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Demystifying Venture Capital Economics, Part 2

Andy
Rachleff

One of the most challenging things for people outside the technology world to
understand about venture capitalists is why they are willing to fund companies that
operate at a significant loss. After all, classic security analysis teaches us
companies dont have any value if they cant produce a profit. The operative word
in that statement is cant. Just because a company operates at a loss today doesnt
mean it cant be profitable in the future.

As I explained in Part I of this series, big winners drive venture capital fund returns.
Prior to the emergence of the Internet, venture capitalists made their big returns
behind technological breakthroughs. Almost every successful venture capitalist followed the same playbook
originally designed by Tom Perkins, the founder of Kleiner Perkins Caufield & Byers: Find companies that have
high technical risk and low market risk. Technical risk was reasonably easy to evaluate if you had a good enough
network of experts on which to call. Lack of market, not poor execution, was, and still is, the primary cause of
company failure. Therefore you never wanted to take market risk. You looked for companies that attempted to
build something that was so technically challenging that you knew people would want to buy it if it were
successfully delivered because it offered such a huge price/performance advantage.

Software Changed The Funding Formula

Post 1995 the world changed drastically. Almost every innovation came in the form
of software. Unfortunately software startups have the opposite characteristics of
what Tom Perkins taught the VC industry to look for. Software companies have
relatively low technical risk and high market risk. You know the company could
deliver its product. The question was would anyone want to buy it. As I said before,
market risk is generally not worth taking, so the intelligent VCs had to change their
business model. They outsourced to angel investors the earliest stage funding for
what they considered the poor risk/reward consumer-focused companies and
instead focused on backing them only when they proved the dogs wanted to eat
the dog food. The angels thought they won the business away from the VCs, but
the poor average returns of the angels would say otherwise. Waiting until a company proved it had
product/market fit meant having to pay a much higher price than they did in the past. Fortunately the Internet
enabled much bigger markets to be addressed than in the past, so their outsized returns could be maintained.

Let me illustrate with some numbers. Twenty years ago venture capitalists typically initially invested in startups at
a $5 million valuation with the hope the company could someday be worth $500 million. That could represent a
return of 20 to 30 times their investment based on the likely dilution incurred in future financing rounds (please
see The Impact of Dilution for an explanation of dilution). Today VCs are more likely to initially invest at a $50
million valuation with the hope the company could someday be worth $5 billion. Amazingly the number of
companies that generate $5 billion of value today is comparable to the number of companies that generated
$500 million of value 20 years ago. That means todays smart VCs are still able to generate the same kind of
returns as 20 years ago despite the much higher entry valuation. Please keep in mind not all initial VC rounds
are valued at $50 million. My intention was to provide an example that was correct in terms of order of
magnitude.

Invest After The Value Hypothesis Has Been Proven

The challenge for the VC is finding a company that exhibits product/market fit but not so obviously that she

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has to pay too high a price. Eric Riess phenomenal book The Lean Startup, provides an intellectual framework
that I believe best explains the VCs behavior. Eric (and I) believes in order to increase the likelihood of
succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The
value hypothesis should state the founders best guess as to what value will drive customers to adopt her
product and indicate which customers the product is most relevant to, as well as what business model should be
used to deliver the product. Its highly unlikely that a founders initial hypothesis will prove correct, which is why
an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is
achieved. As a consumer company, you know you have proved your value hypothesis if your business grows
organically at a rapid pace with no marketing spend.

Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The
growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders
mistakenly pursue their growth hypothesis before their value hypothesis. I explain the perils of this approach in
Why You Should Find Product-Market Fit Before Sniffing Around For Venture Money . Companies that nail their
value hypothesis are highly likely to figure out their growth hypothesis, but the inverse is not true (Socialcam is
perhaps the most outrageous example).

As you might imagine a company that has figured out its value and growth hypothesis is worth much more,
perhaps three to five times more, than the company that has just confirmed its value hypothesis. Therefore the
really good VCs try to invest after the value hypothesis has been proved, but before the growth hypothesis
works. In other words VCs are willing to take the leap of faith that the company will figure out the growth
hypothesis. You might think this is an obvious observation, but as I explained in Part I of this series, the vast
majority of VCs are not willing to take that risk.

Once a company proves its value and growth hypothesis, it has likely achieved the leadership role in a new
market. This usually spawns a bunch of imitators, but you might be surprised to learn that seldom does an
imitator or laggard ever overtake the leader once it has achieved product market fit. Thats true even if the fast
follower develops a better product. The only hope for number two in a segment is to change the definition of the
market (Nintendos Wii is a great example).

Market Leaders Attract Cheap Capital

You might also be surprised to learn that the leader in a market is worth more than all the other players
combined (Priceline is a great example). Thats why venture investors try to beat down the doors of a company
to have the opportunity to invest once it has achieved market leadership.

Technology market leaders often accept this additional financing even

when they dont need it to execute their business plans. To do so they
must believe the increased growth from investing faster in their
businesses has to justify the dilution associated with the unneeded
financing.

Im sure you have read about many successful consumer Internet

companies that recently raised on the order of $50 million, or more, at a
$600-million pre-money valuation soon after they did another round of
financing. This is the most common valuation these days (although
incredibly high by historical standards) when a startup has achieved
clear market leadership in a market that has a chance to be very large.

To justify the dilution associated with such an unneeded financing, the

management must believe the incremental percentage growth in
revenues from the financing is greater than the dilution taken in the
round. For example, lets say a company currently has a $10-million annualized revenue rate with expected
annual revenue of $160 million in four years. Lets further assume it can raise $50 million at a $600-million pre-
money valuation and with that money increase its revenue expectation in four years to $200 million. That would

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mean it would trade off an extra 7.7% of dilution for a 25% increase in revenues in almost every case that
would lead to a higher value per share for all stockholders.

Cheap Financing Drives Accelerated Growth (And Increased Losses)

The only way the revenue could have been increased by such a sizable amount was to have accelerated the
companys hiring of engineers to produce needed product more quickly (assuming more product leads to faster
growth) or to increase paid marketing (assuming it would generate a positive yield).

You often see subscription businesses like SAAS companies accelerate their marketing spend as long as their
cost to acquire a customer is less than their average customer lifetime value. This acceleration may lead to
significantly increased short-term losses if the annual revenue contribution of an average customer is less than
the initial customer acquisition cost; over the long term, however, it is highly worthwhile.

Lets look an example to illustrate this point. If we assume a companys average customer generates a profit of
$100 per year, 33% of the companys customers churn each year and it costs the company an average of $150
to acquire a customer, then it is highly worthwhile for that company to spend as much as it can as long as those
economics hold. Thats because the customer lifetime value of $300 ($100/33%) is far greater than the customer
acquisition cost of $150. However each customer the company adds decreases its profits (or increases its
losses) by $50 in the first year ($100 increased annual profit $150 customer acquisition cost), so it may appear
to uninformed outsiders that the company has made a stupid decision. Over the long term the trade will prove
worthwhile because the company will continue to generate $100 per customer for three years (the horizon over
which the average customer churns).

As frequent observers of this phenomenon, VCs encourage this trade despite the poor short-term optics as long
as they believe their portfolio companies long-term margins are likely to be attractive. Their point of view is
reinforced by the research we shared in Winning VC Strategies To Help You Sell Tech IPO Stock that found
technology companies performance post-IPO is most dependent on revenue growth, not profitability.
Accelerated revenue growth is almost always rewarded with a higher valuation as long as management is able
to convince investors that it addresses a huge market and can easily generate profits in the future.

The most exaggerated example of this strategy is Amazon. You have often heard Amazon say it could have
much higher margins if it wanted to. This is no joke. Management knows the smarter decision is to invest in
growth and they have been handsomely rewarded for it.

Technology Companies Are Valued Differently

There is a huge incentive to grow faster rather than generate profitability. This may sound like heresy but its the
way the technology business has always worked. Almost every market leader could generate a profit relatively
early in their life, but that would leave them open to an aggressive new entrant that wanted to change the rules
on them. Its far better to defer profitability and cement your lead than try to make a profit early.

Unfortunately people from outside the technology business dont understand how technology companies are
valued. As software continues to eat the world, youll likely hear many representatives of old line or soon to be
disrupted businesses denigrate the disrupters by saying they have an unsustainable business model or will likely
go out of business due to their spending rate. They also might point out how small the new entrant is; ignoring
the fact that at its current growth rate it will soon become very big. Psychologists have done many studies that
have found human beings have a hard time comprehending the impact of compounding. Ive been to this movie
many times and it always ends poorly for the incumbent once an upstart achieves product-market-fit. Thats
because momentum seldom dissipates quickly.

All That Matters Is Growth

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The other knock the uninformed and threatened use against young companies
with momentum is their VCs must be nuts to have invested so much in them
because companies in our space arent valued like tech companies and therefore
cant justify the sizable capital invested. Professional public tech investors care a
lot more about the growth of the company in which they invest than they do about
the traditional multiples of the industry in which the company participates. Time
and time again weve seen new software-based entrants that disrupt an old-line
industry get valued at what, historically, would have been viewed as crazy
valuations. Its pretty clear the Internet-based winners in cars, clothing, recruiting
and travel, among others, command lofty valuations. Motley Fool has dedicated
numerous posts to the correlation between growth rate and the price to earnings (P/E) ratio. The higher the
growth rate, the higher the P/E, independent of industry. Once again the top VCs understand that this
relationship is unlikely to change any time soon.

Economists believe the only way to earn outsized returns is to invest in highly inefficient markets. The lack of
common understanding around what constitutes the ideal way to build a startup is one of the greatest examples
of inefficiencies I know which makes it a huge source of the premier venture capitalists tremendous returns.

Related Posts:

The Impact of Dilution

Demystifying Venture Capital Economics, Part 1

The Wildly Different Financial Outcomes for Employees in Acquisitions

When Success & Stock Options Make It Expensive to Leave

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