VC Math
Posted on .[Editor’s Note: This post was written in response to recent conversations I have had with entrepreneurs. I have heard entrepreneurs say that the more money you raise the higher price you get from VCs, as if they have “cracked the code” on the venture capital market. If you are an aspiring entrepreneur this post may save you some headaches and might even save your business.]
First a few stats: on average, venture-backed companies raise money every 18 months, and the average holding period of a venture investment is seven years. If you put this together, most companies raise money four or five times before they are sold or go public.
This venture capital treadmill is a tough ride for many entrepreneurs. First, every round results in new dilution. Companies should expect to sell a third of their business in the first round, and a similar percentage in the second round. By the third and fourth round the valuation is normally high enough that there is less dilution, but it still adds up. Second, venture-backed companies need to grow. The average step-up between rounds is normally a 2x, which translates into over 100%/yr growth on a compound basis. Companies that fall short of this target often have a hard time finding new investors. They might get bailed out by their existing investors, but that has negative consequences for management.
The math of compound growth means that small differences in the starting point produce a cascade of big jumps in the out years. See the example below:
An Example of Valuation Growth
Scenario 3 might look attractive, but out of 2,000 digital media companies funded every year only 1-2% will have the revenue growth to sustain Scenario 3. Most that go down this path fall out of orbit sometime after the first round closes.
If I could convey one lesson for entrepreneurs it would be to think about the next round AND the round after that. Realize that over the next three years you will have to find multiple new buyers at even higher prices. Experienced entrepreneurs that have been through this process before often try to raise the LEAST amount of money possible. They understand how starting off on the wrong foot is likely to cost them their job in 3 years.
Ian Sigalow
http://sigalow.comIan is a co-founder and partner at Greycroft Partners in New York City. He has been a venture capitalist since 2001.
AUTHOR flipberkin
Posted on 2:04 pm July 31, 2011.
Having just come from a company that raised too much money, I fundamentally agree with Ian. We did a lot of dumb things because there was this pressure to put the capital to work fast. Shortly after I left they had to go back to the well and I’ve heard the ensuing down round was brutal.
However, from the entrepreneurs perspective there are a couple of reasons why a larger round is better. Raising the same amount of capital in fewer rounds is preferable from a dilution stand point. Additionally fund raising is incredibly distracting. The company would be better served by mngts attention focused on refining the product and getting customers to pay for it. The CEO is often instrumental in getting new business and keeping existing customers. This gets neglected when the team is on the road pitching investors.
With a couple of notable exceptions most companies go through a series of ups and downs on the road to an exit. With more capital on hand the entrepreneur can better weather the down turns and has a chance of raising money when the company is doing well and the market conditions are more favorable.