There has been a lot of good material written in the last few months about the impact of the topsy turvy fundraising market and the importance for entrepreneurs to shift their focus from growth to profitability. Some of the better posts over the last few months include Joseph Floyd‘s TechCrunch article and Bill Gurley’s The Road to Recap.
I agree with this sentiment to some extent, and have been preaching it with my entrepreneurs for many quarters as well. I fear, though, that the pendulum is at risk of swinging too far the other way. That is, entrepreneurs are not appreciating or understanding the true value of growth and thus taking the slow road to building a big company. Right now, it’s fashionable to humblebrag about your startup that was a “15 year overnight success”. The problem is that the slow road to success doesn’t typically result in “venture returns”. And the entire VC-backed fundraising model is predicated on generating venture returns.
So What Are “Venture Returns”?
In order for a venture capital fund to be considered a success, they need to deliver on one of two metrics: 1. a cash on cash investment multiple of greater than 3 times invested capital, or 2. a net internal rate of return (IRR) of greater than 15%. You can quibble around the edges, but these are basic truisms of our business that have held true for decades. The reason for these performance milestones are related to the fact that the money is tied up for many years (i.e., is not liquid), and is considered riskier than many other types of investments. Thus, an illiquidity premium and a risk premium are required.
For a portfolio of investments to achieve 3x invested capital, though, the winning investments must achieve something like 10x or better. In any portfolio, you will have mostly losers – investments where you lose all your money or perhaps get your money back after many years of hard work. But a few large winners of more than 10x your money will make the entire portfolio a success. Fred Wilson wrote an excellent retrospective on USV’s first fund, Losing Money, where he cites the fact that they lost all their money in 40% of his portfolio companies in one of the best fund performing funds in the history of venture capital. Yet, they had five companies produce outcomes that were better than 20x, which drove their outstanding results.
What Does It Take To Achieve Venture Returns?
For a company to achieve a 10x or 20x or better return on invested capital, it needs to grow very, very fast. To bring this to life, take a look at the table below. It represents a profile of three startup company examples that start at $1 million in revenue at “year 1” (note – to achieve its first in revenue often takes 2-3 years from inception). If you model out three different growth rates – 100%, 50% and 25% – for the subsequent six years, then the fast growing company has a shot at achieving venture returns. It will grow to $64 million in revenue and, assuming a 6x revenue multiple (reasonable assumption for a company growing that quickly at that scale), it would be worth nearly $400 million. Assuming the company required something like $20-30 million in capital over the life of its growth – perhaps accumulated across two to three rounds of financing – and assuming the position of early investors is a post money valuation of $40M (again, reasonable assumptions based on my experience), then a 10x outcome is achieved.
Lastly, if the third company is growing at only 25% YoY, your firm will lose money–a lot of money. These companies, because they’re slow growers, maybe only be worth 2x revenue and so worth $7.6M, only 20 cents in return on each invested dollar in capital. Think about that for a minute – six years in a row of 100% growth, executed perfectly, and you get to 10x. But if you achieve “only” 50% growth over six years, which is still outstanding performance by almost any other metric, and have a revenue multiple of 4x (lower than the 100% growing company for obvious reasons), you have a company worth only $45 million in value and investors basically get their money back.
Now obviously this is a simplified example – growth rates change over time, often starting faster and slowing over time as markets mature and the base numbers you’re trying to grow from get larger. But the point is pretty clear: there’s a reason venture capitalists and entrepreneurs are so focused on growth. To generate venture returns, VCs need companies to consistently grow north of 100% year over year. And if a few companies in a portfolio don’t achieve this, then no one generates venture returns. And if no one generates venture returns, the whole system breaks down.
This example also uncovers a structural tension between the VC and the entrepreneur. VCs are naturally going to push entrepreneurs to grow faster in order to be that one portfolio company that achieves the 10x result that makes their fund a success. The entrepreneur is going to be more cautious to grow at the right pace, without burning too much capital or burning out customers or employees.
So, yes, let’s make sure we’re building real companies that are generating real value, and over time, real profits. But let’s not forget that to get there, our companies need to grow very, very fast over a consistent period of time. Remember that the next time someone tells you to slow things down.
SEEING BOTH SIDES 
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After having followed the SaaS industry for awhile and its growth-at-all-costs strategy (maybe a non-sequitur here!) it is refreshing to read articles like this and see some analysts and some investors and even some CEO (Adam Miller of Cornerstone on Demand, for example) decide that profitability is not a four-letter word and that that strategy does not fit a sustainable business model.
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Hi Jeff, really enjoyed the post. However, the analysis above makes it easy to fall into the trap of focusing too narrowly on revenue growth. A 100% grower with large and positive contribution margins for its core products and with 5x revenue / capital raised is much more valuable than the counter case – and I would guess that these two metrics vary pretty widely across startups.
With enough funding it should be easy to get to the 100% growth case, but it might not yield good VC returns. Examples would be the on-demand companies charging less than their cost of service to boost revenues or online lenders slashing pricing (i.e. loan APRs) to boost loan originations without making adequate provisions for loan losses. Without audited financials it’s hard to say, but anecdotally it seems there are still a large number of “unhealthy 100% growers”.
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Interesting post, Jeff. But I’ll challenge some of the assumptions.
1) You assume each business above was backed at an average valuation of $40mm. That’s realistic for the 100% growth scenario, but unlikely for the 50% and 25% scenarios for the same reasons you give relating to exit value assumptions. Let’s say the 50% deal is done at an average of $15mm. Now the multiple of money is 3.0x in Y7 assuming the same $45mm exit. That’s not going to achieve venture returns but is a much different outcome. It’s a different story if you thought the business was going to grow at 100% and you paid up for that growth. Then you’re in trouble.
2) It’s likely the hold period would be longer in the lower growth scenarios. But if we take your 50% growth scenario out three more years, the company is at $38mm in revenue. Let’s say it’s generating $15mm in EBITDA. A business like that could trade for 15x-20x EBITDA with that growth + margin combo. So now you’re at $175mm-$300mm enterprise value with a lower basis since you didn’t pay up for growth and you see your 10x+ potential.
I might reframe by your post to state something along the lines of the following: if early stage investors pay up for growth, they need that growth to continue or returns will be poor. But if you adjust the prices you pay to reflect the profiles of company #2 (probably not #3) then you can still deliver excellent returns.
I’m curious to see if investors will resume paying up for growth the way they did in ’14-’15. But if this correction has legs and more people focus on building cash flow positive businesses that require less venture capital but ultimately scale to have good margins and good growth (as opposed to bad margins and massive growth) then maybe we’ll see good returns with a different profile similar to company #2 above. But it will be for the companies that raised with 2015 prices to grow into ’16 prices. Interesting times for sure.
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Thanks for this, Brent. You raise a great point about capital efficient startups and the value of raising less money and a lower post-money valuation. In my experience, $40m post is realistic even for the 50% and 25% growth scenarios. It is rare for a company to achieve any scale with less than $15-20m of capital raised. A $15m post basically means you’ve raised only $4-8m in capital. Again, very rare to achieve that over 6-9 years. Your EBITDA assumptions are also off in my experience. First, most companies require at least $20m in revenue to get to EBTIDA positive. At $38m in revenue, EBITDA is more likely to be $5-10m. Finally, EBITDA multiples are more likely 8-10x for a 25% growing business and 10-12x for a 50x grower, not 15-20x. Over the years, I have seen the trap of these marginally optimistic assumptions bite investors and entrepreneurs alike.
Interesting times indeed!
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Jeff – Can you please explain the 10-12x multiple? Since public companies are getting 15-20x where they are growing less then 10%, is the lower multiple because they are private and not liquid? Frankly, who would not buy a company generating 30% EBIDA and growing 50% per year. Lets say Year 1 Revenue is 10M and EBIDA is 3M. By year 5 they are at 75M in revenue with 22M in EBIDA. If you pay 10x EBIDA in year 1, you just bought this company 5 years ago at 30M.
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Which public companies are you see achieving 15-20x EBITDA that are growing less than 10%? Technology companies in hyper competitive fields very rarely generate 30% EBITDA margins at scales as small as $75m in revenue and growing 50% per year. I can’t think of any. If you look at the history of tech IPOs and what their full year performance looked like before going public, they were investing heavily in growth and in order to achieve 50% growth rates, were either losing money or barely breakeven.
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Hi Jeff. Nice analysis. And this does not even consider liquidation preferences, which may actually mean that even at 50% growth rates you end up loosing money because there’s not much left for early investors after all the late stage preferences are paid out.
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