Why VC funding might spike your dreams

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By Francis Moran

One of the more thought-provoking presentations at last week’s International Startup Festival was by Randy Smerik, a serial entrepreneur who has lived through more than one startup, venture capital investment and eventual acquisition. His personal experience added a significant note of authenticity to his session, “Build 2B Bought,” but it was the statistics he presented that really got me thinking.

Let me summarise Smerik’s narrative.

  • There is a 90 percent chance that the eventual liquidity event for a startup will be its acquisition by another company.
  • The average merger-and-acquisition (M&A) exit is worth $20 million.
  • A VC investing only $2 million into a company and acquiring 20 percent of its equity based on a $10-million post-money valuation will need to earn $20 million on that investment to get the minimum 10x return that VCs target from each investment. (Admittedly, Smerik did acknowledge that most funds get a 20x to 30x return from two out of every 10 investments they make, with the other eight returning little or nothing.)
  • At a 20 percent ownership level by the VC, that means the company must sell for $100 million.
  • But the average M&A deal is only $20 million.

As Smerik said, “Yikes! This is a problem.”

And it’s a problem for any group of founders who find themselves favourably considering the chance to be bought for a sum that represents a multi-million-dollar payday for them, probably a pretty decent return for their early angel investors, but something less than the minimum 10x desired by their VC investors, who then spike the deal.

Real-world scenario shows an impressive exit for founders and angel investors but a sub-par return for VCsIn the scenario outlined to the right, the VCs would probably invoke the protective provisions they insisted on when they put in their money and veto the deal, insisting that the company continue to operate until it grew to be worth much, much more. Think for a minute what that would do for founders who saw their golden ring snatched away from them but who still had to labour each day on a project they had been quite willing to sell off.

Just as distressingly, this narrative makes me wonder why anyone would engage in venture capital in the first place. As Fred Wilson details in this post, the 10-year returns for most venture funds were lower than those offered by any of the three major public stock market indices.

I asked Smerik that very question after his presentation. “The business model for VCs does work because in reality, they do get two out of 10 to be that 10x return on their investment.” He acknowledged, however, that “the returns are less (for VC) than (for) standard investments…with much higher risk.”

So why the heck would anyone invest in VC and why the heck would any entrepreneur take the money? The latter is a question I believe more and more entrepreneurs are dramatically answering as they bootstrap their companies and explore alternative funding mechanisms such as crowd funding.

As for why VCs continue to put money in the game? Here’s Smerik again: “People still do it and they do it for a strange reason in the sense that there’s a lot of people with just so much money and they have to put it to work. And they’re willing to take that risk.”

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