December 11, 2018
Why Largess is Important - the Economics of VC Investing
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It is commonly recognized that it is difficult for startup companies to attract venture capital funding. In fact, the rule of thumb is
Consider venture capitalists that expect their investees to complete an IPO as a means to achieve investor liquidity (M&A exits should be comparable for the VC). As significant shareholders at the IPO, many venture capital investors will have their shares held in escrow until many months after the IPO date when the initial fanfare is over. Accordingly, venture capital investors want their investees’ IPOs to be of a size that will support an “efficient and liquid market” to ensure a successful trading environment that they can sell into. With institutional investors typically making up 75% of the trading activity, a successful trading environment must include these investors. Institutional investors can invest millions at a time. Hence, the investee company must complete a larger IPO to be able to accommodate them.
Some rules of thumb. Most IPOs represent, say, 20% of an issuer’s outstanding shares. As well, a “successful” IPO should be at least $25 million. By extension, the issuing company ought to be worth $100 million or more at the IPO date. With typical P/E multiples for IPO companies being, say, 15x to 20x, the issuer ought to have after-tax profits of $5 million to $7 million. Assuming the company has even a 10% net margin (sometimes net margins are much lower), the revenues would be $50 million to $70 million.
Or alternatively, if the IPO is at 1x revenue, the issuing company should have annual revenues of $100 million.
To summarize, it is only these more successful companies that can complete the type of IPO that venture capital investors need to liquidate their investments. And by extension, venture capital investors will only get into companies that are expected to achieve that growth.
For qualified entrepreneurs who are pursuing $100 million-plus opportunities, this means venture capital is readily available in today's environment. The capital required for such aggressive growth is well matched with the desire of venture capitalists to deploy larger amounts of capital into companies that have the potential for huge payoffs.
These economic realities explain why entrepreneurs trying to raise $300,000 to build a $15 million company find little interest from traditional venture capital firms. They may have good ideas that can build profitable businesses. The key issue, however, is scale. Professional venture capitalists will invest millions at a time. As well, the amount of due diligence required to invest wisely in smaller deals is at least the same as (more likely greater than) the amount of due diligence necessary to make larger investments. Combining these factors, venture capital investors simply cannot afford to invest in small deals that don't have the potential to become portfolio superstars.
So, an easy filter about whether to seek VC funding is simply the question, "Will you ever reach $100 million in annual revenue within the next five years?" Generally, if the answer is "no", then you probably will be wasting time seeking VC funding.
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