VCs and Risk AversionApr 16, 2008
Paul Graham writes another thought-provoking essay today on both why founders don’t sell early (or why they might) as well as castigates corporate development organizations and VCs for not being risk takers when it comes to valuing companies. I think he is mostly right, as usual, as do a bunch of other people.
On venture investors taking risk, I get asked at least once a week something to the effect of “Where exactly is the ‘venture’ in venture capital?” Frankly, I agree. I am often surprised at how many venture capitalists aren’t very “venturesome”.
I think part of this is simply that venture capitalists have to put more money to work today. I cannot overemphasize how many entrepreneurs tell me that they really only need $1MM but are asking for $3MM-5MM because that is what they have been told investors want to invest. If I was a VC at a traditional firm and needed to invest $3MM I would be risk averse too. Say that I am buying minimum 20% of the company. That implies a $15MM post-money. For me to get my 10x return on just my initial investment, I need an exit of $150MM to make it work. It takes a darn good company to exit for $150MM these days (in fact, more than 75% of all M&A transactions in the last four years have occurred at prices lower than $150MM). If I have questions about the team, the market, the distribution strategy, the competition, or even if I have a bad consultation with my ouija board, I am going to pass on the deal.
This is why I like seed investment and the First Round Capital model so much. Our initial investment is much smaller (our average initial investment is $500K) and the post-money valuations are correspondingly much smaller. Which means to get to our 10x takes a much smaller exit. And hey, if you want to take the company big, I love that too. The optionality is good for both investor and founder – I really enjoy the alignment that comes from sitting on the same side of the table with the entrepreneur.
I do want to take issue with something that PG said. Specifically:
“I’ve tried to explain this to VC firms. Instead of making one $2 million investment, make five $400k investments. Would that mean sitting on too many boards? Don’t sit on their boards. Would that mean too much due diligence? Do less. If you’re investing at a tenth the valuation, you only have to be a tenth as sure.”
If a typical $2MM Series A is done at a $6MM pre-money, then the hypothetical seed investment Paul refers to would be done at a $600K pre-money, leaving me with 40% of the company for $400K. Good deal if I can get it but I don’t see a lot of those deals today.
Paul: If you know of any companies that are looking for this structure, send them my way!