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Explaining the Funding Math


When I speak with Founders and Visionaries (I prefer to call them visionaries because they have the courage to dream of a better future and strive to improve the lives of millions), a common complaint I encounter is their frustration when told their idea isn't "big enough." These entrepreneurs are often thinking about a trajectory that leads to millions in revenue and a substantial 8 or 9 figure exit. They struggle to understand why venture capitalists (VCs) often write them off saying that their idea is "not big enough," especially when a 4x exit, translating to a 300% return on investment, seems so so amazing. Imagine a 300% return on investment, that's huge, right?

Here's where the motivations of venture capitalists (VCs) can seem a bit unconventional, and they significantly differ from those of angel investors and funds. While angel investors are primarily concerned with how their capital will grow (the multiple, the time period, the rate of return, etc.), VCs operate within a framework of regulations that often compel them to act in ways that might seem contrary to their individual interests.

For instance, VCs have a one-time opportunity to invest their money. If a fund is targeting a 3x return (a standard industry benchmark), and you propose a guaranteed doubling of their money in six months, the fund should not engage in that investment, even though it might seem attractive to you or me as individuals. The fund's goal is to achieve a 3x return overall, and a 2x return would actually dilute the overall returns. The speed of the return is irrelevant because the invested capital cannot be reused. Once an investment is made, it's like a bullet fired from a gun - there's no taking it back.

So that means each bullet has to have a chance to help a VC produce their target return. But paying a $10M valuation and getting out at $50M is greater than a 3x, right? I mean, getting 5x is better than 3x, right? Well, yes, but it's not that simple. VCs have to consider the entire portfolio, not just one investment. If a VC invests in 10 companies, and 9 of them return 0, and one returns 5x, the VC has a 5x return on that one deal, but a 0x return on the other 9. That's a 0.5x return overall, which is not good. So the VC needs to make sure that each investment has a chance to return 3x or more, so that the overall portfolio can return 3x or more. Very very complicated, right?

Absolutely, but let's not forget that many early-stage companies don't make it. In fact, a surprising number of Series A and B investments end up returning less than the amount invested. It's a bit like a plot twist in a thriller movie: surprisingly, more Series A and Series B companies are likely to fail compared to their Pre-Seed and Seed Funded counterparts.

So, this reality nudges the return requirements even higher. Imagine if you're a VC and you assume that half of your investments are going to flop. Suddenly, you need a 6x return on every deal that does work out. Now, let's say some of the deals only return 1x, or less than 3x — the returns on the successful ones need to be even more astronomical, pushing towards a whopping 10x. It's like a high-stakes game of investment poker!

In reality, different funds have different appetites. A relatively small fund, perhaps run by a group of high-powered executives from a major corporation, might be perfectly content with exits in the $200M range or even less. They can make their portfolio work on those terms because they believe their focus will allow them to invest in businesses that have a higher success rate.

But here's the twist: some funds, particularly those focused on consumer sectors, face a high number of binary outcomes — it's a hit or a miss. As the number of businesses that return success within a portfolio decreases, so does the required upside for each deal. If a fund's strategy allows for more than 60% of the portfolio to fail, they need to ensure that each investment has the potential for a staggering 50x+ upside. That way, the one deal that hits the jackpot makes up for all the ones that didn't. It's like playing a game of investment roulette!

So, there you have it, a sneak peek into the venture world. If your idea isn’t "big enough," it simply means that VCs are aiming for very very huge multiples to compensate for their investments that don't hit the mark. After all, they only have so many bullets in their investment ideas, and each one can only be fired once.

So what is the solution to this? Find VCs with fund sizes and theses & ideas that fit your business, not the other way around. Or forget VCs, find out the best path for your business — angels, debt, or as crazy as this may sound, self funding or bootstrapping as we call it in Founder's Speak. If your customers pay you and you can reinvest, you have no dilution and no silly VCs on your board asking how to “make the idea bigger”. It's your business, you know what’s best for it.

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See you next time! Cheers! 👍🏻