Why your revenue projections aren’t big enough for some VCs

I just read a great post over the weekend by Michael Dempsey: Why your startup idea isn’t big enough for some VCs.

In the post, Michael explains how VCs think through whether or not you’re startup is big enough for them to invest in. In short, VC returns follow a power law distribution meaning that the majority of returns are driven by the outsized returns of a few investments. As Peter Thiel put it, “to a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund” (via Blake Masters). Therefore, each time a VC considers an investment, they need to believe it has the potential to return the fund. Given the fund size and desired ownership target (typically 20–25%), you can figure out what type of exit you’d need to return their entire fund. He dubs this Return the Fund (RTF) analysis. The resulting equation is:

RTF = fund size / ownership target

I have explained this concept to several startup founders in the past — I usually take it one step further and explain how this relates to revenue projections. Keeping with Michael’s RTF terminology, my equation is as follows:

RTF / Revenue Multiple = 5 year revenue threshold

Revenue multiples are commonly used to help value companies, particularly companies that have negative earnings and/or where data is scarce (ie. young tech companies). Within sectors, multiples are often tracked as they provide a helpful way to index a company against a benchmark. Bessemer’s Cloud Index is a great resource for SaaS Revenue Multiples (typically EV/Revenue) for publicly traded SaaS companies. For private companies, where data is not as readily available, these multiples can be harder to come by but private companies typically are valued at multiples in the higher end of the public range. The rationale, as Tom Tunguz at Redpoint and others have shown, is that higher growth rates typically result in a higher revenue multiple. So it’s common to see fast growing private SaaS companies get acquired or go public at multiples at the higher end of the range.

For our purposes, I typically will take the prevailing median EV/Revenue multiple for public SaaS companies (currently 6.5X for a group that I track but let’s round up to 7X) and apply that to a SaaS company’s ARR run rate. I find that this is a good way to approximate the higher multiple that is likely to result from above average growth.

Here’s an example calculation that brings this all together. Say that you are a SaaS company that is going to pitch Venture Fund XVII. You did some research beforehand and found a press release that said VF closed on a $250M fund last year. Here’s the quick calculation that you should do while assembling your deck:

Venture Fund XVII

  • Fund size = $250M
  • Ownership Target (min) = 20%
  • RTF Exit = $1.25B
  • ARR Run Rate @ 7X = $179M
  • ARR Run Rate @ 10X = $125M

So if you are a going to pitch Venture Fund XVII, you need to come armed with financial projections that tell a credible story around how you are going to get to $125M —$180M in ARR within the next 5–7 years (that’s $10M-$15M in MRR). If you are projecting $36M ARR / $3M MRR by the end of year 5, you are most likely not telling them the right story (independent of how well you are telling the story).

Obviously there are some exceptions but I tell my CEOs that this is how VCs have modeled their deals in the spreadsheets they’ve presented to their LPs. So if you want to know what they are looking for, this is the rough math.

One final point, this does not mean that you should just tell the VC what you think they want to hear. You need to build a credible case and accept the fact that you might not be a fit for all investors.

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