On to the fieldnotes...

In every segment of Deciphering, I explain something you might hear from a VC. Today I’m tackling…

“I don’t think this is venture backable”

This phrase is rarely followed by “and here is what I mean by that…” which leaves founders hurt, insulted, and confused. I’ve had multiple founders over the last month reach out in exasperation. They yell, “How could they say this? What do they mean? Look at _______”

• How severe the pain point is for these customers!

• My beautiful / incredible product!

• My track record and experience!

• My current revenue!

• My potential revenue!

I understand why someone who genuinely has identified a real pain point, built a great product, and generated revenue would be confused and even irritated. With all these amazing things going on, what in the hell do investors mean “this isn’t VC-backable??”

What it all means

First – if an investor says they don’t think your company is venture-backable, they AREN’T saying:

• There’s no customer need

• Your product sucks

• You’re a crappy founder

• Or even... you’re a bad business

In short, they’re simply saying, they don’t think investing in the company fits their business model.

To be clear, they might actually think you’re not running a good business because that for sure doesn’t fit their business model. But that specific question hits more at their doubts that even if you are a great business, that it can’t be big enough to return enough money to fit the VC business model.

Not fitting the VC business model

Remember – the VC business model is an outlier business. Venture capitalists invest in a portfolio of early stage companies expecting the vast majority to be worth $0. For this strategy to work out, any one investment they do has to have THE POTENTIAL to be extremely large so that if it is one of the very few that doesn’t go to zero, the proceeds from that win will cover all the other zeros in the portfolio.

If a VC decides to invest in a business that will make a lot of money but not be big enough to “return the fund” (i.e. exit large enough to give the investor returns equal to the size of their whole fund) then they’ve not only wasted one of their few bets but also the time and effort it will take to manage that deal.

Said another way, if a founder raises $4MM from a venture fund and sells for $50MM pocketing something like $25MM, she has made a life-changing amount of money. That’s a personal grand slam.

For the VC?

That might as well be a zero. Let me repeat. That might as well be a ZERO.

How??

Let’s break it down:

The math

Assuming the fund wants to make 25 investments with a $4MM average first check size and reserves 100% for follow-on investments (additional checks written into an existing investment), this would be a $200MM fund ( [$4 + $4] * 25 = $200 ). If the fund owned 20% of the company when it exited, it would make $10MM from the sale of the company (2.5x of their investment!).

2.5x might sound good, but owning 20% at the time of an exit is a generous estimate and for a $200MM fund, it would need to have twenty of those exits (out of 25 investments) paying out $10MM each in order to just return 1x of the fund. That doesn’t even take into account deduction of management fees!

A fit for VC

Consider instead that this firm invests in a company that sells for $20B to Adobe. After multiple rounds of dilution they own 5% of that company. They’ve now returned $1B in one deal. Every other investment that was a zero is inconsequential. A deal that just returned $10MM is a rounding error and also inconsequential.

This model only works if every single bet they make has the POTENTIAL to be that $20B Figma outcome. So if you don’t fit into that model, then no matter how good of a business you are, you won’t be venture-backable.

So what should you do if you hear that?

First, consider the feedback. Are they right?

If in your heart of hearts your company could be massive, then consider why they misunderstood or didn’t get the message. Was it a communication problem? Did they not believe your assumptions? Were there concerns about specific inputs into the business?

I put together a simple worksheet to help think through how you would fit into a venture portfolio. Check it out to make sure your assumptions work in the model! – https://docsend.com/view/7pd3f8x2h8ue35aj

If after honest reflection (and my worksheet) you realize you might not be running a business that fits a VC model, what should you do?

If you’re running a good business that doesn’t fit but you like what you do, keep going. Venture capital isn’t the only path to capitalizing a business. Focus on financing through revenue (i.e. bootstrapping) and consider calculated investment through debt or other lines of credit.

Finding out you shouldn’t raise venture-capital early on is a gift – follow the path that is right for you.

Smart Twitter Takes

Good thread on business models and revenue. If you have really “good” revenue…help VCs realize that when you talk to them.

Part of convincing investors in the earliest stages is showing them you have what it takes to find product-market fit. Read about that process so you can make sure that’s communicated well in fundraising

P.S. Itz me