A New Era is Upon Us…
Getting into a relationship and some math for fundraising. VC Math really isn't traditional investor math, and realizing it is critical.
First off, sorry for disappearing over the last 3 months. As the last email covered, I’d gotten into the Antler India Residency, a startup residency based in Bangalore that placed you in a cohort of other potential entrepreneurs. There, you were to find a potential cofounder, hone in on an idea, and start building a startup… you then pitch to the Antler team to raise investment at a standard term of USD 250,000 (INR 2 crore) for 10% equity.
Well, that at the moment, isn’t seeming too likely…
After talking to hundreds of startup founders in Bangalore, I’ve come to two super interesting conclusions - both of which might not receive the due importance that they should (and there’s a reason for that, its in the incentives at play).
Conclusion #1:
A cofounder relationship is SUPER serious. It’s as big as a marriage, and might be even more consequential because it can destroy your personal and professional life at the exact same time. So, the find a cofounder in 3 months approach isn’t working for me.
It mostly just didn’t click in the way I’d have hoped for, but I’ve since thought about it A LOT and quantified what it is… this is what I look for in a cofounder relationship:
#1 - Do you just generally get along and trust each other? This is way more important than any skills or prior success metrics. In a startup, you’ll likely be spending years (count on at least 5-8 years) going through some extremely turbulent times with the person. Have you found someone to do that with without either of you disintegrating is the top consideration.
#2 - Do your fundamental attitudes on the world and business align somewhat? It’s not necessary that they do, but what is necessary is that there is agreement on what happens when your takes differ? Who’ll be the decider? (PS: I’ve always worked in environments where I’m the decider, and I’ve really prioritized my life to keep it that way! Changing this isn’t easy…)
#3 - Is there enough acknowledgement and spirit of equal contribution for you to share equity? Do you believe your cofounder brings as much to the table as you, maybe in a totally different area? Example: If the tech cofounder feels they’re doing the heavy lifting, while the business cofounder believes they could just hire a tech guy - resentment on equity share, discontent and trouble are around the corner!
The solution to this likely comes from #1 (getting along, trusting and respecting each other), but complementarity of skills and explicitly recognizing why you’re choosing that person as a cofounder is critical. Don’t jump into it if you can’t articulate it was my takeaway…
#4 - Clear and concise communication! This one won’t matter to everyone, but it does to me. Can the person effectively and succinctly communicate (in any medium - I can over email and text, but I also am not that great doing it in-person when it’s off the cuff). But yeah, if you can’t communicate core ideas well, it’s an issue.
#5 - Both interested in working in the same space and having a buy-in on the idea. This one is kind of tricky, but usually the founder who came up with the idea is likelier to persist through low times, while the other one could want to pivot / change the idea. Iterating fast is great, but there’s a method to it. Constantly changing up isn’t it. To prevent this, idea buy-in from both is super important!
Ultimately, the 5 things on the checklist above just didn’t click, and neither did I find anyone else’s idea super exciting to work on for years!
This gets us to…
Conclusion #2:
Big VC math is kind of INSANE! You need to make sure you believe your idea fits the VC bill before raising, otherwise it can become problematic.
Let’s do the math:
Venture returns are highly skewed!
First off, it takes 5-8 years (sometimes 10), for an early stage VC fund to roll over its entire fund - scout startups, invest, grow startup, raise further rounds, hopefully exit at higher valuation - consider this to be a 7-8 year cycle.
In a normal return of 10% (as can be achieved through stocks and bonds), money doubles in this time period of 7-8 years. For anyone to take the risk of doing VC investing (and covering the cost of running a VC fund - salaries of analysts, running programs like the residency - costed about 2 crores in just stipends for one batch - the funds expect a return of AT LEAST 20-25%. 4X - 6X (4-6 times) of the fund in 8 years. [$100 turns to $400 - $600 in 8 years].
But here’s where is gets crazy!
Look at the graph above, and VC funds know that 64% of funds deployed are going to zero. Another 18% will give on par returns to a bank deposit… 6% gets a 3-5X multiple,
that means the other 12% really has to return the entire fund’s returns…
Say a VC invests $100…
64% goes to zero.
Another 18% gets 2X’s, that is $36.
Another 6% gets 4X’d, that is $24.
After 8 years… with 88% of the investments, the VC’s $100 becomes $60 (36+24)… and this is WITHOUT accounting for the costs of running a fund! When you include salaries for the staff for 8 years, you’re below 40-50% of the fund’s starting investment (but let’s ignore that for now).
So, you have $60, but the other 12% investment needs to get you to 4-6X to just be an “okay” fund… that means that $12 of initial investment needs to become $500 - $60 = $440.
So… $12 goes to $440… the magic of math tells us that’s a 36.6 times return!
If you look back at the table above - it’s not looking great… within the 12% of successful startups bucket 7% returned 5-10X, and 3% returned 10-20X. So really, you’re counting on the 2% of startups to go way beyond the 36X multiple to even be a decent VC fund!
Let’s see where this gets us to:
7% return 5-10X, assume 7.5X, that is $52.5
3% return 10-20X, assume 15X, that is $45
Out of the $500 you needed after 8 years from your initial $100 corpus, you now have back $157.5 ($60 from the first 88% of companies, and another $97.5 from the next 10% of companies). That’s below the returns of just putting money in the stock and bond market, where it would have doubled to $200 in 8 years!
That means the only remaining set… the top 2% of companies, needs to make you $500 - $157.5 to be a decent VC fund - without accounting for ANY expenses!
That’s $2 becoming $342.5!!
Let’s assume Antler’s standard terms - $ 250K for 10%… that means Antler owns just 10% of the company (not even accounting for dilution when you raise money in later rounds and Antler’s ownership % also declines).
So basically in the $2 of investments made, just 10% of the company’s equity needs to be worth $342!
Keeping with Antler’s standard terms, assuming they invested in 100 companies, 2 of the companies need to account for those returns…
Turning $250,000 X 2 = $500,000 into a whopping 85,500,000 without accounting for salaries, dilution or anything at all really…
This means those 2 companies need to be worth at least $ 855 Million because Antler only owns 10% (and way less in reality). When you account for costs and salaries over 8 years, plus dilution when the startup raises money after Antler… it’s clear they NEED a Unicorn (a company worth over a Billion dollars) to outdo normal stock market returns!
That’s where the race for unicorn status comes from… it’s just VC math.
As a founder, you can still do well while not building a unicorn, hey, many have done it never making a cent in profit and actually burning millions of dollars… but you need to know the game you’re playing.
Do you want to build a profitable, stable business or do you want to build a unicorn. Some types of VCs want unicorns, many base their investing on more normally distributed success patterns where a unicorn isn’t required as the failure rate is lower… Many funders even might just care about cash flows and not valuations. So who you raise from must match with the type of business you’re building! Or inform you on if you even should raise money or bootstrap the thing…
Conclusion:
These two conclusions, and a few other lessons have really transformed my thoughts on how to approach entrepreneurship… more on that in the coming weeks!
In the end, Antler was an excellent experience and I’ve met some truly awesome people I hope to stay in touch with for the rest of my life… as for fundraising, I think I want to hit a few more validation checkpoints before I’m willing to commit to taking on the money.