VC views on opportunity sizing
I’ve met with and discussed business opportunities with a wide variety of Venture Capitalists here in the silicon valley. I always ask VCs how they valuate opportunities and what criteria they use to determine whether an opportunity is big enough to invest in and pursue. Beyond their usual pithy statements around “I invest in good teams not necessarily the strength of a single idea”, a few of them have given me insight into their investing patterns. I’ve been challenging myself to write up more of what I learn but haven’t found as many hours in the day as I’d like (yes, we all have this problem and I’m waiting to invest in whoever can solve either by a) adding hours to the day or b) cloning).
My problem was solved recently when one of the VCs I know started writing an informative blog about their viewpoints and positions. I’ve found the blog to be fairly fascinating written by RRE Ventures and I wanted to share two recent posts.
The first post I wanted to highlight was around how VCs come up with valuations. RRE gives their thesis that everything is rooted in the public markets, that they have to use the most liquid market they can find to make valuation estimates on individual startups. I like the point that RRE makes around using whatever tools are available no matter how “chunky” in nature:
http://fiveyearstoolate.wordpress.com/2008/10/24/flat-is-the-new-40-markup/
The second post that was interesting to me revolves around making future projections on your revenue stream. The RRE poster all but admits that if you can’t reasonably project $50M in revenue over the first 4-7 years they most likely won’t invest in you. I highlight this post because I know this is the struggle that many of us are dealing with: how do we find ideas that are big enough?
http://fiveyearstoolate.wordpress.com/2008/11/04/the-truth-or-what-we-want-to-hear/
Sanjay – just to clarify a bit of my post on “What we want to hear”, I think you have hit the nail on the head when you ask the question – how do we find ideas that are big enough? It’s not that teams or their ideas aren’t good enough. But one of the first lessons any investor learns (hopefully the easy, academic way and not the difficult, practical way) is that success in a small market just, well, doesn’t matter very much. If you are targeting a $50 million market, even if you are hugely successful and take 50% market share, you top out at a $25 million business. That’s a good business, but if you step back and think about it from the investor perspective, it doesn’t justify the level of risk.
In that example, imagine that you actually get to $25 million in year 5 and can sell it for 4X revenues (in a market where there’s virtually no headroom for growth, this is optimistic, but let’s assume it anyway). You’ve got a $100M exit. That’s a nice exit. If I invested in you at $10M post-money valuation, I’m looking at a 10X return, and that’s a great return.
The problem, as I hopefully communicated at Five Years Too Late, is that we cannot simply assume that you will achieve best-case scenario. We have to discount for the very real possibility that you will not. Further, the rosy scenario where I fund this company at $10M and it exits for $100M and I make 10X assumes that they never need to take additional capital, which is a rare outcome. If another round needs to be raised, I am looking at having to put in more money at a higher valuation (but with the same upside) and probably taking dilution from new investors.
Now this is the world in which early-stage investors live in, and that’s fine. We know that it’s going to take a lot to get a new company to a big outcome, and that the process is fraught with risks. We are making bets on very speculative companies by their very nature. Without the belief in a big exit, it just doesn’t make sense. If you prefer the MBA approach, the discount rate required for this type of investing makes those investments with limited upside of questionable value when you consider the time it will take to get there in most cases.
So ultimately, I think you are looking at this the right way, the way I suggest on the blog. Entrepreneurs who want a firm like RRE to invest should try to have a product and market vision that’s large enough to justify the type of valuation that a Series A venture-backed company requires. Alternately, there are other investors who may be interested in companies promising smaller outcomes, but if they are rational they will need to envision lower risk to make the math work. There are examples of investors who invest in high-IP, post-development/pre-market companies where they believe risk has been taken off the table. These investments can have a lower upside and still make sense.
Hope this is helpful
[…] Original comment here, Five Years Too Late – RRE […]