Entrepreneur Tools: The Returns Analysis

tl;dr: To successfully target VCs, view your deal through their eyes.

pov2I got an outstanding piece of advice in my first job: “Always see the world from the other person’s point of view.”

If you’re trying to sign the pivotal customer, think from their perspective about what price they can accept. If you’re trying to recruit the killer engineer, understand how she weighs moving her kids when they’re halfway through elementary school.

And if you’re trying to raise capital from a VC – someone who invests other people’s money, and is out of a job if there’s insufficient return – analyze your own deal the same way he will.

I learned this the hard way.

In 2007 a somewhat younger and substantially less gray-haired Matthew was out raising a venture capital round for my previous company Lux Research. The good news is that it ended well – we were fortunate to bring on west coast VC firm Catamount Ventures, where partner Mark Silverman brought a rare combo of vision and pragmatism to the board. The bad news is that I wasted a lot of time pitching to firms that I should have known weren’t a good fit in advance, because the returns math couldn’t work for them.

My mission today is to arm you so you don’t make the same mistake.

When a VC investor hears your pitch, he’ll do math in his head to figure out if your company is in-bounds. (While bigger factors like team and market determine a “yes,” the math can rule out a “no.”) Typically, he’s answering two questions:

over90001) Can this investment move the needle? A venture investor can only attend to so many portfolio companies at once. To earn one of these limited slots, an investment has to be “needle-moving:” A successful outcome must be big enough in absolute terms to warrant a spot (regardless of the ratio of dollars out to dollars in).

As you can imagine, what’s needle-moving depends on the size of the fund that’s making the investment. A billion-dollar fund needs billion-dollar IPOs to return a profit; while investing $1 million into a company and getting $10 million back would yield a phenomenal 10x return multiple, you’d need 100 such outcomes just to break even! On the other hand, the same $10MM-for-$1MM return would be massive to a $10MM seed fund, where that single investment would put the fund in the black.

While there’s no magic number, a decent rule of thumb is that a needle-moving investment must return at least 10% of the fund to the VC in the success case. Here’s a close-to-home example: At Venrock we’re currently investing out of a $350MM fund. “Needle-moving,” according to this heuristic, is therefore $35MM. We tend to own 20% or so of the companies we invest in on average, so any one of them must be capable of being worth $35MM / 20% = $175MM when it’s bought or goes public – at an absolute minimum. If a successful outcome for your company would be getting acquired for $20-30 million dollars, you should not pitch me; target other investors with more appropriately-sized pools of capital who would view this outcome as a big win.

returnpaint2) Is the return multiple big enough? After assessing the absolute return, the math moves on to the return multiple, which is a relative measure. If everything goes right, how many dollars will I get out for each dollar I put in?

The return multiple that a VC investor seeks depends on the stage at which it invests, because of the time value of money: You earn about 8%/year if you make 2x your money over 10 years, but you could earn the same 8% by getting 1.08x in one year. As a result, early-stage investors (who invest at company founding and go 5-10 years before seeing an outcome) target higher returns than growth-stage investors, who aim to put in money shortly before the acquisition or IPO. Also, early-stage investors fund younger, riskier companies, most of which fail. Therefore they seek higher multiples in the success case than do growth-stage investors, who make some profit on most of the companies they back.

Again, there’s no magic number, but a good rule of thumb is that an early-stage VC needs to be able to envision a 10x return multiple if everything goes right. (A growth-stage investor, on the other hand, may see 2x to 5x as the target to hit.)

Armed with these principles, you can model the investment returns that a VC would get by putting money into your company, and use that information to target your investor search. Use the spreadsheet template that you can download here (which I’m archiving on the tools page) to do the math and model the return from the VC’s perspective. As inputs, you’ll need your financial projections (revenue, cost of goods sold, and opex); your capital plan (how much money you’ll need to raise and when); and a valuation metric (the spreadsheet uses price-to-sales, but you could also use price-to-earnings – in any case, set the metric by looking at comparable companies that have gone public or been acquired, and use a conservative consensus number in the model). What you’ll get out is the VC’s absolute return and return multiple.

As an example, consider this case:

returns_example3

Let’s say that this company is an energy analytics start-up trying to figure out if it should pitch to VC X, an early-stage investor with a $300MM fund. The company is raising a $10MM Series A aiming for a $15MM pre-money valuation, and thinks it will need another $25MM in two years to get to profitability. It believes it will have $80MM in revenue at year six, and an analysis of comparables shows that similar companies have been bought or gone public at 5x revenue. VC X would do half the A round ($5MM, purchasing 20% ownership) and invest its pro rata amount of the round to follow (i.e., 20% of the $25MM B round = $5MM more in two years), for $10MM invested over the life of the company (if everything goes right).

The good news is that, from VC X’s perspective, the investment clears the “needle-moving” hurdle. If the company hits its $80MM revenue target in six years, it’s worth $80MM x 5x = $400MM; VC X will own 20%, so its absolute return of $80MM is well above 10% of VC X’s $300MM fund size.

The bad news is that VC X can’t quite see its way to a 10x return. It’s going to put in $10MM in total ($5MM now and $5MM later) for an $80MM absolute return, yielding a multiple of $80MM / $10MM = 8x. This is good, but not excellent if it’s an upper bound; if it represents a true maximum it may not be enough. There would likely need to be compensating positive factors (phenomenal team, opportunity to expand to other markets, a pivotal early partner, demonstrably active acquirers) for this opportunity to compete against others.

A secondary point worth noting: The $10MM invested over the life of the company would be 3.3% of VC X’s fund – big enough to be a “real” investment worth a partner’s time, but not so large that it sucks up too much of the fund (VCs generally avoid putting more than 5%-10% of a fund behind any one company).

When you go through this exercise, run multiple scenarios – the VC you’re pitching certainly will! See what things look like with a slower revenue ramp, a lower valuation metric, a higher capital requirement (Venrock lore holds that companies typically require 2.5x more money over their lives than they anticipate at first fundraising), etc. However, I don’t recommend putting this kind of analysis into your pitch deck – it presupposes too much knowledge of the other party’s motivations and comes off as kind of arrogant. Keep it to yourself and use it to inform your financial plan.

Hopefully this tool will equip you for more successful fundraising. Let me know your feedback, and please point out my inevitable Excel errors for correction in an update…

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This entry was posted in Numbers, Unsolicited advice, Venture capital. Bookmark the permalink.

One Response to Entrepreneur Tools: The Returns Analysis

  1. Paul Sereiko says:

    Nice post Matthew. One additional metric that I always ask about is stage of fund. In my experience it’s generally not productive for an early stage company to pitch to an early stage investor managing an early stage fund, if that fund is in the back half of it’s life. Why? Because the fund will want to harvest the investment in 3-5 years and the early stage company will likely need more time to reach an exit.

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