When planning your startup journey, a common misconception reads as follows: All you need is traction to raise funding. And if you are not profitable you will just raise more funding! Right?
Not always, as not every company that creates a value for users is necessarily able to monetize it. And not every company that shows growth, or even profitability, is able to raise financing.
Investable Growth Trajectories
To raise (smart) investor money, you need to pitch them a startup that is “investable”. But what is an investable company? In essence, you need to leave enough growth for your next investor on the table. For that you need a large enough market (that juicy billion+ dollar market) and grow any of your metrics fast enough to see great enough valuation jumps. If a VC can’t hope to make at least 10x on her investment, there is no way to justify all that startup risk.
Why Startup Investors NEED High Returns
Let’s have a look at an example. Imagine an investment fund makes ten investments of one million dollars each. But as we all know, the vast majority of start-ups fail. Even the best venture capital funds will have a portfolio of hits and misses. Imagine only one out of the ten companies will see an exit and in the process increases its valuation by 100% every year for 5 years until its exit. The company’s value will have increased 32x.
However, given the fund had to invest $10m in total and only received back $32m, the IRR on the portfolio is only 26% over the 5 years. That sounds like a decent return, but of course its only twice the historic average of most stock markets! And we can’t forget that for reaching 5 years of high growth, there might be follow-on investment rounds which might dilute the original investment.
Hence the valuation increases don’t necessarily translate into equal investment returns for an investment fund. Also venture capital firms will charge substantial administration fees to their own investors, hence if you are an investor in a venture capital firm, your personal investment return will be even lower than that of the fund as whole.
As a consequence, many good companies just won’t be VC investable. They just can’t render the ultra-high returns necessary to justify ultra-high startup risk.
Companies that are UNATTRACTIVE to VCs
For example, most restaurants or consulting companies are not VC investable. They have too high operating costs or have too limited scaling potential. They may render incomes far greater than achievable through regular employment to their owners, but to reach an IRR of a 100% for an investor, a company needs to double in value each year. That means turning a million-dollar company into $32m dollars in just 5 years!!
Such companies can’t wait for a profitability for 10 years like many tech giants did. They need to have a fast track to profitability, ideally solely funded by their founders, or at least operate in a business model that can attract bank loans.
Investment Size Restrictions
Additionally, you will need to align your financing needs with the valuation size. Investors, individually or as a group, tend to only purchase packages of 10 to 30% of all equity outstanding. This is partially psychological and partially due to practical reasons. If investors believe in your company enough to put in money, they will want a piece that is large enough. They need to get the feeling they are actually participating in your growth.
Also, analyzing and tracking an investee company is a costly process. Managing more than 20 portfolio companies is very time intensive. Hence, investment funds of say $100m will likely not invest less than $5m at a time.
At the same time, the total value of the respective current round should not exceed 30% of the total outstanding shares as the founders might get squeezed so much that they lose interest in the company’s future development. New investors might gain too much influence over the company.
As professional investors are aware of such dynamics, nobody will even want to take a too large stake either, as one would fear the risk of nobody being willing to invest in future rounds. Unbalanced cap tables are very unattractive!
Also, as previous investors will likely have at least a voting right (if not even a veto right) in regard of fund raises, they would likely try to block any new investment proposal that aims to sell too large a portion of the company.
The essence of an investable company is its potential for ultra-fast valuation growth at investment volumes that fall into the 10 to 30% equity bracket.
So, if you need to raise $300k, your company’s post-money valuation should be between $1m and $3m.
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