Ask a VC: research a VC before asking for a meeting
(Originally posted on 8 June 2018, last updated on 30 October 2023)
This is a follow-up post to my previous one on how to get in touch with Expon Capital.
I had an early breakfast this morning with an entrepreneur I knew. He came with a list of VC names that he wanted an intro to from me. This raised 3 concerns:
Although I fully understand that his job is not to be a VC expert, he clearly had no clue about how a VC works, what we look for, and had made very little research on the VC industry. Yet, he was adamantly asking for a big check size for his business and for the intros.
Firstly, most VCs have a specific investment thesis, and typically invest in either a specific industry, specific technology, or specific geography, at specific stages. Most of us have gone into the trouble of describing that on our websites. Check the sites! Read about our past investments. As this morning showed, it doesn’t make sense to put Seedcamp and Atomico in the same target VC list, because they cater to companies at different maturity stages! And even within a fund, different partners have different specialties or tastes. Do your research instead of wasting a VC’s time and your own. There are professional advisors who can help with this, with pros and cons. They know intimately each fund, and the partners. A targeted list of investors suited to your company will help save so much time for everyone.
Secondly, if we start with the basics of a transaction, the best salesman never sells. He makes the buyer buy. Trivial? Well, my entrepreneur this morning only spoke about his business, about his product, about how he did this and that, and that therefore he was somehow “owed” an investment in his business. This is wrong.
It so reminds me of this parody video when Microsoft re-designs the iPod packaging.
Selling is all about talking about yourself and listing a series of product attributes. That seldom triggers a purchase decision (any academic reference on this anyone?). A much better approach is to project benefits to the buyer, and make him buy your product. That means understanding what triggers the buyer, in this case a VC and actively listening to the person in front, not just reciting a prepared pitch.
Hence, VCs are basically asset managers for third parties, what we call in our jargon, the Limited Partners. They give us money to manage, usually for 10 years, and expect a return on this money. Most VCs aim to return 3 times their fund. With an average of 6 years of holding time for each investment (and we’re on the lower end here of the bracket — see pages 30–31 of the NVCA report 2017), that is equivalent to a 20–25% IRR/year.
The VC’s job is therefore to make money for his LPs; and as any asset manager would do, work on the risk / reward ratio. I will repeat this: on the RISK and on the REWARD of a potential deal. There you go, this is what you need to talk about in a pitch, after talking about what it is your company does, the VALUE PROPOSITION.
- VALUE PROPOSITION: what pain are you solving, on what market (size, growth), for which customers, by doing what specifically, hopefully which a competitive advantage (more on this in another post).
- REWARD: how much ROI can the VC expect to be doing on this investment.
VCs will assess this by looking at the market size (understand the difference between TAM and SAM) and at how much the company is aiming to achieve in sales. This gives an expected % of market share. Too small, and the company won’t really matter in the marketplace (hence will probably not get a good exit). Too big, then the entrepreneur is not realistic and also will not get an exit.
Valuation of the company plays a big role here, as multiples of EV or EBITDA or sales will be used in order to predict a potential exit price, hence the projected ROI the stake a VC would take now, taking into account future financing rounds, hence dilution.
Let’s assume a SaaS business, raising 2m€ on a 8m€ pre-money valuation, implying a 8+2=10m€ post-money valuation at a series Seed stage (yes, companies pitch us those valuations…). The VC takes a 20% stake in the company. Let’s assume a series A with a 25% dilution, and a series B with a 25% dilution, that stake will be worth an 11,25% stake in the business at exit.
The usual metric is that 1 company out of 10 will succeed, all the others will either go bust or return the money; we then need each company to have a potential of 30x, so that a portfolio of 10 companies, will return 3x (assuming all others return 0, which is over-simplified, as some companies will return 1–3x).
Hence, an 11,25% stake has to return 30x. In this case a 2m€ stake x 30 = 60m€ stake value at exit (assuming also no capital gain tax); the company has to be worth 533,33 m€ at exit (the majority of exits in Europe is 10–20x less — see PitchBook European Venture Report Q1 2018 — page 13…. The median exit valuation in 2017 was 33m€ ! ). Let’s assume a 15% EBITDA. Using market data, Software has an EV (= enterprise value, assuming no debt here) / EBITDA of 22. Hence the company has to make 24,24m€ of EBITDA, and hence 162m€ of revenues at exit time (let’s say 6 years after investment). Assuming a 1b$ market size, this requires a 16,2% target market share… and requires, assuming a doubling every year of year 1 : 1m€ revenue, year 2 2m€, year 3 4m€, year 4 8m€, year 5 16m€, year 6 32m€, year 7 64m€, year 8 128m€, year 9 256m€… That is exponential, but maybe too slow, and the starting year might be below 1m€ ! Hence the company has to find a way to increase revenue even faster !
Tough to make the maths work, unless the team, market opportunity, competitive advantage, etc. are exceptional. And this is the mental back-of-the-enveloppe calculation VCs make when they meet an entrepreneur and ask for a market size and expected revenues… which often leads to an early NO to an investment.
The way to deal with this is to make the calculations yourself before coming to a meeting (meaning really understanding your unit metrics and competitive advantage), and understand how you are shooting yourself in the foot, by asking too high a valuation at the beginning, or taking too much money.
Raising the same money with half the valuation, ie. 2m€ new money on 4m€ pre-money valuation, will give a 33% stake in the business to the VC (maybe a bit too much, so raise less money ? be more lean ?), but will also require less revenue to be achieved, hence a more plausible outcome scenario, hence a likelihood to get more yes from VCs, even a few, hence to drive the price up again for those who really want to invest. Starting with a high valuation is usually a bad idea. And makes it difficult to raise the next round if the milestones have not been met (more on this on another post).
I’d highly recommend ‘Venture Deals’ book, by Brad Feld to better understand this.
- RISK
All questions a VC asks thereafter on market, competition, competitive advantage, unit metrics, team, go-to-market and so forth, is a way to assess the likelihood of the company to reach the target revenue, hence target valuation, hence target return on the invested money.
It is a great idea to think about all the risks (ie. what could go wrong), and how to mitigate them. And write them down. When a VC invests, he usually writes an investment memo, shared with his LPs, where he WILL list a long section on risks. Help him out by doing part of the work. For sample risks (too detailed), check the Risks section of an S-1 document (the prospectus for going public) on any tech company on Edgar.
Preparing a meeting with a VC is not that hard and not magic. The aim is to make him invest in the business, not to give him a detailed lecture on the ins and outs of your industry and on all the features of your business.
As for the original request this morning, I personally would do an intro to another VC almost exclusively if I’m interested in investing in the company myself and would like to syndicate the deal. It’s almost a red flag if I’m sent a deal by another VC who has declined to invest himself. The only reasons would be of a conflict of interest with an existing portfolio company, or if for some very good reason I can’t do the deal and I know that the other VC would be interested in having a look at it.
note: this morning’s situation has happened a lot, and I’m sharing in order to give insights on the way VCs work, hoping to help entrepreneurs be more prepared for a meeting, and getting more often to a yes ;p
ps: asking me if I have time for coffee out of the blue, without stating that you are actually trying to raise capital is a waste of time. I don’t have time for random coffee on a weekday. It’s much better to email me with a full deck, or apply on my website. We have a very good process to work on your funding round. Don’t be fooled in thinking that because you pitched me casually over coffee that you are establishing an advantage. If the market is big, the problem is real, and you are executing a great solution to it, with splendid unit metrics, then I’m interested in reading your deck and potentially meeting you. And I’ll serve you a cup of coffee 😐
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I consult with corporates and startups and help them address issues like this and many more. Don’t hesitate to reach out at www.rodrigosepulveda.com or book a video call with me on intro.co.
