Editor’s Note: This post was originally published on Seattle 2.0, and imported to GeekWire as part of our acquisition of Seattle 2.0 and its archival content. For more background, see this post.
By Gerry Langeler
We know it can be very frustrating to entrepreneurs to put their best foot forward, make what they consider a compelling presentation, and yet get turned away, again and again.
So, why are we so “mean”?
Well, hopefully we are not that, even if we don’t choose to invest. In fact, our internal goals are for those we turn down to go away at least with some valuable free consulting for their time and effort.
But we do say “No” the vast majority of the time, and owe it to you to explain ourselves better, in general and in specific. For this post, I’ll focus on the general and on our internal dynamics. Over the coming weeks, I’ll address things that begin to reach more directly across to your side of the table, and to those specifics. If you want some perspective in advance, feel free to visit the OVP blog and check out the now 5-part series “Behind Closed Doors“. (link is to the first in the series)
We say “No” most often because, frankly, the vast majority of start-ups simply aren’t right for institutional venture capital. The companies involved are never going to scale to a size that makes our investment worthwhile.
To explain, here’s some simple math, using our fund as an example. OVP VII is a $250M pool of capital. Our fees and expenses will eat up about 15%-20% of that over 10 years (let’s call it $40M). We’ll make about 24 investments in OVP VII, and assume we average about $9M invested in each company over their life. We’ll usually own 20%-25% of each of these companies. Finally, assume typical venture fund dynamics: that 33% fail (where we lose some or all of our investment), 33% are only OK (we get our money back, or maybe a little bit of a profit), and the final 33% are the ones we feel good about.
For the eight that failed, say we lost 50% (say $35M) out of the $72M put in, so we’re now “down” $75M from where we started ($35M, plus the $40M expenses). On the next eight, let’s say we got 1.5x our capital paid in, or a $35M profit on top of our $72M invested, so we’re back to $40M under water.
Internalize that: we’ve just accounted for 2/3 of our investments, and we’re not back to break even yet!
To be a good fund (greater than 2x paid in) those last eight have to get us at least $540M ($500M + the $40M we’re down). That means each deal has to return, on average, ~$70M. At 20% ownership, that means each has to average a market value of $350M. But for those eight to average that, probably two have to be well north of $500M, with one probably close to $1B. Those are “big ideas” indeed.
Now, how many start-ups can legitimately claim that if all goes according to plan, they will reach a market capitalization of $350M-$1B? Yet, if we invest in a company knowing it never can – even if it executes well – then we are stacking the odds against us ever having a good fund for our investors.
To be fair, we actually do this periodically, because we know that a higher hit rate of companies in the lower $100Ms can balance us out. And we talk ourselves into believing that THIS deal is not going to be one of those losers, hence the higher hit rate. (I’ll leave it to you to decide whether this is folly.) But, at numbers below $100M as an optimistic exit value, the math just doesn’t ever work for us. Yet, there are many, many fine companies that can be built that end up in this value range. They can be very rewarding to their founders and employees, serving their customers and society well.
This is why there is a real place for investors such as friends and family, angels, small venture funds, customer financing, the whole panoply of financial backers to assist the whole range of companies for whatever scale they should strive to be. For example, if you were to divide all the numbers above by 5, and then approach a $50M venture fund or angel group, you might see something that fits your world (and theirs). The important thing is to match your realistic company scale to the proper financing source. If more entrepreneurs did this before approaching potential investors, there would be fewer disappointments on both sides.
Of course, if you do have one of those “big ideas”, we VCs most definitely want to check it (and you) out!
Next time, more specifics that you can use…
