Consider Outside Investors? Begin With their Financial End in Mind

What Do Angels and VCs Ultimately Want?
If you are considering taking outside money to fund your company, it is in your interest to understand the goals of your investor. While many entrepreneurs understand the psychic gratification that angels get from helping the next generation of entrepreneurs, they may not understand the implications of capital that’s invested for the purpose of seeking high returns (angel and venture capital). These motivations can drive how long the entrepreneur is involved in the company, when to sell the company, how to prioritize the company budget, recruiting, which customers to pursue and on and on.

To understand the financial motivations and behaviors of angels and venture capitalists, let’s look at the ending they want and work our way back. Both angel and venture capital investors seek investment returns that are greater than what can be achieved by investing in the stock market, say the S&P 500. These investors place capital in and work hard with earlier stage, illiquid but hopefully high growth companies. Why? Because they expect that one or two out of a portfolio of 10 companies will generate high enough returns to pay for all those that don’t pan out, yielding an average return over investments that exceed the expected S&P return.

Returns are determined by the amount of money invested over the course of the company’s development (capital in), the money paid by the acquirer or the public markets (capital out) and the amount of time that has passed from investment to return. Let’s look at each of these in turn.

Capital In: Capital In is the total amount of capital the company will need over the years to achieve the revenue growth rate or other milestones that will justify the desired (or required) high exit valuation. But it’s more than just the total. Each slice of capital needs to accomplish some critical milestones that take the company to the Next Stage of valuation. Here’s an oversimplified example:

  • Early Stage Financing- You self-funded the company to make a prototype, show to customers and you think you know who your “first, best” customers are. You need to generate revenues from a handful of customers to prove the market and the value proposition. To prove this, you might raise $500k from angels or an angel group.
  • Once you’ve validated with some initial customers, you’d like to go after the rest of the customers in that market and perhaps an adjacent market. If they believe the company can grow rapidly, venture capitalists might be willing to invest $2-5M in a Series A financing to flesh out the business. Figure that VCs want to own ¼ to ½ of the equity, so this means the company needs to justify a pre-money valuation in the $3-8M range.
  • Series B is to expand the business faster than organic cash flow can supply. Areas of expansion might include developing related products or markets, expanding internationally, or expanding sales through distribution. Series B might range between $7M to $20M or more depending on the industry and the opportunity.
  • Series C can be to further expand the business beyond cash flow generated, or to create the scale of operations that can achieve profitability.
  • Note: Rarely do companies step without faltering between each of these stages. Sometimes it takes a couple of rounds to accomplish each of these goals.

Capital Out: Several years after the initial investment, investors want to get all their capital back plus some compounded return in compensation for putting the initial capital at risk of 100% loss and being illiquid for several years. Even as angels and venture capitalists consider their initial investment, they are asking themselves, “Can this company generate 5-10x the original investment (after paying for investment bankers, motivating management and employees, paying the fund) over a 5-7 year period?” If the answer is no, then there’s no point making the initial investment.

What type of businesses are acquired in 5-7 years for 5-10 times the original investment? The short answer is companies with very fast growing revenues and/or companies whose revenues can be leveraged immensely by the acquirer’s distribution network. And recent transactions indicate a return to the “old way” of valuing companies; rapidly growing profits that deliver increased valuation to the acquirer’s net income.

Time: Finally, the same Capital In and Capital Out generate vastly different returns depending of the time between the investments and the final exit. In the late 1990’s the average time to exit was less than 3 years. The average time to exit in 2008 is 7 years. If an investor doubles her money in 3 years, that’s a compounded rate of 25%. If another investor doubles his money in 7 years, that’s a compounded rate of 10%. The graph below compares fund vintage to returns. Funds stared in 1995-1997 achieved extraordinarily high returns as their companies exited in the bubbly 1999-2000 stock market. Funds started in 1999-2000 have faced lower exit valuations and longer investment times, and vastly increased competition from many new funds; which yielded much lower returns.

Needless to say, venture firms today face huge issues ranging from the large number of companies funded and still alive from 1999-2000, to an out-of-reach IPO market, to an anemic acquisition market, to increased taxes on their long term gains. In fact, some venture capitalists say that the industry would be better off at half its current size.


Money Isn’t Everything

This post was meant to discuss the financial motivations of angels and venture capitalists. It’s important to understand their financial goals and therefore the implications to your company, the path forward and your role.

Both angels and venture capitalists bring much more to the table than money. They bring experience, contacts, perspective and hard work that are at least as valuable as the capital invested.

Lucinda Linde, CFO Consultant
Next Stage Solutions
June 2009

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