Sounds obvious. So I am puzzled when I get pitches where the basic parameters of investment returns are not met. There are many different types of venture capital investors. You should know which type of investor you are talking to. So here’s one real example from last month:
We’re selling an edge appliance for IoT management to mid-sized enterprises. We had a great year, doubling our revenue last year from $10 to $20 million, and still growing 72% next year, and now we’re raising our Series B.
Doubling Revenue – enough at your stage?
Doubling revenue sounds great. Especially when you already have $200 million of it and are 5 years old. But this is a Series B. You have only $10 million, and you have a few years to go. If you’re continuing to slow your revenue growth by 28%, then your growth forecast will look something like this:
That still looks good when seeing the revenue growth at 53% 3-year CAGR:
Keeping your Valuation
Let’s say at that growth rate, you get a valuation equivalent to 9x of Last Twelve Months (“LTM”) revenue (At your projected revenue growth rate that’s also equivalent to about 5.2x Next Twelve months (“NTM”) revenue multiple, btw). You are growing your revenue, and if I just keep want to hold the same valuation over the three years and are not interested in any gains (yeah, right!), I require lower and lower minimum LTM revenue multiples:
Increasing your Valuation
BUT (You knew there was a “but” right?!). I don’t just want the same valuation. Maybe I want to see a valuation increase of 3.0x at the end of three years. You also are going to raise another round, and my current investment might get a 17% dilution. So for a 3.0x valuation increase at 17% dilution, your LTM revenue multiple needs to be actually higher than before, at 9.1x LTM revenue!
But … your growth rate slowed significantly. So why would an acquirer buy at a higher LTM revenue?! There are man reasons. But you need to tell my why, and you have to give me the conviction, a reason to believe, that you can reach that goal.
3.0x Valuation Increase?! Really?!
You can look at this from two angles: (A) Return on burn, and (B) VC portfolio construction.
(A) Return on Burn
There is a great insight by Fred Wilson on Some Thoughts On Burn Rates. So say you’re at $10m LTM revenue and are getting a 9.0x valuation multiple (a valuation of $90 million). per the example above, your revenue will grow to $17m, $26m, $36m over the next three years. Lets assume:
- I am OK with a valuation increase of 1.5x in three years. Then I need a minimum LTM multiple of 4.5x in three years (per the table above).
- Your capital efficiency is 60 cents to the Dollar: for every one Dollar you spent on all of your operational expenses, you get 60 cents of revenue.
- I would like to see an annual value creation of 4x on the burn rate.
As a rule of thumb, and ignoring some revenue and cash flow recognition intricacies:
- Your maximum 3-year burn is $18.2m (equal to the VC and debt funding requirement over 3 years to make payroll, etc)
- But your total 3-year OPEX is $132.0m (per capital efficiency above), so in the three years you need to collect $113.8m in cash … or about 144% of your revenue.
But now I am also accepting your need for $58.1m of VC funding and venture debt over three years. That doesn’t seem very capital efficient. The bottom line here is that your growth rate is just not fast enough for the cash I need to supply you with. Your venture capital and venture debt efficiency is just very low.
(B) VC Portfolio Construction
Keep in mind that many things can go wrong. While my 3.0x / 44% IRR seems quite aspirational, I know that you are 70% likely to fail. My portfolio construction needs to reflect that risk, and my investment committee will ask hard questions and requires a minimum hurdle for both Multiple on Invested Capital (“MoIC”) and IRR.