One of the most common misunderstandings between entrepreneurs and investors stems from the difference between a great company and a good VC investment. The two are often quite different.
Remember that VCs are judged by one thing and one thing only: return on investment. Limited partners – investors in venture capital funds – generally want VC fund managers to provide at least a 25% internal rate of return (IRR); in Brazil it is perhaps 30% (25% + 5% risk premium).
A 25% IRR roughly equates to making 9 times your investment over a period of 10 years. Again, this is the bare minimum and no VC wants to hold an investment for 10 years. (The average holding period for VC investments is now around seven years — even seven years is considered a painfully long time.)
Achieving an IRR of 25% or better means finding companies that can have huge “exits”, which often means taking a risk on unstable but high-potential companies and passing on solid, consistent companies.
For example, assume that Entrepreneur Y builds Company X to $20 million in revenue, 15% annual growth and 10% EBITDA margins. By most measures, Company X is a great success and Entrepreneur Y has probably sacrificed much of his/her time, money and relationships in building it. Entreprenuer Y would probably wonder, then, why Company X would NOT be of interest to most VCs.
Look at the math:
- Asssume the VC invests $5,000,000 at a valuation of 2x revenue, or $40,000,000 (this is 13x EBITDA – a high multiple)
- The VC now owns 11% of the company ($5,000,000/($40,000,000 + $5,000,000))
- Company X continues to grow at 20% per year until, in year ten, they are purchased by a larger competitor
- The competitor purchases Company X at a valuation of 2x revenue, or $206 million
- Assuming the VC has not been diluted by other investors, their initial investment returns $23 million. Pretty good, right?
- Wrong. The IRR for the investment is 18%, well below an acceptable minimum.
This example is oversimplified but conveys the basic idea: an excellent company does not necessarily make a good venture investment. To make a good venture investment, a company needs to have exponential growth, which in turn leads to a huge valuation when it is acquired or IPOs.
VC is a game of “hits”. More specifically, a game of many failures and a few huge hits. It is not a game of moderate investments in moderate companies.
That is why you often see VCs making many speculative investments that, in retrospect, appear ill-advised – they have to take risks in hopes of finding a few huge successes and this leads to a lot of failures but, hopefully, also to a Skype, EBay or Google.
