Explaining VC Math: Is your Idea Big Enough?

When I speak with entrepreneurs, one of the most common complaints I hear is that they’re offended their idea isn’t “big enough.”  Entrepreneurs see a path to a few million dollars in revenue, and a solid 8 figure exit – maybe even 9 figures.  What in the world could VCs mean “not big enough,” when a 4x exit is clearly a strong possibility? 

This is where VC incentives get wacky, and they differ from angels greatly.  While angels only care about how their capital is likely to grow (what multiple, what time period, what rate of return that represents, etc), VCs are bound by laws that make them act in artificial ways.

For example, VCs can only invest their money once.  So if a fund is aiming to return 3x (a common industry benchmark), and you offer to double their money in 6 months guaranteed, the fund should NOT participate in that investment, even though you or I as individuals would jump on that anytime.  The fund has to be a 3x overall, and 2x will weigh down returns.  We don’t care if it happens quickly because we don’t get to recycle that money.  Once a bullet leaves the gun, there’s no firing it again.

So that means each bullet has to have a chance to help a VC produce their target return.  But paying a $10M valuation and getting out at $50M is greater than a 3x, right?

Sure, but lots of early stage companies fail.  Heck lots of Series A and B investments fail and return less than the amount invested.  So in turn, that pushes the return requirements higher.  If you assume half of the VCs investments are going to fail, then the VC needs a 6x return on every deal that works.  Assume that some of the deals are going to return 1x, or less than 3x – the returns on the ones that work need to be even higher yet, pushing 10x.

In truth, different funds have different needs.  A relatively small fund like SaaS Ventures is fine with $200M exits – we can make our portfolio work on those terms because we believe our focus will let us invest in businesses that succeed at higher rates.  But some funds, especially consumer oriented ones, are subjected to a large number of binary outcomes – where it works or it doesn’t.  As the number of businesses that return 0 within a portfolio grow, so does the upside needed for each deal.  To have an approach that allows for 60%+ of the portfolio to fail, funds need to ensure that each investment has a 50x+ upside, so that one deal that works makes up for all of the ones that didn’t.

So there you have a view into the venture world.  If your idea isn’t “big enough,” it just means that VCs need to shoot for sky high multiples to make up for their investments that don’t work, because they only get to shoot so many bullets, and each one only gets shot once.

So what do you do about this?  Find VCs with fund sizes and theses that fit your business, not the other way around.  Or forget VCs, find out the best path for your business – angels, debt, or as crazy as this may sound, self funding.  If your customers pay you and you can reinvest, you have no dilution and no silly VCs on your board asking how to “make the idea bigger.”