Investing in early-stage startups and building a venture fund is a game of probability; placing multiple bets with the aim to have one big winner (unicorn) to bring all the returns.
It is mathematically more profitable for investors to have one big winner rather than having several smaller winners. It is almost guaranteed that investors won't see returns from a majority of their portfolio, especially when investing at such early-stages. In the end, the total number of failures doesn't really matter as long as there is one well-placed bet. Welcome to the world of venture capital; a game of statistics and chasing unicorns.
In order for VCs to be profitable, they are looking for x100 returns on their initial investment. For most founders, increasing your valuation by x5 or x10 is already a great achievement and it can be difficult to imagine what going to x100 would look like. There is a good reason why 100x has become the standard figure in venture capital. The fund also needs to take into account the dilution of capital that comes with every subsequent round.
<aside> 💡 Investors typically get around 20% of their stake diluted on each new round, leading to a total dilution around 50% from entry to exit for early stage investments.
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The common standard figure on desired returns are as follows: (source)
Seed up to Series A: 100x Series B to Series C: 10x Pre-IPO: 3x
Based on the estimate that a well-performing fund has around 8 to 10% success rate, then out of 10 investments, 1 would bring the needed 100x returns to make the fund profitable. It is possible for a fund to still be profitable without hitting a 100x return on one investment, but this is not the goal nor intention of the fund when reviewing deals.
There are several elements that come to play for identifying whether or not a company is a good fit for VC backing. One general indicator, following the expected returns as covered previously, are companies that can generate $100 million in revenue in around 5 years time.
Mapping this on a 5 year timeline would roughly look like:
In order to evaluate whether or not a company has the potential to generate such revenues, investors look at business scalability and signs of product market fit, especially at pre-seed, seed, and Series A stages.
A business is considered scalable when it has the potential for exponential growth without incurring proportional increases in costs. One key factor in achieving this is understanding the unit economics of the business, specifically the cost of acquiring a customer compared to the revenue generated from that customer. To achieve scalability, a business needs to have a sustainable and predictable method for customer acquisition, enabling it to continue acquiring customers at a lower cost over time. Additionally, exponential growth can only be achieved if revenue grows at a faster rate than the costs incurred to acquire and serve new customers. Ultimately, a scalable business is one that can grow its revenue faster than its costs, which requires careful planning and execution of business strategies.
The most challenging part of any early-stage venture is finding product-market fit. Even startups with strong traction and healthy recurring/projected revenues may not have figured their product-market fit yet. In order for investors to see higher chances of 100x return, investors would need to come in at lower valuations, which in many cases comes at a higher risk.
This is an important element to consider for any startup looking to raise funds from VCs. Even for founders that have successfully raised before, going into subsequent rounds can become exponentially difficult as it becomes more challenging to convince investors of the potential multiple in venture returns.
Raising from VCs is not always ideal or the only feasible solution; when and where possible, focus on reducing overhead costs, growing customer revenues, and learn not to rely too heavily on external capital.