There are a multitude of venture capital firms (although not as many as there were a few years ago and more than there will be a few years from now) with different business models.
Some firms prefer to invest in early stage v late stage companies. Some must be assured at least 20% ownership before they will invest. Some want to lead an investment. Some only want to follow another lead investor. Some only want to follow Sequoia.
Some have large funds where they must put to work a lot of capital. Others have smaller funds where a modest success in the portolio can deliver reasonable multiples for their Limited Partners.
As an entrepreneur, you would be best served by identifying up front what type of firm you’re meeting with and the fund they are investing from or you could be wasting your time. For example, firms investing out of a larger fund and focused on early stage deals must find and invest in startups that have a reasonable chance of becoming larger companies so they can “move the needle” with respect to generating large returns.
You may have a great idea that addresses a legitimate market but if that idea is more of a single product idea or more of a “feature” v. a “company”, then a firm investing out of a large fund may elect to pass. It doesn’t mean you don’t have a great idea and a viable business opportunity but each investing partner only has a limited amount of time to devote to investing/managing their portfolio. They have to weigh the risk of making an investment of their time and money in a company that is more likely to generate a smaller return v a larger return.
What’s a large return? Well, again it depends upon the size of the firm/fund. For the larger brand name firms, we’re talking $100′s M/$1B’s. Big hits. For smaller funds, more modest returns are acceptable. If a firm investing out of a $100M+ fund can generate a 10x+ return from a $5M investment that will return half the fund. For a firm investing out of a $1B fund this return wouldn’t even begin to move the needle.
And, as a recent Silicon Valley Bank report stated, the data for the past 15 years shows that only 2 out of 10 VC-backed software start ups have been successful with a median multiple of 4x. There have been very, very few $1B+ outcomes over the past 10 years.
Another key concern for venture firms is liquidity — how long will it take for a company to grow to a reasonable size so it can IPO and/or becomes interesting acquisition candidate?
With few exceptions, Limited Partners have seen little liquidity from the venture asset class over the past 10 years and are therefore putting tremendous pressure on the GPs of venture firms to deliver liquidity. Delivering liquidity sooner v later is critical to whether or not a venture firm can raise its next fund.
So, in addition to wanting to know how big a company you think you can create, entrepreneurs need to be prepared to discuss how they will grow their company as quickly as possible.
Here’s a good example of how this plays out. SaaS is currently an extremely hot business model. The top public SaaS companies get up to an 8x multiple (e.g. CRM, SFSF) v the top traditional software business model incumbents who get about a 3x multiple (e.g. ORCL, SAP, MSFT).
However, the data suggests that successful SaaS companies take at least 7 years - with 10 years not being unrealistic - before they are large enough to consider a liquidity event (e.g. IPO). A venture firm needs to raise a new fund every 4-5 years. If a venture firm can’t show “realized liquidity” from its companies until after 7 years from initial investment, it may be tough to raise its next fund.
Also, a venture fund is typically formed and designed to wind down after 10 years. The GPs of the firm typically need to request permission to extend the fund (and to collect management fees from the fund) to manage portfolio companies beyond 10 years. If your company will be funded toward the end of a current fund and it’s going to take 7-10 years before you can expect liquidity (a typical SaaS company) then there could be pressure to liquidate earlier rather than later by your investors. So, you need to know whether or not your investor is going to hang in there with you to maximize the return of your hard work.
In summary, when you’re presenting your company to a venture firm, make sure in advance that you’re aligned with them in the following ways:
1. Your business opportunity (e.g size of market/potential size of company) fits with the investment profile of the venture firm.
2. You understand which fund the firm is investing out of; how big it is and how old it is.
As I have said before, raising money from a venture firm is an enterprise sales process. Know who you are selling to in advance of your meeting(s) and gain an understanding of what their motivations are. Don’t waste your time with firms whose funds don’t align with the goals/objectives of your company.