What business metrics are of most interest to a venture capital investor, and how do they make a proper investment proposal? We will discuss the answers to the critical questions of startups that have decided to raise investment.
Specifics of Venture Capital Investment
Few startups can put themselves in the shoes of an investor and understand his logic. You may often see the following words in presentations of startups: “Return on investment in the fourth year of the project.” But the investor is interested in something else entirely. Let’s figure out why that is.
To begin with, imagine that you are an investor. And you are offered to invest your free money in a venture capital fund. At what interest per annum are you willing to support it? Because venture investments are much riskier than keeping cash on deposit or investing in securities, the return on these investments should be higher. Thus, it turns out that for money cheaper than 50%–60% per annum, you should not count on attracting it from a professional angel investor or venture capital fund.
The main difference between the venture capital market and the stock market is the impossibility of instantly returning the invested funds. If you buy shares in a company on the stock market, and you see that the company starts as the stock market as a whole decline, you can exchange the shares for money within a few minutes or a day. It is not the case with a startup. When an investor invests in a startup, he can take his money back in about five years. However, he can’t take his money whenever he wants, as in the case of the stock market.
How Much Is The Investor Going To Get In The End?
Simple math: if we invest at 50% per annum for four years, we will get a five-fold increase in the amount invested. Let’s say that if an investor gave a startup $100 thousand today, then in four years, he expects to receive $500 thousand at 50% per annum.
It would seem that investors should be happy with its projected growth of 50% per year. What’s the catch? Not all startups “fly”; the mortality rate of young companies is very high. Let’s imagine that at least half of the companies succeed. What does that mean?
To get a return of 50% per annum, an investor-only has to accept investment proposals where the entrepreneur promises tenfold growth over four years, which is the minimum. In other words, the investor’s $100,000 investment must result in a $1,000,000 profit. Investors will not consider proposals. There the founder promises to increase the investor’s contribution (and, as a consequence, the value of the company) by less than ten times.
Why Would an Investor Ask About Planned Turnover in a Few Years?
A venture capital investor’s leading source of income is selling a company’s stake. More giant corporations acquire more than 80% of companies that do not go public. Consequently, it is correct to focus not on the company’s price at the IPO but on the amounts for which the prominent players buy companies.
M&A transactions are available for companies with a current annual turnover. Why are companies without turnover usually not interesting? Because such companies don’t have enough money to rebuild their regular management, usually such a company is a “suitcase without a handle.” It doesn’t work without a founder as CEO. And if something doesn’t work without the founder, it makes no sense to buy such an asset.
We see startups with a small annual turnover more often. If we value such a company at one annual turnover, and it needs twice as much investment, the investor must take more than 60% of the company. If this happens, there will be no more investment from the company: the founders’ share of the company of 20–30% is a signal to investors of insufficient motivation.
How Can a Young Company Be Valued at More than Its Annual Turnover?
At the seed stage, companies are valued with a “hallucination”: we remember that the average price of a company at the growth stage is one year’s annual turnover, so we ask a question about the estimated annual turnover in four years. It is the amount we consider to be the price of the company. A startup can be valued at five or ten times its current turnover if significant growth potential.
What do startups with no or minimal turnover do at a very early stage? The price of such a company at the time of attracting investment is the product of several factors:
- a team. It can build a business;
- a large market;
- the growth rate (which is almost non-existent at the pre-seed stage);
- the availability of demand;
- the ability to make money.
If any one of these components collapses (e.g., the team breaks up) and turns out in reality to be zero, then the price of the entire company is zero.
The only two factors on which an investor is willing to discuss reducing his share in a project are:
- Weighty turnover already at the time the investment is made.
- A product that is technologically ahead of its time and far ahead of all its closest competitors.
When calculating potential growth, you must not forget the market: a company can never be worth more than the volume of the entire market. It is a kind of limiter. Conversely, with a large market volume and good indicators of its growth, a startup valuation can significantly increase. However, you also need to know how to count the market.
At first glance, the market appears vast, but it narrows by hundreds of times when examined in detail.
Reduce the global market to a local one, then narrow it down from total sales to only possible competitors’ exhibition automation systems. And then further reduce the total revenue from exhibition automation to those customers who will never buy. As a result, we get a completely different market estimate.
How Much Investment Do You Need?
If the project proposal does not fall under the investor’s interest, they will not consider it. The proposal can only be interesting if the investor is offered a share of 40% of the company, which is too large at the seed stage of attracting investment. Giving such a significant stake in a company will make it challenging to invest further. The correct calculation of the investor’s stake and the amount of investment required is just as important as the market size and valuation of the company.
