AGILEVC My idle thoughts on tech startups

February 24, 2006

Peter Rip of Leapfrog Ventures had an excellent post on his EarlyStageVC blog a couple weeks back on the traditional VC model being broken. His post actually covers a lot of ground from the smaller size of today’s exits (vs. late 90s) to the larger size of today’s VC funds to the capital efficiency of many of today’s startup models. These are all largely interrelated points, btw. The crux of all this is that early-stage VC requires appropriately sized funds… i.e. Series A investing in the low single digit millions range.

One point I wanted to expand upon is the issue of VC’s “bite size”, or what’s the average amount of capital they look to invest in companies. I say average because it inevitably varies… a company might have an exit (positive or negaitve) sooner than anticipated thus VC(s) invest less or things make take longer to develop and you invest more than you expect. An entrepreneur friend of mine recently asked me “Why is it that large VCs [i.e. $500M-1B funds] don’t write $1M checks, or smaller VCs [like me] don’t write $100K checks?”. This is the “moving the needle” question, which as an entrepreneur I never fully understood but now have a better appreciation for as a VC.

There’s no particular rocket science behind this question… pretend you’re a VC with $500M fund and you make a $2M investment into Acme Corp at a $3M pre-money valuation. Suppose the company never raises add’l capital, you have a 10x exit ($5M post x 10 = $50M), and for the moment forget about dividends or participating liquidation prefs and the rest. To most folks (particularly viewed thru the founders’ lens) this is a big win, the VC gets 10X return and even if it takes five years to accomplish you’re still looking at healthy 47% IRR.

So why does the VC with the $500M fund think of this scenario as small potatoes (more or less)? Well if you look at his 10x return, it puts $20M back into his fund. I know it’s hard to use the word “only” when your talking about a $20M sum, but the fact remains that it’s only 4% of the entire fund. Assume for the moment that it takes the GP as much or nearly as much effort to source, select, and be involved in Acme Corp as it does with a different opportunity, Beta Inc. Suppose Beta is a later-stage and/or more capital intensive deal where the VC has the opportunity to invest $25M but with only a 3X potential return.

Isn’t 10X better than 3X? Well, not always. The $75M exit proceeds from Beta actually represents a much larger return in absolute terms… it’s 15% of a $500M fund, hence the impact can be described as “moving the needle”. If you want to put it in more personal terms for a second, if other investments in this hypothetical $500M fund have already returned the original LP capital, then the $75M proceeds from Beta represent $15M into the 20% carry pool vs. $4M for Acme. If this GP has nine other partners and the carry pool is evenly divided (just assume for a second), Beta is $1.5M in the GP’s pocket (vs $400k) and possibly more pull in the partnership.

It’s rare that you can do apples to apples comparisons of deals and the associated opportunity costs, as in the scenario above, but the point is to illustrate the “move the needle” issue. For any given fund size, there are bounds not only on how big an investment you can realistically make but also how small. This dynamic is why large VCs have a harder time making small investments, or why they might try to push a company’s strategy down a more capital intensive path.

A post for another day is VCs thinking about “small” investments not as an asset but as an option…

3,651 Responses to ““Moving the Needle” (aka when 3X > 10X)”

  1. avatar February 24, 2006 at 10:11 PM

    Lee,

    Well articulated as usual. My question is, is venture investing really best thought about as a 3X vs 10X game? This line of thinking seems to imply that size of outcome is for some reason a multiple of the money invested – i’m not sure that is entirely the case.

    (I can think of several reasons that line of thinking does make sense, but for sake of time let me just point out one reason that it may not.)

    Given your examples, if i had the chance to invest $2m at a $5 post-money valuation or $25m for a similar stake in THE SAME COMPANY -i’ll take the former and my 100X on a small sum will beat your 3X return on a large sum every time.

    Of course, life doesn’t quite work that way – but i don’t think the exits-are-always-a-multiple-of-money-invested rationale is quite right either. Certainly size of market, capacity of team and other factors have something more to do with expected outcome than just how much money you are putting in. Doesn’t one every once in a while get a chance to invest in the next Intel at a seed company price?

  2. avatar February 27, 2006 at 2:26 AM

    My point is that large funds would either wait/pass on the $2M on $5M investment you describe, or would think thru strategies w/ the team on how to invest $5-10M now in order to go after the mkt in a “bigger” way. So in reality it’s never choosing between one or the other… either implicity or explicitly, large VC funds often forgo these types of investment opportunities.

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