Five Years Too Late

November 4, 2008

The Truth, or What We Want to Hear?

Filed under: Pitching, Startups, venture capital — Tags: , , — fiveyearstoolate @ 11:18 am
Eric Wiesen

Eric Wiesen

Years ago, when I was a Silicon Valley lawyer, a VC client related an amusing anecdote about being pitched by early-stage companies (I know, VC jokes are always the funniest). The observation he made was that every startup, regardless of sector, business model or average sale price has the same 5-year revenue projection: $50 million, plus or minus a few. The reason, he explained, was that if the 5-year number is much lower than $50M, the VCs won’t be interested, and if it’s much higher than $50M the VCs won’t believe the projections.

Last week, a company that didn’t follow this rule pitched RRE for their Series A round. This was a good pitch – a credible entrepreneur with deep industry experience and network, looking to take a “2.0” approach to a business where the entrepreneur had already had some success back in the 1990s with a “1.0” solution. It was all looking pretty good, and we were progressing smoothly through the presentation, checking off a lot of the boxes I’d need to see in order to start a process internally. Until we arrived at the financial projections.

As a sidelight, the financial projections for an early-stage company are always speculative. Entrepreneurs know it and so do investors. But they help us, if nothing else, get a sense of how a given founding team thinks about the scope of an opportunity. And in this case, the financial projections showed the company quickly ramping up to about $15M and then almost totally leveling off, to the point where the 7-year projection was around $25M. And while I didn’t want to play into the stereotype above, I was professionally obligated to ask why the growth slowed dramatically in the “out years” in the model?

There are a few possible answers to this question, frankly none of them particularly encouraging.

  1. You can (and most people, facing this question, do) argue that the assumptions in your model are so overwhelmingly conservative that while your projections say a small number, you really expect a much larger one. That doesn’t do well – while we appreciate conservative projections, it should be at the margin. If you really think this is a $100M business, your number should be relatively close to that.
  2. You can tell us that this simply isn’t a particularly big market, and that the slow growth in the out years represent an early ramp to scale, and a tough fight for market share once the original ramp has been climbed. This is troubling, as early-stage VCs rarely want to get involved unless the addressable market is large enough to generate a big outcome.
  3. You can tell us that the market is very fragmented, and that growth will be hard to come by as you fight with incumbents for share. This, too, isn’t something we like to hear, as it implies that it will be expensive and difficult to grow, and as Stuart sometimes says, “Some markets are just too hard”.

When pressed, this entrepreneur gave answer #2 – this is a market with a finite number of customers, and the financial projections he gave me reflect his (expert, I agree) estimate of his ability as a newcomer with a superior product, to gain market share – quickly at first, and more slowly in the out years.

The challenge is this – I appreciate the honesty this founder showed in telling me his genuine viewpoint on where the company can go. He also shared that he views this is a “good but not great” exit. A “double” if you like baseball metaphors. He’s doing this the right way, building realistic expectations for his business rather than telling me what I want to hear.

And yet – what I want to hear is that this can be a $100M revenue business that we can credibly see as a billion-dollar exit if everything goes according to plan. Because early-stage investing is simply too difficult to bet on companies where the best-case scenario is a $100M exit, even if that’s a great multiple on a couple million invested. Because best-case scenarios are rarely achieved, and when they are, it needs to be a real event for RRE.

So if I were this entrepreneur’s friend, and he asked me for advice on pitching RRE on this business, what would I tell him? I think the route he chose is admirable, but isn’t going to get him an investor. I simply can’t pound the table at our Monday meeting and insist that we have to do this deal, because even though I really like the team and the product vision, if they don’t think it can be a huge winner, I can’t. And I certainly don’t want him to lie to prospective investors about likely success, because that will simply lead to an unpleasant and combative Board of Directors/Management dynamic, when investors realize they’ve been sold a bill of goods.

No, I think what I would tell him is this: Go back over your plan from the beginning and see if there’s a way to make it bigger. Are there adjacencies you can exploit once you’ve established a beach head in your target market? Are there additional streams of revenue you can exploit? Underlying data assets, lead generation, marketing partnerships, greater distribution? Are there different verticals or other opportunities for value-added services within the vertical you’ve chosen?

If you want to be a venture-funded company, try to find a way to have a $50M business doing what you’re doing. Because while the anecdote at the outset is amusing, the risk profile of early-stage venture capital is such that you are going to get a lot of no’s if you can’t look us straight in the eye and get to some number close to that.

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  1. Great post… except that you missed out on a very important data point. What was the capital being sought by this entrepreneur? You mentioned that it’s a “double” situation with $100M exit. Besides the reasons you already mentioned, the venture doesn’t sounds like a capital efficient business to begin with. If the capital being raised is at the low-end of a typical Series A deal with further look into operationally lean business, what’s wrong with a $100M exit? You also infer directly to the “capital gap” in early-stage investing. Generally speaking, from a close to $1B AUM like RRE, this is not a good deal. Remember, there are other venture invetors with smaller pot of money and they will be happy with this “conservative” outcome. The generalization of “a venture-funded company” with $50M business as a mediocre outcome is overstatement.

    Comment by Chris — November 4, 2008 @ 12:31 pm

  2. I think you as the VC are way off on your expectations. These are new times my friend.
    This could be considerable less risk then a typically investment you make due to the individuals track record and knowledge. On a risk adjusted investment basis this could be a great deal. Perhaps your model of missing 10 times out of 11 will not serve so well in the future. The big payouts for “pretend businesses” based on eyeballs are gone, you are going to have to adjust or find a new job.

    Good luck.

    Comment by Ron — November 4, 2008 @ 1:07 pm

  3. Chris – let’s say for argument’s sake that the company was raising $5M on a $5M pre-money, which would make a $100M outcome a 10X return for RRE. That would assume that we can sell the company in 5 years for 5X the $20M revenues it projects. There are a lot of assumptions here – that the company is successful to plan, that we get 5X revenues, and perhaps most importantly, that they never have to raise any more capital. None of these are necessarily great assumptions, and on a risk-adjusted basis, it doesn’t justify the deal in my mind. If other investors disagree, they are welcome to get involved. But this isn’t simply a matter of a company needing $2M to get to a $75M exit in 2-3 years, which is a good deal for a lot of funds.

    Ron – Thanks for the comment. But I think you make too many assumptions about our investment thesis here at RRE. We don’t expect to lose money on 10 out of 11 investments and see the 11th turn into Ebay. That’s never been our model here. And if you look at our portfolio we have very few “eyeballs businesses”, so I’m not sure where you are getting that. At the end of the day, the point of the post is that an early-stage, pre-revenue business that offers a relatively modest best-case outcome is going to have a hard time getting funded, here or elsewhere. You assert that on a risk-adjusted basis this could be a great deal … without knowing anything about the deal, because out of respect for the company, I haven’t told you. But my conclusion after seeing the presentation was that while it looked pretty good, it was for exactly the inverse of your claim that I passed – it’s not a good risk-adjusted bet given the company-building that has to happen and the displacement of incumbents that needs to take place for even a modest outcome.

    Comment by fiveyearstoolate — November 4, 2008 @ 1:15 pm

  4. NY VC firms are rarely about hitting 1 out of 10 out of the park. We are more data-driven and deliberate, likely thanks to a Wall Street mentality. Silicon Valley is more tolerant to writing off 90% of their investments in exchange for the grand slam that returns twice the fund.

    RRE’s portfolio is largely comprised of B2B companies, and pretty much no ad-supported models. They do not make capricious investments. They invest wisely and thoughtfully.

    A 10x return is certainly an attractive opportunity, more than a double in my opinion. The problem is that too many things have to happen correctly in order to reach that 10x return. That’s a best-case scenario. It could feasibly wind up being a 4x return, which is good but may not be worth the brain damage of due diligence, Board presence and syndication of any future rounds.

    Comment by Andres Moran — November 4, 2008 @ 3:52 pm

  5. Thank you for the introductory peak into the kind of deals that RRE looks for. I wonder how your parameters have changed over time, as RRE as matured and as the economy has slowed?

    Comment by Aaron — November 6, 2008 @ 12:11 am

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