C. Fund Fit

Up to this point in the book, we’ve been exploring the market and industry aspects of the value network. Now it is time to look at the mechanics of how an investment in a startup would fit into our fund, or as VCs like to say, “can we make the math work.” We will explore strategies to maximize financial return.

As we are looking at a startup from the VC fund perspective, it may not be surprising that many founders have not deeply considered this point of view. They understandably focused first and foremost on product/ market fit, ensuring that they could indeed create value.

They may also have considered the competitive threats to that value creation. Only the most seasoned entrepreneurs, usually ones who have a worked with venture capitalists before, are able to sit in the shoes of their would-be investors.

What this means in practical terms is that VCs may not get much help from the founders in determining whether the startup is a fund fit. Whereas, we’d expect slides in their pitch decks to cover the key aspects of product/market and founder/industry fit, we will have to perform much of the fund fit analysis on our own.

Further, we’ll have to gauge whether the founders will be on board with the direction we would need to take to make the deal work for us. With our hit-driven investment thesis, we count on a small number of startups in our portfolio to outperform the rest. We need each investment to have the potential to be one of those hits to move the needle on our fund.

This focus on the endgame and whether a startup might be a hit for us creates a structural challenge for this book. Arguably, these chapters are out of order. Rather than starting with growth milestones, we should probably put the exit first (as we discussed in Part I, “Work Backwards from the Exit,” p. 68). However, I have decided that the exit feels more natural to be at the end, but we will necessarily allude to our exit strategy as we look at the growth milestones we intend to hit along the way.

Another consideration for these sections of analysis is that they are even more future-focused than any chapter we’ve covered so far. In competition, we were concerned with today’s threats as well as how competitors may react tomorrow. In product/fit, we wanted to understand product/market fit for the current target market as well as future segments.

However, fund fit is all about the future, specifically a new future for a startup that only becomes possible if the startup receives our venture capital investment. This is a future that we will help create. Every venture capitalist must have a vision for how to make this happen, becoming both strategist and prognosticator.

Given the level of uncertainty in predicting the future, different VCs will have different approaches and will often disagree. This level of analysis does not lend itself to right and wrong answers. More relevant are compelling narratives, weaving numbers and story into a vision for the future. We will never know what was right or wrong. We will know, with the help of time, if the path chosen worked or not, but we’ll never know what might have worked.

We’ll be investigating three elements of fund fit: growth milestones, exit strategy and return analysis, answering these fundamental questions:

BONUS: there is also a bonus MORE VC MATH section on this website, as well as a RETURN ANALYSIS WORKSHEET.

7. Growth Milestones

Perhaps the most important strategic concept for maximizing financial returns in a venture capital investment is milestones. Any time a milestone is hit, the underlying valuation of the startup increases, just as a public company’s stock price rises when the company hits its numbers. Setting, funding and hitting milestones are imperative for creating value in a venture.

Each milestone is tied to one or more key risks. Hitting a milestone results in demonstratively lower risk, which translates into higher valuation. Though there are some shared characteristics across all startups, every industry has its own set of inherent risks. Biotech companies, for example, will have vastly different milestones than software startups. The challenge for venture capitalists is to identify key risks in a startup and determine whether there are milestones the startup could achieve to mitigate those risks. The second part of that challenge is to fund the activities required to hit the milestones.

For example, a software startup may have beta testing, new feature releases and/or strategic partnerships to forge. Biotech companies have regulatory and approval processes. Hardware companies build prototypes and release products. Young founding teams need to recruit seasoned executives; experienced founders may need to bring in young, energetic talent.  Most startups will benefit from many of the achievements listed, and it will be the job of the venture capitalists to figure out which of the activities should be funded with a round of venture financing.


Example Milestones Also covered in this chapter:

  • Functional prototype
  • First paying customer(s)
  • Beta customer(s)
  • Successful clinical trials
  • Proof of concept
  • Technical achievement
  • Product release
  • New feature release
  • Site goes live
  • Strategic partnership
  • Critical mass
  • Patent secured
  • FDA approval received
  • X number of customers
  • X daily average users
  • X dollars of revenue
  • X number of page views
  • X% repeat customers
  • X decrease in COGS
  • Hired rockstar CMO

  • Milestones and Risk
  • Use of Funds
  • Hit Movie Example
  • Building Equity
  • Airbnb Example
  • Negotiated and Time Limited
  • Seed Stage Valuations
  • Convertible Notes
  • Dilution and Pro Rata

8. Exit Strategy

As we’ve noted many times before, venture capitalists never make an investment without a vision of how to exit that investment. We are not buy and hold investors. Our hit-driven business model requires a liquidity event so that we can return capital to our investors, our limited partners. For VCs, success is one-dimensional. A VC is, after all, a capitalist, and as such has a legal obligation (fiduciary duty) to return capital to investors. There is only one definition of success for VCs: high financial returns.

There is a replicable pattern in the growth of a venture-backed company on its way to a successful exit. It is characterized by several rounds of VC financing (Series A, Series B, etc.) separated by periods during which the startup team is deploying the capital in an effort to hit milestones.

The Exit Strategy for a VC investment in a startup includes a prediction of what may happen at the end (what kind of exit, an estimation of valuation at exit, etc.). However, just as importantly, it includes a path to that end, driven by a series of value-creating milestones. The size each round (Series A, Series B…) is not arbitrary. It should be the amount of cash needed to reach the next big milestone.

Beach House Exit Strategy Example

Back to our earlier example in which we inherit a beach house. Let’s assume it is a fixer-upper and is worth a million dollars in its current condition. The best strategy to reach positive cash flow quickly would be a quick sale. Put it on the market at a reduced price and get cash fast. Perhaps we could get $800,000 in that scenario.

Or we could take the time to go through the normal home selling process with a real estate agent. That could take a few months and cost a 3-6% commission, but perhaps we’d get the full million dollars or even more. However, it is not guaranteed. It would be a higher return with a longer period and some uncertainty. Which is a better strategy?

Lastly, looking at other properties in the neighborhood, we think our house could be worth $1.5 million if we make some improvements. We estimate it would cost $100,000 and take another five months. Now we have a third option for exiting this investment. Which “exit strategy” is best? It depends.

In the above example, we have all our wealth tied up in an illiquid asset, and three different exit strategies have been proposed. The one we choose will depend on a number of factors: our appetite for uncertainty, our access to cash, our willingness to oversee a project, our interest in making more money, our need for immediate cash, etc. You might break the variables down like this:

Table: Comparing exit strategies for inherited beach house

Exit Strategy Investment Time Proceeds Uncertainty
1. Quick Sale $0 0-1 month $800K ~10%
2. Regular Sale $0 2-3 months $1M – 6% ~20%
3. Fixer Upper $100K 5-8 months $1.5M ~30%

My guess is that most of us would likely put the house on the market, wait the few extra months and be very happy with the million dollars. But if our sole goal was to maximize financial return, we’d find a way to raise the $100K so that we could get the extra $500,000. There are not many opportunities out there to earn half a million dollars on a $100,000 investment in five months. Think of the things you could accomplish with an extra $400,000 lying around!

VCs similarly need to exit startups (illiquid) so that we can return a liquid asset (cash or public stock) to our LPs. As we’ve discussed in Part I, the exit can come in the form of an acquisition by another company, or via an initial public offering, or IPO, in which shares of stock are sold on a public market. The IPO is much more challenging and rare than an exit by acquisition. Going public is only a viable option to the few startups who can reach huge revenues (usually north of $100M) with significant predictability. Public markets are driven by expectations, and startups are ill advised to go the IPO route unless we are very confident of the growth trajectory.

Much more common and nuanced is to pursue acquisition as an exit. When going this route, VCs and founders will identify potential acquirers early in the process to form relationships that may ultimately culminate in acquisition. An ideal exit strategy should include the following:

  • Model the startup venture to be a good candidate for acquisition based on recent M&A activity: What companies are actively acquiring other companies? What strategy do they appear to be following? What metrics are they using for success? What valuations are in the market?
  • Establish and achieve milestones that create the most value (and lead to highest price) for potential acquirers. Is the acquirer interested in customers, talent, technology and/or revenue?
  • Begin relationships early with potential acquirers, perhaps by bringing them on as early strategic partners or strategic investors.

One key lesson here is that these strategies are not necessarily in concert with achieving maximum profits. Perhaps the most common example in this arena is the customer base as the most important asset and driver of exit valuation. Examples include unicorns exits by Instagram (acquired for $1B by Facebook), YouTube (acquired by Google for $1.65B) and Myspace (acquired by News Corp for $580M).

Now let’s take a look at the theory behind the math…

Also covered in this chapter:

  • Return Analysis
  • Total Investment
  • Proceeds from Exit
  • Exit Valuation
  • Comps, Multiples and DCF

9. Return Analysis

VC Math 101

The two most fundamental terms in a venture capital term sheet are the pre-money valuation and the investment size. Adding those two gives you the post-money valuation:

For example, VCs have offered to invest $4M on a $6M pre-money, sometimes called a “4 on 6” deal, though it is becoming more common to hear this as a “4 on 10 post,” as the post-money would then be $10M.

The next level of this algebra is used to determine the ownership structure, and needs to become second nature to a VC. Pre-money divided by post gives you founders’ percent ownership. The investment divided by post gives you the VCs’ stake.

       

In our 4 on 6 example, we end up with:

       

 

Another quick example, let’s say a VC firm is investing $2M in a startup with a pre-money valuation of $3M (or 2 on 3). The post-money valuation is $5M and the VC owns 40%, the founders 60%.

 

$2M Investment + $3M Pre-Money = $5M Post-Money
 

 

VC Ownership =

$2M Investment
______________

$5M Post-Money

= 40%

 

VCs quickly learn to do this algebra in their head. Knowing the key deal terms, like “1 on 2″ or “5 on 5,” VCs will immediately know that their ownership would be 33% or 50%, respectively. See the table for a cheat sheet of percent ownership for various deal terms.

Shark Math

I want to take a quick aside to address what I call Shark Math. Due to the popularity of ABC’s show Shark Tank, many people think that equity deals should be offered as “_% of the company for $__.”

As we’ve already discussed, this is not how VCs offer deals because it implies that a percentage of a pre-existing company is being sold (p. 57). With VC investing, a new class of preferred stock is being created and new shares are being sold. Nonetheless, the algebra is the same. Money comes into the startup, and the investors now own a percentage of the company.

If a deal is offered as _% of the company for sale for $__, we can solve for the valuation:

VC Ownership =

Investment
____________

Post-Money

Post-Money = Investment
_______________VC Ownership

 

For example, let’s look at a deal where 25% of the company is being offered for a $100,000 investment. Plug that into our deal algebra:

 

25% VC Ownership

 

= $100,000 Investment
________________Post-Money

 

Post-Money

 

 

=

$100,000
___________25%
Post-Money = $400,000

 

If you are a regular viewer of Shark Tank, you have heard sharks say something like, “Do you realize you are valuing your company at $400,000.” This is actually a manipulation (or a mistake). Take a moment and see if you can catch what the Sharks are trying to do in the above example by claiming the founders are pricing their startup at $400,000.

What is the mistake? (answer below)

Also covered in this chapter in the book:

  • Breaking it Down
  • Seed Round
  • Series A
  • Series B
  • Series C
  • Fund Fit Alert!
  • To the Exit
  • Back to the Forest: Rules of Thumb
  • Adding the Option Pool

 

The founders are actually pricing their startup at $300,000 prior to receiving the investment. The $400,000 valuation derived in the formula above is post-money. That valuation includes the investment, which the startup has not yet received. The current valuation should be pre-money, and should be $300,000. The valuation will increase to $400,000 after the cash is received.

In manipulating the math, the Sharks are employing a negotiation technique to make the valuation seem higher. Coming up with a valuation, also known as “pricing the deal,” is often the stickiest part of the negotiation. I believe that is why I’m hearing more VCs talk about 4 on 10 post deals, when they used to all say 4 on 6 ($4M investment on a $6M pre-money).

The use of post-money vs. pre-money as the valuation can make a big difference in perception if the investment is for a large percentage of the company. If you take a traditional 2 on 2 deal: a $2M investment on a $2M pre-money valuation, and reframe it as a 2 on 4 post—wow, we just doubled the value of the company!

More VC Math – Breaking Down a Deal

More VC Math

Breaking down a deal.

The book gives a case in which a VC firm is considering an investment in a startup, which is pitching for a $100,000 seed deal.

As we’ve said many times already, when VCs first look at a startup, we are thinking holistically about the entire life of the investment, not just the Series A. We will map out in our heads a best guess as to every round of investment on the way to exit.

For this case, while the startup is pitching a $100k seed round, the VCs are thinking about the A, B and C rounds, and are (internally) guessing that it may look like this:

  • Seed round: $100K investment on a $1M pre-money valuation
  • Series A: $1M on $2M
  • Series B: $5M on $10M
  • Series C: $20M on $40M
  • Exit: $200M

Of course, this is all an educated guess, but this type of educated guessing is a key component of thinking like a VC. In this scenario, we start with a $100,000 seed round, followed by a Series A, B and C. Each follow-on round dilutes the ownership of earlier shareholders. In this case, each follow-on round happens to be diluting by 33% (1 on 2, 5 on 10 and 20 on 40). There is no magic to the 33%; it’s mostly just coincidence. If we anticipated hitting a huge milestone, for example, there would likely be a bigger jump in valuation between rounds.

I’ll walk you through the math later, but for now, take a look at the effects of dilution:

Every round projected is an up round, or course, as we are forecasting success. The seed investment of $100,000 on a $1M pre-money yields a post-money of $1.1M. The Series A has a pre-money of $2M. This implies that milestones must have been hit, as the value has increased approximately 1.8X.

The seed investors’ $100,000 investment is now worth $180,000 (on paper), and the $1M worth of stock owned by the founders, as determined by the seed round pre-money valuation, is now worth $1.8M. The image to the left shows the pre-money breakdown; the $1M investment is not in there yet. (Series A is a 1 on 2 round.)

Similarly, between the A and B rounds, we are projecting a healthy up round, going from a Series A post-money of $3M to a Series B pre-money of $10M, or a 3.3X increase. Finally, from Series B to Series C we see another increase of 2.7X, from a post of $15M to a pre of $40M.

With the $200M exit projected in this case, the splitting of proceeds is represented in this pie chart.

The seed investors and founders, while suffering dilution, benefit from all of the up rounds. Multiply them all (1.8 x 3.3 x 2.7 x 3.3) and you get just over 54X on the way to a $200M exit. Series A enjoys three bumps, 3.3 x 2.7 x 3.3, or 30X. Series B has two jumps, 2.7 x 3.3, or 9X.

You can see why a firm would want to participate in the early rounds, with 30-55X returns for the seed and Series A. However, very little capital was put to work. If VCIC. II only participated in the seed and A rounds, they would not have returned even half of their $75M fund. Total proceeds for seed and A are $5.4M + $30M = $35.4M.

After the Series A, VCIC Ventures owned 39% (6% from the seed and 33% for Series A). If they were able to maintain pro rata through the B and C rounds, holding at 39% at exit, they would indeed return the fund with this investment: 39% of $200M = $78M.

We will now dive into the weeds of the math so that you can understand how all of this works. The algebra gets pretty complicated, and we’ll use a cap table to keep up with all the moving parts. However, I’ll will attempt to keep it all in perspective so that we don’t fall too deep into a spreadsheet!

Seed Round

In the seed round, this particular startup had very low capital needs ($100,000) to hit the next milestones. Some VC firms would not bother with an early stage investment like this. They would “pass” and ask the startup to come back when they were ready for their first institutional round.

However, VCIC Ventures’ strategy is to find early stage deals like this. The purpose of the seed investment is to get an early seat at the table for the Series A, as the returns from seed investing will not likely move the needle on the fund (see the previous section: total returns on the seed investment were $5.4M).

For the seed round, VCIC Ventures invested $100,000 on a $1M pre-money valuation, resulting in a 9% ownership stake.

VC % ownership = investment/post

$100,000/$1,100,000 = 9%

On a cap table, the seed round would look like this:

You can view and create a copy of this capitalization table in Google Sheets by clicking here. The chart above is a tab called “Seed Round.”

 

For more, order Venture Capital Strategy on Amazon.

 

 

Return Analysis Worksheet

I recommend you watch the VCIC training videos first.

Disclaimer: this is not written in stone. VCs are notoriously individualistic. There is no agreed upon “VC Method” despite some teachings that claim otherwise. If your team understands the thinking behind the advice below, and you can explain your thinking to the judges, you will have a successful partner meeting. If you fill in the blanks but are not really sure of what it all means, and then tell the judges you used some form or standard VCIC methodology, you will have an uncomfortable Q&A with judges.

To download a printable version, go to bit.ly/vcic-return-analysis.



HOW TO HANDLE SEED ROUNDS

There are two different types of seed deals to consider:

Seed Round is Significantly Lower than Anticipated Series A (less than 1/5):

  • Think of the seed deal as the chance to get in the deal early but use the projected Series A to calculate potential return.
  • E.g., $100k seed with an expected $2M Series A. You may negotiate the seed at a $1M pre-money, resulting in lower than 10% ownership. But the Series A is projected to be a 2 on 4, at which time you will get 33%. Base your return analysis on the Series A.
  • You could even offer a SAFE, but you still must project potential return based on the anticipated future Series A.
  • Point is, you don’t care (much) about the valuation of this round…you’re focused on the A.

Seed Round is Close to the Size of the Series A (within 4X):

  • Use the seed round to establish your percent ownership and reserve 3X of the seed round to maintain pro rata.
  • E.g., $1M seed with an expected $3M Series A. For the seed round, negotiate approximately the percentage ownership you’ll need at exit, say $1M on a $4M pre, or 20%. Reserve another $3M, total investment is $4M (which is appropriate for a fund size in the $50-80M range).

 

For more, order Venture Capital Strategy on Amazon.