One of the smart people I’ve recently met (through Twitter) is David Kirk. I’ll quote from the NI-tech blog to give you an idea of David’s background:
David Kirk is a successful executive, entrepreneur and investor. During his career – almost four decades of software, networking and telecommunications – he has held executive level positions in engineering, marketing and sales, with start-ups and Fortune 10 companies. He was Vice President at American Online (AOL), where he led the world-wide launch of their online service, and managed the development and operations of their business systems, including billing, eCommerce, Internet advertising and fraud management.
After AOL, David was Senior Vice President at Cisco Systems, where he managed their core software development, and was general manager of their enterprise voice business. Currently David is an active private investor, and has board positions on a number of companies, including Axis Three in Belfast. He is passionate about promoting Northern Ireland as a tech destination.
David was born in Belfast, and now resides in San Francisco, California.”
His main activity is as a business advisor & private investor and he has a very strong interest in developing Irish technology start-ups. In the past 2 months alone he has evaluated 60+ business plans from Irish technology companies. Based on this experience he has offered to write a 2-part blog-post on how a VC looks at the funding process and how what calculations a start-up looking for funding should use. Below is the first part of his post:
Whether you are an entrepreneur or a VC – I like to think I have a foot in each camp - we live in interesting times. Barely a month goes by without a new report showing some “interesting” aspect of investment in 2008/2009, whether it be valuation multiples, return multiples, shift in investment stage focus or just the consolidation of funds out there.
While there is, and always will be, market specific conditions that free or freeze funds, the basics of investing in technology companies, remains somewhat constant, and should always be considered as the backdrop to any specific funding strategy.
When a company seeks funding, they are selling themselves and the investment opportunity that their business represents to the investor. I’m of the opinion that selling, whether it be ice cream or cars, is always much more effective when you really know your potential “customer” – their needs, their wants, what they look for, hot buttons, turn off’s. Its no different with VC’s. It’s a business. We need to make money, just like you.
So how does it work?
The returns on any investment, is governed by its risk. The riskier the investment, the higher the returns expected. Investing in technology startup companies is very risky. Failure rates of up to 90% are quoted. VC’s expect and plan for 60-70% of their portfolio companies to fail or limp along. Similarly, investors in venture funds – the Limited Partners – expect a corresponding higher return than safer investments. The US ten-year average returns (IRR) on all venture funds in ~17%.
At this point, the discerning reader has all the information needed to determine every ratio and “rule-of-thumb” that will follow. But there is need for a great big caveat. Presented here will be pro forma numbers. I have never seen, nor heard of any business, investment opportunity or fund that mirrors exactly what is given here. The exactly numbers and ratios are somewhat interesting, more – much more – importantly are the ideas behind the numbers. Grasp these, and you’ll be able to apply the principles to any, real-world situation.
Right. Now that’s out of the way, back to arithmetic.
I’m a fund manager. I have ten portfolio companies. Being smart (i.e. I’ve lost money in the past) I’m planning for three of those companies to fail without returning anything, and three or four to “go nowhere”, returning, perhaps, the money that was invested. That leaves three “winners” in the portfolio to generate all the returns for the limited partners, the “carry” for the General Partners, and to cover the management fees. That means that each of these “winners” has to return x10 – x15 the investment, to cover the “losers” and the “going nowhere”.
My personal rule of thumb is that an investment needs to return x7 – x10 my investment in 3-5 years.
OK. Next we need some discussion on how to calculate “return”. On one hand its very easy to calculate, but the simplicity in calculation, belies an ocean of “art” and “judgment” surrounding it. If my investment in a company buys me x% of equity, then my return is x% of the exit valuation $y. At this point, given two variables, it could almost appear that we can plug in whatever values for x and y we like, to come up with our investment multiple. Not quite. I look for 20%-25% equity in a company (but, full disclosure here, every investor and VC has there own perspective on this). Less and you lose “influence”, more and you risk demotivating the founders. But be very careful here, you’ll hear many times the argument, would you like 80% of $1M business or 20% of a $100M business.
Equity understood. Check!
What about valuation. This is where you will need to do your own analysis, based on industry, business model, geography, etc.. In general, the exit valuate is based on a multiple of either revenue or profit. As an interesting sidebar, in the absence of both – as we experience in 1999 – valuation of those dotcom darlings was $1M per developer. Science? Nay, magic eight ball. Over the past 15 years, predominantly in software, I’ve used smaller and smaller multiples. In the mid-90’s, x5 revenue seemed to fly with trade sales. Today I use x2, and even that is appearing to be generous. Exit or investment valuation is 90% art, 10%science and 100% negotiation. You need to understand this.
OK. At this point you should be able t answer the last question a VC asks “is this a good deal for me?” But there is one big variable that will depend upon whether you are looking for investment from a $1B fund or a $10M fund. That is scale and bandwidth. An individual VC can only adequately manage a handful, or two, of portfolio companies. If there are n VC’s in a $1B fund, then the average deal size is likely ($1B/10n)*.60 (where 60% is ration of funds invested initially). Calculate that out. Perhaps their sweet spot if $5M – and likely you can find this on the home page of their website. So now you have a very simple litmus test.
With a $5M investment (ignoring followon money), a 25% equity position, and an exit value of x2 revenue – the revenue in year 5 should be at least $100M.
Big gulp!!!
Part 2 will go into the first three things a VC looks for in an investment opportunity; a big market, a hot product, and a team that can deliver.
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