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.