Venture Math

by Steve Finn

Do The Numbers Work? workshop given on February 26, 2019 at DLA Piper Philadelphia.

Understand the motivations of your investor

What is VC investable? High-growth potential companies with a high CAC/LTV ratio. This is where the value is created. If it costs $5 to acquire a customer that will yield $20 of gross profit over their lifetime, it means every $5 I commit to this company is creating significant value in excess of itself. If you don’t have a company that can be high, scalable growth (like an agency, where costs increase proportionately with scale), and you don’t have a scalable plan to acquire customers and extract significantly more money out of them than you paid to acquire them, you don’t have a VC backable business.
Pre vs post money valuations - appreciation between rounds is the appreciation between last rounds post and this round pre.
Angels are all looking at things differently. Some want to get involved in something exciting, some are after more passive returns. Some make one investment every few years, some make many a year. Some want to see a quick exit, some are ok funding a lifestyle business that spits out cash to equity owners. Who the investor is makes a big difference. Do your homework.
VCs are generally looking only for investments that they see a clear path to a 10x+ exit. At the early stage, let’s see what that looks like, and try to think like a VC who is considering investment in your company.
VCs check size/ownership percentage - VCs generally have a target approximate check size and a target approximate ownership percentage, meaning you can rule out many VCs quickly if your valuation is not in line with it. Example - Fund XYZ generally writes check for ~750k targeting ~15% ownership. That means that even if they love you, if you’re not shopping a round around a 5MM post, they’re not looking at you.
Most of what I’ve seen, particularly in Philly where I’ve seen a ton of pitches, is a (pre)seed first round (not counting sub 250k friends and family), where founders are trying to raise 500k-2MM on a convertible note, usually at a 4MM-5MM valuation cap, 15-20% discount, 4-10% simple interest. Let’s define what this looks like. In practice for conversion, this means that the pre-money valuation at which these investors convert is the lesser of 20% off of the pre-money valuation of the new priced round and the valuation cap.

Example: Assume first financing (Pre-seed). Founders own 100% going in to this. 1MM Note Raise, 4MM Cap, 20% discount, 8% interest

What happens when you raise your priced round 18 months later?

Raise 1.4MM Seed @ 4MM Pre:

After interest - 1.12MM Investor 1 buying power
Effective Pre Money Valuation After Discount - 3.2MM
Post Money Valuation - 6.52MM
Founder Stake = 1 - ((1.4 +1.12)/6.52))

= 61.3% Founders, 21.5% Investor Seed, 17.2% Investor Pre-seed

Let’s say you give up ⅓ of the company 2 more times before acquisition, and each transaction is spaced by an additional 18 months. Think of it as a 5MM round on 10 pre (series A), and a 15MM round on 30 pre (series B).

For the series A:

Raise 5MM @ 10MM Pre:
Post Money Valuation - 15MM
Series A Investors: 5/15 = 33.3%
Series Seed Investors: 2/3 * 21.5% = 14.3%
Pre-seed: 2/3 * 17.2 = 11.5%
Founders: 2/3 * 61.3 = 40.8%

For the series B:

Raise 15MM on 30MM pre:
Post Money Valuation - 45MM
Series B Investors - 33.3%
Series A Investors - ⅔ * 33.3 = 22.2%
Series Seed Investors - ⅔ * 14.3 = 9.5%
Pre-seed: ⅔ * 11.5% = 7.7%
Founders: ⅔ * 40.8% = 27.2%

Acquisition @ 100MM:

Series B: 33.3MM - 2.22x
Series A: 22.2MM - 4.44x
Series Seed: 9.5MM - 6.79x
Pre-seed: 7.7MM - 7.7x
Founders - 27.2MM

NOBODY gets their 10x

It’s easy cognitively to think that the first investor here, who got in at what become an effective 3.2MM valuation AND had an extra 12% in firepower from interest would have easily gotten 10x, maybe 20. Not the case. This is why this outcome is not viewed as a home run by VCs. They need to invest in one of two things. Unicorns that can bring this multiple up high enough to pay back the whole fund, OR companies that are so capital efficient they don’t need much future financing to achieve an exit of this magnitude in their timeframe.

Additional Caveats

It’s risky to be an early stage investor

Later stages are rarely written down to zero. MOST pre-seed investments are.
Future investors have all the negotiating power when they come in. They can push for liquidation preferences, seniority, and lower valuations, all of which hurt the returns and increase risks of early investors.

VCs are internally assigning probabilities to your projected outcome

If you present financials and exit opportunities, expect that VCs are thinking about your business as AT BEST a 50% chance of achieving what you plan to achieve. 65% OF VENTURE FINANCINGS ARE 0-1X! After adjusting for probability, that leaves the pre-seed investor expecting a 3.85x return in this example. Not worthy of investment.

Time matters

Investors expect a premium for the risk, illiquidity, and timelines of early VC funding. In our example, the Pre-seed investor got a 7.7x return. That’s pretty happy in reality, but how long did it take to get there? 6 years. 40% IRR. This is very good, but not good enough in a world where more than 50% of investments will go to outright 0. That’s not the kind of IRR that lets this investment come close to paying back a fund where all else fails.

Let’s dig into VC LP structures

VCs raise money just like companies. The majority of reasonably well established VC funds are “2 & 20” - meaning a 2% annual fee and 20% of profits. For simplicity, let’s say that the pre-seed VC in our example has 1 LP (investor), who committed exactly 1MM on this hypothetical fund of 1 deal. In practice, there would be many LPs, more deals, and a GP stake, but I’m trying to keep it simple. Let’s boil down terms for the actual investor.

2% Management fees - over the 6 year life of this investment, that’s an additional 120k in management fees, so the actual capital committed is 1.12MM. Subtract that from pre-seed proceeds of 7.7MM, you’re left with a net gain of 6.58MM after the 100MM acquisition. 20% of that goes to the fund, leaving the investors with 5.2MM gained, meaning at the end investor level, this is a 4.7x, with an IRR of 36.9%. Super early stage funds are generally hoping to return 4-5x invested capital to LPs. In this case, this is a good outcome, but it is far from a great one, as the success of this investment doesn’t do anything to offset the failures in the portfolio. This is NOT the outcome early stage VCs are looking for when they evaluate investment opportunities.

Moral of the story:

Know your numbers cold. Be able to immediately answer questions about CAC, LTV, pricing/WTP, gross margins, projected expenses, and have a believable and compelling story for each one.
Model for scalability - create a world where your costs do not rise proportionately do your revenues.
Try to build a model with reliable recurring revenue - not always possible, but helps VCs back out their own assumptions on CLV
Start small, dream big - start your company with a narrow focus (i.e. “first foods for babies”, “worlds best mattress”), but with a logical roadmap on how to increase CLV. Increasing CLV is often done by increasing either lifetime or checkout price. Baby gear is a great example of where you can increase lifetime. In the case of little spoon, they are adding a line of toddler foods to their “first foods” offering. That means it takes a lot longer for customers to naturally graduate from the program, extending their lives and increasing CLV. For Casper, they’re unlikely to get you to buy more and more mattresses, so they expanded into adjacent high margin product lines to get your ticket price to be higher - like pillows, sheets, etc. Figure out which type of business you are and hope to be, and establish a roadmap that shows investors that things get better over time, not worse.
Your CAC is BS. At the earliest stages, CAC is all over the place. It can be that your channels are under optimized, so your CAC goes down as you refine your strategy. It can be that your channels are bringing in low hanging fruit who is chomping at the bit for your product, but that you run out of these customers quickly and your CAC goes up a lot to bring in the next cohort of slightly less interested customers. You won’t know until it’s too late, so the more you can test, optimize, and relay actual real world data to VCs, the farther along you seem, and the more trustable the rest of your story becomes. Figure out a way to learn as much as you can for as little as possible.

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