This question has been going around and around for quite some time… Essentially, will the VC model wither and die?
This pertains to early stage tech startups, specifically Internet and Software companies. This doesn’t apply to retail, manufacturing, healthcare, biotech or energy companies – among just a few.
Why the model simply doesn’t work for tech startups:
a startup is looking for capital and approaches a VC who wants to invest $3M for 33%
VC will be looking for a 20X return
the startup will have to sell for $180M to see that happen
How many companies are ever going to see that level of exit? 0.1%? 0.05%? Less? It doesn’t even look that much better for a “low level” investment of $1M by a VC (still assuming a 30% stake). An exit with a $1M investment will still need to be a minimum of $60M…
That is still a low percentage of exits. There are a lot of exits happening for $5-20M. If you receive an investment of $1-3M you are essentially pricing your company out of the market. This is a numbers game, so know the numbers.
A maximum investment of $300,000 will allow a profitable exit for all parties at a $20M exit.
Of course, this model changes if VC (or any investor) is looking for a lower multiple or if they take a greater percentage of the company. One of the key calculations entrepreneurs need to make when starting a company and looking at taking on investment is what is the likely exit scenario for their business and how much equity and control are they willing to give up.
About nathan kaiser
Nathan, seems like this is especially applicable to web apps / tools as opposed to online retailers, e.g. Scribd vs Amazon. Many of these startups require a dev team and some data collection qua India (read->teachstreet). When you take the physical goods out of the value offering the margins do seem less appealing, at least for a VC.
Cool post.
-Denny Chapin
I’d been thinking along very similar lines recently, being concerned about over capitalization when so much development can be done with very low burn rates these days. I was thinking about it more with regards to a lot of companies that have already been capitalized to the tune of $10 or $20 million and what their exits would have to be to make those VC’s any significant return. Is the 20x return unreasonable? Even at 5x or 10x some of the companies are going to have a hard time exiting.
This is why there needs to be a hybrid investment structure along the lines of micro-loans for Third World countries. It also screams out loud that the economics of VC doesn’t make sense. I believe VCs, as a group of professional investors are just as over-priced as the Wall Street bankers. Until they face the music and reduce their fees, and learn to do more with less, like the rest of the world, they will be irrelevant.
This would of course mean lower fees, or even smaller investment pools, and it would drive the investment size smaller. They need to get back to basics, pre 1995 days. I think startup guys are smart enough to know on the margin, VCs are just not providing enough value.
Your math is very biased.
First of all, VCs don’t model 20x, they model 10x returns and depending on the opportunity and business growth, they will settle on a 5x or 2x exit (a 2x exit on a business that stopped growing is a win). I actually know stories of VC exiting at 1x because the business stopped growing.
Second, if VCs are investing $3M for 33% for the comanpy, that means a pre-money of about $7MM. So, the company might be overvalued from the get go, which means a $7MM exit doesn’t make any sense at all.
But the premises of the post are rights. You diminish your chance of a lower exit every time you take investor’s money (VC or angel).