Can Your Startup Generate Venture Scale Returns? Check the Math.
My good friend Elizabeth Clarkson at Sapphire Ventures spots the best articles. This one, by a partner at JME Venture Capital, shows one way for company founders to see their businesses through investors' eyes.
I've summarized the article here, so the post is longer than usual.
- Remember the business investors are in - getting their money back plus a risk-adjusted return that makes sense measured against the size of their fund.
- This is just math. The author highlights these rules of thumb:
- An early-stage venture fund is going to invest in 20 companies
- To achieve a 2x cash-on-cash return and 15-25% IRR for limited partners, the fund aims to get a 3x gross return (before fees) across all its investments
- The expected distribution of outcomes is 1/3 losses (7 companies with 0x returns), 1/3 money-back (7 companies with 1x returns), 1/3 successes (6 companies with substantial returns). The expected distribution of the 6 successes is 1 home-run and 5 "meaningful exits."
- Crunching these numbers, each "meaningful exit" must generate 1/3 of the original amount of the fund. In other words, if a $50m fund must generate $150m overall, each investment (averaging $2.5m) must have the potential to generate $17m in 5-7 years.
- A founder/business owner can use the math to back into enterprise value targets that investors will be thinking about as they assess investments.
- The author assumes that an investor is going to construct a 20% ownership in a successful company over time (not an easy task).
- So, for a $50m fund, an investment must generate at least $17m in returns to be considered meaningful, with a 20% ownership position for the VC at the time of the exit, implying that the company has to be sold for at least $83m. (If the VC had only 10% of the company instead of 20%, the company had to sell for $167mm instead of $83 just to be meaningful.)
- The enterprise value target and valuation multiple at exit lead to a revenue target. Gross margin and growth rate are some of the most important factors to determine the valuation multiple.
- As examples, the author assumes (a) no debt, (b) the same growth rates and (c) these basic gross margin and valuation metrics:
- A SaaS company with 75% gross margin can be sold for 5x ARR
- A marketplace company with 15% take rate can be sold for 1x the last twelve months (LTM) gross merchandise value (GMV)
- An e-commerce company with 30% gross margin can be sold for 2x the LTM revenues
- Now that we know the size of the exits we need (e.g. $83m for the $50m) and the expected revenue multiples for different business models (e.g. 5x ARR for SaaS), we can determine the revenue targets for the different combinations of them:
- a SaaS company has to be able to generate $17m in ARR in 5–7 years
- a marketplace company, $83m in GMV
- an ecommerce business, $42m in revenue
- So, as a business owner, can you grow fast enough to become a meaningful exit for this kind of investor? Continuing the example of the $50m fund and the SaaS company:
- Consider that some of the best SaaS companies have followed an annual growth rate of T2D3 (triple, triple, double, double, double). This means that, if current ARR is $200k ($17k MRR) and this revenue trajectory is achieved, the company reaches ~$14m ARR and might be a meaningful exit for the VC.
- Then consider sales & marketing costs and other expenses required to achieve this goal, and assess whether the overall picture is achievable.
The takeaway: Different investors have different parameters. Make some assumptions and do the math to estimate exit requirements of investors you might want to target. Focus on those whose requirements you can achieve.
Read the whole article here.
Posted on December 30, 2016
by Frank Williamson