From founder -> to VC: 6 months in (so far...)
A bit more than 6 months ago I made one of the toughest decisions I’ve ever made in my professional career. Stepping away from day-to-day activities in my own co-founded startup CastPrint to join Verge HealthTech Fund, a one of its kind VC fund that invests in early stage healthtech startups globally. Why and how I made this decision, you can read about it in my previous post.
Now, almost six months later, I have started to gain some of the first glances at how the world looks different from being on the “other side”.
As this week marks the 11th anniversary of TechChill, which will bring more than 300 startups, 200 investors from around the world to Riga, I wanted to share my first key takeaway that I would have liked to know when I was just starting out as a founder before going to conferences and pitch to investors.
Know the rules of the “game”: or the math needs to work
I remember when was pitching CastPrint to VCs, I learned the “theory” of the game.
Venture capital is for high growth, scalable tech businesses that potentially can provide huge returns to everyone.
What I did get wrong was, that a huge return for founder/angel investor is not always equal to huge return for VC.
Jyri Engeström, from Yes VC, has an already been vocal about this and has prepared a great presentation, as well you can listen to him talking extensively on a podcast in detail about how VCs business works.
What do I mean by huge return for founder/angel?
Say you created a startup and an angel invested $1M at $9M pre-money making the valuation of the startup $10M post-money. Ten years later the startups is sold for $50M. Not unicorn, but hey $50M is $50M still, right? Angel gets $5M, founders get $45M - everyone is happy!
Now let’s change that angel to a VC that has $20M fund - again nothing too big to keep this example down to earth.
The case is the same, VC invests $1M at $10M post-money and the startup exits at $50M ten years later. Founders get $45M, VC - $5M. Everyone again happy? Wrong.
The despite getting the $5M back from $1M investment the VC has nothing to be happy about. Why? Remember – the fund is $20M thus your startup has returned only 25% of the fund. Don’t forget that VCs has also their investors (a.k.a. LPs) also want a return from the $20M fund. So, the VC must return around $60M (3X return which a benchmark in the industry - and for the sake of keeping things simple, let’s exclude all the fees and carry VCs charge LPs out of this). So, the $5M from your startup, still leaves the VC $55M short.
“Well, the VC should just invest in 10 more startups such as mine” you say.
Well, yes, VCs are doing this exactly. They create a portfolio of startups. However, don’t forget the truest statistic in startups – most will fail . So, in our example the VC has lost his LPs money if nothing else worked out.
When would a VC be happy then?
Most VCs would be happy if a single investment returned them their fund, but they would be much happier (and more likely to invest) if they think you can get them their entire returns as well. So, let’s get them their $60M. They invested $1M -> $60M. That’s a 60X return needed. Remember, the valuation at the investment was already $10M, so to singlehandedly get the VC their return (which most VCs are aiming for then they make their investment), the valuation at exit must be 60X -> $600M!!!
As you can see there is a difference between $50M exit and $600M exit. Now imagine what kind of revenue, growth %, markets the startup must generate to be valued at $600M? And this is a very simplified example not considering any additional funding, dilution (as more money usually is raised etc.) This math even gets crazier if the fund of the VC is even bigger.
Of course, in real life, usually, a good investor has more than one startup of his/her portfolio that can provide some returns, however the purpose of this example is to showcase how quickly the math changes and how it can potentially influence a VCs mind.
I found about this just recently, by actually being on the VC side and boy, would I have loved to learn it sooner. All the numerous VC calls, pitches, etc., when I was pitching a $50M business. So much time was wasted and would have been avoided if I did my homework properly before. Looking back no wonder no VC ever invested in us. And, why some angels where happy to invest.
But that’s ok. Angels are an amazing source of funding for startup, where you can get the money and the knowledge and in the end everyone is happy. As I said, VC funding is not for every tech startup. (Despite what the public image may want you to believe)
So, you see, when preparing for TechChill this week or any other conference or fundraising in the future – first things first, as a founder, go hard and honestly through your numbers. Are you pitching a potential $50M business, a $200M business, or a $600M business? Once you know this about yourself and you know the business of VCs and angels, you will know to whom to reach out to (and remember not all investors have purely financial objectives, including ourselves) and have a higher chance of success.
If you disagree or agree with this, always looking forward to constructive feedback, new ideas and perspectives. I’ll be at TechChill this week (27th-29th) and if you are an early-stage healthtech startup or any other startup ecosystem member, feel free to reach out and let’s connect!
The math really helps me understand how VC thinks. Thanks for writing it up in such a clear way.
It leads me to wonder: if all VCs think this way and everyone is chasing the unicorn, shouldn't that create a void in the financing market for all the 'not unicorn but still a decent business' startups? Who's filling that void?
Amazing content. Thanks for sharing! Raphael