I feel very privileged to say David Kirk is my friend. We’ve shared laughs and commiserations, broken bread at the two best Italian restaurants I have ever eaten in and talked family almost as much as finance. He’s encouraged me in my latest inane scheme of owning a boat (by showing my pictures of his yacht) and tempted me with boozy cocktails in arid climates.
In this case, I’m giving him kudos not only because of his history of being a senior executive in companies like AOL and Cisco but because he’s also now a seasoned business advisor and serial investor. David sent me this, a part one of two, which attempts to explain how the Venture Capital system is meant to work from his point of view.
Whether you are an entrepreneur or a VC â€“ I like to think I have a foot in each camp – we live in interesting times. Barely a month goes by without a new report showing some â€œinterestingâ€ aspect of investment in 2008/2009, whether it be valuation multiples, return multiples, shift in investment stage focus or just the consolidation of funds out there.
While there is, and always will be, market specific conditions that free or freeze funds, the basics of investing in technology companies, remains somewhat constant, and should always be considered as the backdrop to any specific funding strategy.
When a company seeks funding, they are selling themselves and the investment opportunity that their business represents to the investor. Iâ€™m of the opinion that selling, whether it be ice cream or cars, is always much more effective when you really know your potential â€œcustomerâ€ – their needs, their wants, what they look for, hot buttons, turn offs. Its no different with VCâ€™s. Itâ€™s a business. We need to make money, just like you.
So how does it work?
The returns on any investment is governed by its risk. The riskier the investment, the higher the returns expected. Investing in technology startup companies is very risky. Failure rates of up to 90% are quoted. VCâ€™s expect and plan for 60-70% of their portfolio companies to fail or limp along. Similarly, investors in venture funds â€“ the Limited Partners â€“ expect a corresponding higher return than safer investments. The US ten-year average returns (IRR) on all venture funds in ~17%.
At this point, the discerning reader has all the information needed to determine every ratio and â€œrule-of-thumbâ€ that will follow. But there is need for a great big caveat. Presented here will be pro-forma numbers. I have never seen, nor heard of any business, investment opportunity or fund that mirrors exactly what is given here. The exactly numbers and ratios are somewhat interesting, more â€“ much more â€“ importantly are the ideas behind the numbers. Grasp these, and youâ€™ll be able to apply the principles to any, real-world situation.
Right. Now thatâ€™s out of the way, back to arithmetic.
Iâ€™m a fund manager. I have ten portfolio companies. Being smart (i.e. Iâ€™ve lost money in the past) Iâ€™m planning for three of those companies to fail without returning anything, and three or four to â€œgo nowhereâ€ returning, perhaps, the money that was invested. That leaves three â€œwinnersâ€ in the portfolio to generate all the returns for the limited partners, the â€œcarryâ€ for the General Partners, and to cover the management fees. That means that each of these â€œwinnersâ€ has to return x10 â€“ x15 the investment, to cover the â€œlosersâ€ and the â€œgoing nowhereâ€.
My personal rule of thumb is that an investment needs to return x7 â€“ x10 my investment in 3-5 years.
OK. Next we need some discussion on how to calculate â€œreturnâ€. On one hand its very easy to calculate, but the simplicity in calculation, belies an ocean of â€œartâ€ and â€œjudgmentâ€ surrounding it. If my investment in a company buys me x% of equity, then my return is x% of the exit valuation $y. At this point, given two variables, it could almost appear that we can plug in whatever values for x and y we like, to come up with our investment multiple. Not quite. I look for 20%-25% equity in a company (but, full disclosure here, every investor and VC has their own perspective on this). Less and you lose â€œinfluenceâ€, more and you risk demotivating the founders. But be very careful here, youâ€™ll hear many times the argument, “would you like 80% of $1M business or 20% of a $100M business.”
Equity understood. Check!
What about valuation. This is where you will need to do your own analysis, based on industry, business model, geography, etc. In general, the exit valuate is based on a multiple of either revenue or profit. As an interesting sidebar, in the absence of both â€“ as we experienced in 1999 â€“ valuation of those dotcom darlings was $1M per developer. Science? Nay, magic eight ball. Over the past 15 years, predominantly in software, Iâ€™ve used smaller and smaller multiples. In the mid-90â€™s, x5 revenue seemed to fly with trade sales. Today I use x2, and even that is appearing to be generous. Exit or investment valuation is 90% art, 10% science and 100% negotiation. You need to understand this.
OK. At this point you should be able to answer the last question a VC asks â€œis this a good deal for me?â€ But there is one big variable that will depend upon whether you are looking for investment from a $1B fund or a $10M fund. That is scale and bandwidth. An individual VC can only adequately manage a handful (or two) of portfolio companies. If there are n VCâ€™s in a $1B fund, then the average deal size is likely ($1B/10n)*.60 (where 60% is ration of funds invested initially). Calculate that out. Perhaps their sweet spot is $5M â€“ and likely you can find this on the home page of their website. So now you have a very simple litmus test.
With a $5M investment (ignoring follow-on money), a 25% equity position, and an exit value of x2 revenue â€“ the revenue in year 5 should be at least $100M.
Part 2 will go into the first three things a VC looks for in an investment opportunity; a big market, a hot product, and a team that can deliver.