit the scale metrics to attract a venture investor. On the other end the spectrum, an app store or mobile payment solution holds promise to support a large business – this is a “venture backable” enterprise.
In terms of investment period, VCs typically want to build significant value over a number of years. When a VC commits capital, it is in hopes of seeing that investment returned with a significant multiple. A 10X return is a typical benchmark for an early-stage venture investor. A VC fund only gets to make so many investments, and each one needs to contribute to the overall returns of the fund. The basic calculus: 20 investments with a “goal” of a 10X return on each – knowing that many will fail and only a small number will actually return 10X. This means an early-stage investment with the potential for a quick 2X or 3X return over a 2 or 3 year period does not work within the broader context of how a venture fund generates returns. The VC knows that there will 2X or 3X returns in their portfolio – they just can’t afford to start with those expectations.
The capital requirements and eventual value of a company at its exits are essential to the VC calculus. The more capital required to get to an exit – the lower the returns. The higher the exit values, the greater the potential return. VCs regularly get this calculus wrong – and they know it. As a result, if they can’t get comfortable with the pro-forma financial metrics around a particular opportunity, the response is likely to be cool. A credible story of capital efficiency and hard facts around potential exit values are essential to this part of the conversation.
Of course, there is a lot of give and take in looking at the first four factors. Nor are they the only considerations when VCs evaluate potential opportunities – other factors: quality of management, size of market, defensibility & differentiation, implementation risk, valuation expectations – are all major factors successful VCs will look at. The startup that can pass muster on the first four factors and address this second set of considerations has a higher probability of receiving favorable attention from the venture capital community.
At the end of the day, venture capital is only one avenue for financing a startup business. Even with the venture discipline, Shikhar Ghosh of Harvard Business School reports that only 25% of venture-backed startups return more than their investor’s capital. The statistics are even lower for comparable non-venture backed companies. You can agree or disagree with the filters and metrics above, but they have evolved as key indicators of a potentially successful investment over the past 40 years and are at the heart of how VCs approach potential investments.
Bob Ackerman is founder and managing director of Allegis Capital. Prior to forming Allegis Capital in 1995, he had more than 15 years of general management, venture capital, and strategic mergers, and acquisition advisory experience with information technology startup companies and multinational corporations. Bob teaches New Venture Finance at the University of California – Berkeley in the MBA program and is also active in the non-profit world, focusing on education and the arts.
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