December 8, 2008 by raymond
There has been a lot of healthy discussion about the true implications of VC investments. Markus Frind (plentyoffish.com) wrote about it a year ago and Basil Peters (AngelBlog) has been analyzing how VC math influences a startup’s DNA.
In a nutshell, a $50 million exit = a $5 million exit when you factor in two things: risk and payout (the cash you actually take home). In the example below, the upper tree shows a $50 million exit and the bottom shows a $5 million exit:
The $750k represents the expected value in both cases. How come they are the same?
The VC-backed example represents a “home run or bust” investing philosophy. The exit is bigger ($50 million) but so is the risk (only 1 in 10 will make it). Also, your portion is smaller, only 10% at exit in my example. So if there is only a 10% chance you’ll earn your $5 million payout, the expected value is only $500k (10% X $5 million). Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.
The other example is a startup done lean or with some friends, family and Angel money. The exit may be much smaller because the funding isn’t there to go big. But nor is there the desire to “go big or go home”. So out of a much smaller $5 million exit, you retain $2 million (a bigger chunk) plus your chance of success is now 25% instead of 10%. So 25% X $2 million = $500k. Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.
Some people may object to the numbers:
- 10% ownership at exit is too low – Actually, you may own less these days given lower valuations. See this presentation from Union Square Ventures.
- 90% chance of failure is too high – I agree this may be pessimistic but there are a lot of VCs out there who don’t have one home run every 10 investments.
- The success rate is too high for modest exits – Few people would claim they could get higher rewards with lower risk…
I’m definitely not suggesting that the numbers I’ve used are the right ones for you. But they are a revealing way to explore alternatives when funding your company. Every option has pros and cons and it’s up to you to understand them. This method gives you a way to quantify those options.
You may be surprised to find out that bigger is not necessarily better, at least not in terms of how much money you take home when you exit your company.
December 1, 2008 by raymond
CC by greefus groinks
I seem to spend a lot of time convincing people not to raise money. The #1 culprit is not The Downturn or a lack of good ideas. The real problem is that people are trying to raise money too early when things are still half-baked.
Here is my top 10 list of tough questions all entrepreneurs should ask themselves before trying to raise money:
- Is your idea ready? – Most ideas need time, not money. E.g. time to really vet ideas, get outside feedback, and do a deep dive into everything. Money won’t help you do this faster and will be a distraction.
- Are YOU ready? – Anyone can, and should, start a business, but you should be honest about your personal timing. Can you afford to take a pay cut and work long hours at this stage in your life? Have you built up some relevant career experience to help you? Do you have good general management skills? What can you do to develop your own skills?
- Do you have a good network? - It is so much easier to build a company when you have a good network to support it. Networking is free and fun and you’ll hone those skills you’ll need when you are building your own company. Don’t like networking? Don’t start a company!
- Do you have big gaps in your team? – Don’t try to raise money when you have a technical product with no engineer on board. Build your core team first. Hint: don’t do it alone, ever!
- Do you understand the fundraising game? – There is no excuse to be under-educated about the fundraising game. Everything is available on the Web and many funders blog about their deals. Don’t wait until you start pitching to learn what a term sheet is or what valuation to expect.
- Do you know your target customer intimately? - Don’t just talk about customers as if they are an abstract concept. Be able to personally name 10 customers (who you have talked to) and be able to describe them in intimate detail.
- Do you have a detailed and paranoid view of the competition? - Why start a business before thoroughly understanding the competitive landscape? And yet most competitive analyses fall far short. Many ignore obvious direct competitors and few deal with substitutes effectively. Be more paranoid!
- Are you ready to work for someone else? – When you have shareholders you’ll no longer be working for yourself but for them. It’s a major mindset change from being a sole owner to being a manager who can be fired…
- Do you have a better alternative? – Successful bootstrappers know that you can do without most of the things you believe you can’t do without. Make sure you weigh the time and probability of raising money with your next best alternative, which might actually be pretty good.
- Are you ready to give up a modest payout to yourself to go for a bigger, riskier payout for your investors? A lot of people don’t understand that a “lifestyle business” that generates $1 million in profit per year is not interesting to many investors. But it’s very interesting to most entrepreneurs. Understand why investors and entrepreneurs have different motivations before you take on any investors.
Answering these questions will help you diagnose whether you’re ready to raise funding or if you should be looking for investors in the first place.