I was fortunate enough to have a fairy tale startup--we bootstrapped, raised $5M, grew to be a market leader, and had a great exit. Since then I’ve played all the other roles around the table in other companies’ stories--some fairy tales, some tragedies--as an angel, VC, seller, acquirer, advisor, and Board member.
What I’ve found is that those seeking capital usually don’t understand the motivations and limitations of those providing capital. When I was running my business, I certainly didn’t.
This lack of understanding makes it harder than it has to be on the entrepreneur. Running your business, figuring out a growth strategy, getting an investor to believe in your story--these things are hard enough. Divining the opaque rationale behind decisions that investors make is the burden I’m trying to alleviate here.
Find a structural fit, not a strategic fit.
Since equity is the most high profile of capital options, in Part 1 of this series I’m going to concentrate on "The First Questions You Should Ask a VC/PE."
These questions are not intended to address strategic fit, such as whether the investor has market knowledge of your industry, or whether the partners are value-add board members. The focus here is finding the right structural fit--whether the investors have the ability and desire to put cash into companies like yours right now.
All things being equal, I always found that structural fit was a higher priority over strategic fit. My company was a great strategic fit for lots of investors, but it wasn’t a structural fit for most. So I got nowhere. In the end, I raised money from a group that was not a strategic fit, but was a terrific structural fit.
Go get the cash.
In the end, strategic fit is neither necessary nor sufficient to raise capital, but structural fit is. So, onto the questions.
Your question: "When did you close your current fund?"
Their answer: "We closed our fund within the last 24 months."
What it means: "We have money burning a hole in our pockets and need to invest in as many businesses as we can right now."
VC/PE firms are General Partners in 10 year "closed-end" legal Limited Partnerships. That means the fund is contractually bound to invest and divest its investments and return money to its Limited Partner ("LP") investors within 10 years of when it is created (investments can and do go longer--frequently---but it’s not the goal).
Firms want to put their money into companies within 3 years so they have time to mature and get to exit, because average hold times are approximately 7 years. If their last fund closed four to five or more years ago, they still have money in their fund, but it’s almost all reserved for their existing investments.
Timing is everything.
All this means that your company could be a perfect strategic fit that the firm loves, but they can’t invest because it’s not a structural fit for the fund due to timing--because they’ve already placed their bets. There are two exceptions to this:
- If the firm has had a lot of big exits in the first few years (this is statistically rare), they’ll be able to recycle the returns into new investments like yours and still have time to exit within the 10-year time frame.
- If your company has a direct and high probability path to exit in a very short time period
Probability-wise, though, your chance for greatest success is to concentrate your efforts on VCs/PEs that are in the honeymoon phase of their latest fund (within 3 years of latest close). They’re ready, willing, and able to invest--indeed, they have to get the cash out as soon as possible because they have a "burning platform" of the 10-year total time window.
A firm’s initial investments define its style.
Your question: "What size is your average total investment?"
Their answer: "We typically invest $2M at first and reserve $4-6M total for each investment."
The answer tells you a lot about the firm’s style--early stage, late stage, growth, buyout, etc. For example, you can have two identical size funds, but a larger initial investment means they are looking for either larger companies or to control positions in smaller companies.
Importantly, this also means they will have fewer investments to get to their target return--that means they want less risk (more mature companies means less chance of an investment going to zero) and have a narrower target return window (they don’t need investments to be a Google-type exit to offset a lot of zeros). This makes sense because when fewer companies fail, the remaining ones don’t have to be intergalactic home runs for them to get the fund to its target returns. (The next section will elucidate why this is important.)
Your relationship with risk should guide your search.
PE firms focused on more mature businesses average a capital loss ratio (how much of their investment capital goes to zero) of about 15 percent, whereas early stage VCs average about 35 percent. That means those PE firms take on much less risk than the typical VC, and that means they are looking for more experienced management, and companies with more revenue and profits, diverse and large customer bases, and a leading market position.
Knowing this is important because the VC/PE firm’s style has to suit who you are and what you want. Let’s say you’ve been slaving away to get your business to $10M in revenue. You see big opportunities but you’re sick of the grind and want some cash now while someone else sweats the pressure of growth and competition.
You need a firm whose strategy will allow a control recap (give you some cash for a majority of your equity) and growth capital (new cash on top of the cash that goes to you) and is comfortable finding new management. This is typically a firm with a larger fund (>$200M) that makes larger first investments (>$5M).
You might find a VC/PE firm that’s a great strategic fit (that knows your product type and market), but if they make smaller investments, they are looking for minority equity in a hungry entrepreneur who wants to lead the company to world domination. Your situation won’t be a structural fit and therefore they would be unlikely to invest.
Understand their funding from their point of view.
Start by asking the following:
Your question: "How big is your current fund?"
Their answer: "Our current fund is $100M."
What it means: "We need to return $300M to our Limited Partners."
VC and PE behavior is driven by aggregated returns to their LPs. A typical target return for a fund is 3x cash-on-cash return and >20% IRR (net of fees) to LPs over 10 to 12 years. With such returns they’ll be a top performer in most years and will be able to raise another fund--which is most professional investors’ ultimate long-term goal.
This return target is a pretty universal rule for all equity investors, whether a $25M or $500M fund, a VC or PE, or early or late stage specialists. An individual firm’s focus may vary--which determines strategic fit--but all firms need to rattle their cups to get money from big pools of money (ie LPs), and managers of those pools are similar in looking for such returns.
Here’s why this matters: Fund size determines everything in a deal that matters to an entrepreneur.
Do the math.
Think of it this way: If I’m a $100M, early stage VC fund, about $20M goes to management fees (10-year fund, 1.5-2 percent management fee per year, plus deal fees, plus dead deal costs, etc), and about $30M goes to zero (average VC capital loss ratio is 35 percent). That means only $50M will actively make returns. On average, about $25M will just return the original investment, leaving $25M of investment bets to make $300M.
A typical such fund averages 15 bets, starting off with a $2M investment per company and reserving an average of $5M (which not every company uses). Based on the average numbers, 5 companies will be a total loss, 5 will return the original investment, and 5 will be responsible for returning the lions share of the $300M.
That means each of those winners must return $50M+ a piece. That’s a 10x multiple of the total $5M investment in each company. We’ve all heard how VCs look for "10 baggers" and this math substantiates why. What entrepreneurs don’t know is that this drives the types of companies the VC/PE can invest in, and the price they can put on those companies (their valuation).
If they love your company, can it still work out? (No.)
Let’s say a VC loves a company--the industry, the product type, the stage, the entrepreneur. It’s a 100 percent strategic fit. They can’t make the investment unless they can structure the deal to potentially get them their target return of $50M+. How do they do this?
First of all, they need to believe the business can eventually sell for enough to make the return. For example, you have a $2M revenue software business, and your plan says it’ll grow in five years to $15M with a $2M profit. Excluding the fairy tale world of Instagram, a good price is 2-4x revenues, so let’s say 3x revenue, or $45M.
That means even if the VC owned 100 percent of your business, they can’t reach their target return of $50M+ (absent an Instagram lotto ticket). So even if a VC loves everything about your company, and objectively growing from $2M to $15M in five years is great, the investment is not a structural fit for the fund because of return potential.
Second, a VC/PE’s ownership percentage needs to support the return target. Let’s say your projections show explosive growth from $2M to $50M revenue and $10M EBITDA in five years. That’s an eventual projected sale price of $150M (at that size, EBITDA multiples are more common, and 15x EBITDA is a generous middle-of-the-road valuation). The VC needs to own one-third of your business at that sale price to get their $50M. If you want $5M, the maximum valuation you’ll get is likely $10M or less.
Here's the take-home: Listen to the math.
Math around what the VC/PE believes will happen at sale--not your plan, your product, or you--is what drives valuation. And valuation is usually the hot button issues for entrepreneurs.
So if you know how fund math contributes to VC/PE investment decisions, you can more efficiently determine whether your company is a structural fit with a particular VC/PE.
These questions should help you ascertain the key characteristics of a VC/PE to see if they’re a structural fit for your company. In Part 2 of this series, I’m going to go over the questions you should ask yourself so that you know if, what type, and what amount of capital is appropriate.