After having this conversation with more than 10 founders over the past week, I realized this post is long overdue.
When deciding if to raise a venture round, it’s critical to ensure your venture investor shares the vision for the company: both the product roadmap and the financial goals of the company. We have all heard horror stories about venture investors and founders – these are mainly the result of differing visions and expectations of founders and investors.
The vast majority of founders never consider the impact on fund size on VC motivations. As long as there are enough reserves to invest as the company grows, a founder might think, that’s fine with me. But this is a dangerous assumption.
Fund sizes influence the goals of a VC. A $50M fund and a $500M fund are looking for very different exits and have very different investment and management strategies which will impact their management of a startup.
Let’s take a look at the economics of these two funds. Assuming each fund seeks to return three times the capital invested in 10 years to provide a good return for investors, the total value of the portfolios must be $150M and $1,500M respectively. The funds have different target ownerships and therefore different average investment sizes. They also take different risks. You can play with the numbers – these are illustrative only.
All this boils down to a target value of a company at exit. The larger the fund, the larger the exits must be for the venture investors to be successful.
|$50M fund||$500M fund|
|Target return multiple||3||3|
|Implied Portfolio Holding Value||$150M||$1,500M|
|Total Market Cap of Portfolio||$1,500M||$6,000M|
|Avg Investment Size including reserves||2.5M||$10M|
|Number of Investments per Fund||20||50|
|Company Failure Rate||50%||70%|
|Avg Market Cap of Exit||$150M||$400M|
If a founder intends to sell a company in the $50M to $150M range or if the market size is about $1B to $1.5B, the founder should choose a smaller fund – and vice versa. If you’re going for a $400M or billion dollar exit, larger funds are an ideal match. In this way, the incentives of the investor and the founder are aligned.
To justify large exits, VCs will also look for large markets. Typically, the most a public company will pay for an acquisition is about 20% of their market cap. If you have a $1B market cap leader in a segment, then the high outcome for the market is likely $200M. So a $400M fund will likely need to see a market size of $2B+ or a market leader with a market cap of around $3B to $4B to justify the market size in an existing markets. If your company is creating a new market, then these calculations are moot.
Larger funds will push companies to pursue larger exits. When raising capital, ensure that your investors share the same vision and commitment to the product, but also verify that your target outcomes for the business are in the same ballpark and that you both define success in the same terms.