9/25/2014

Demystifying Venture Capital Economics, Part 2 - Wealthfront ...

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Demystifying Venture
Capital Economics, Part 2
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September 24, 2014

Andy Rachleff

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ne of the most challenging things for people outside the technology

world to understand about venture capitalists is why they are willing to
fund companies that operate at a significant loss. After all, classic

security analysis teaches us companies dont have any value if they cant produce a
profit. The operative word in that statement is cant. Just because a company
operates at a loss today doesnt mean it cant be profitable in the future.
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As I explained in Part I of this series, big winners drive venture capital fund returns.
Prior to the emergence of the Internet, venture capitalists made their big returns

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behind technological breakthroughs. Almost every successful venture capitalist

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followed the same playbook originally designed by Tom Perkins, the founder of
Kleiner Perkins Caufield & Byers: Find companies that have high technical risk and
low market risk. Technical risk was reasonably easy to evaluate if you had a good
enough network of experts on which to call. Lack of market, not poor execution,
was, and still is, the primary cause of company failure. Therefore you never wanted
to take market risk. You looked for companies that attempted to build something
that was so technically challenging that you knew people would want to buy it if it
were successfully delivered because it offered such a huge price/performance
advantage.

Software Changed The Funding Formula

Post 1995 the world changed drastically. Almost every innovation came in the form
of software. Unfortunately software startups have the opposite characteristics of
what Tom Perkins taught the VC industry to look for. Software companies have
relatively low technical risk and high market risk. You know the company could
deliver its product. The question was would anyone want to buy it. As I said before,
market risk is generally not worth taking, so the intelligent VCs had to change their
business model. They outsourced to angel investors the earliest stage funding for
what they considered the poor risk/reward consumer-focused companies and
instead focused on backing them only when they proved the dogs wanted to eat
the dog food. The angels thought they won the business away from the VCs, but
the poor average returns of the angels would say otherwise. Waiting until a
company proved it had product/market fit meant having to pay a much higher
price than they did in the past. Fortunately the Internet enabled much bigger
markets to be addressed than in the past, so their outsized returns could be
maintained.
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Let me illustrate with some numbers. Twenty years ago venture capitalists typically
initially invested in startups at a $5 million valuation with the hope the company
could someday be worth $500 million. That could represent a return of 20 to 30
times their investment based on the likely dilution incurred in future financing
rounds (please see The Impact of Dilution for an explanation of dilution). Today VCs
are more likely to initially invest at a $50 million valuation with the hope the
company could someday be worth $5 billion. Amazingly the number of companies
that generate $5 billion of value today is comparable to the number of companies
that generated $500 million of value 20 years ago. That means todays smart VCs
are still able to generate the same kind of returns as 20 years ago despite the much
higher entry valuation. Please keep in mind not all initial VC rounds are valued at
$50 million. My intention was to provide an example that was correct in terms of
order of magnitude.

Invest After The Value Hypothesis Has Been Proven

The challenge for the VC is finding a company that exhibits product/market fit
but not so obviously that she has to pay too high a price. Eric Riess phenomenal
book The Lean Startup, provides an intellectual framework that I believe best
explains the VCs behavior. Eric (and I) believes in order to increase the likelihood of
succeeding, a startup should start with a minimally viable product to test what he
calls a value hypothesis. The value hypothesis should state the founders best
guess as to what value will drive customers to adopt her product and indicate
which customers the product is most relevant to, as well as what business model
should be used to deliver the product. Its highly unlikely that a founders initial
hypothesis will prove correct, which is why an entrepreneur has to iterate on her
hypothesis through a series of experiments before product/market fit is achieved.
As a consumer company, you know you have proved your value hypothesis if your
business grows organically at a rapid pace with no marketing spend.
Only once the value hypothesis has been proven should an entrepreneur test her

growth hypothesis. The growth hypothesis covers the best way to cost-effectively
acquire customers. Unfortunately many founders mistakenly pursue their growth
hypothesis before their value hypothesis. I explain the perils of this approach in
Why You Should Find Product-Market Fit Before Sniffing Around For Venture Money.
Companies that nail their value hypothesis are highly likely to figure out their
growth hypothesis, but the inverse is not true (Socialcam is perhaps the most
outrageous example).
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As you might imagine a company that has figured out its value and growth
hypothesis is worth much more, perhaps three to five times more, than the
company that has just confirmed its value hypothesis. Therefore the really good
VCs try to invest after the value hypothesis has been proved, but before the growth
hypothesis works. In other words VCs are willing to take the leap of faith that the
company will figure out the growth hypothesis. You might think this is an obvious
observation, but as I explained in Part I of this series, the vast majority of VCs are
not willing to take that risk.
Once a company proves its value and growth hypothesis, it has likely achieved the
leadership role in a new market. This usually spawns a bunch of imitators, but you
might be surprised to learn that seldom does an imitator or laggard ever overtake
the leader once it has achieved product market fit. Thats true even if the fast
follower develops a better product. The only hope for number two in a segment is
to change the definition of the market (Nintendos Wii is a great example).

Market Leaders Attract Cheap Capital

You might also be surprised to learn that the leader in a market is worth more than
all the other players combined (Priceline is a great example). Thats why venture
investors try to beat down the doors of a company to have the opportunity to
invest once it has achieved market leadership.

Technology market leaders often accept this additional financing even when they
dont need it to execute their business plans. To do so they must believe the
increased growth from investing faster in their businesses has to justify the dilution
associated with the unneeded financing.
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Im sure you have read about many successful consumer Internet companies that
recently raised on the order of $50 million, or more, at a $600-million pre-money
valuation soon after they did another round of financing. This is the most common
valuation these days (although incredibly high by historical standards) when a
startup has achieved clear market leadership in a market that has a chance to be
very large.
To justify the dilution associated with such an unneeded financing, the
management must believe the incremental percentage growth in revenues from
the financing is greater than the dilution taken in the round. For example, lets say
a company currently has a $10-million annualized revenue rate with expected
annual revenue of $160 million in four years. Lets further assume it can raise $50
million at a $600-million pre-money valuation and with that money increase its
revenue expectation in four years to $200 million. That would mean it would trade
off an extra 7.7% of dilution for a 25% increase in revenues in almost every case
that would lead to a higher value per share for all stockholders.

Cheap Financing Drives Accelerated Growth (And

Increased Losses)
The only way the revenue could have been increased by such a sizable amount was
to have accelerated the companys hiring of engineers to produce needed product
more quickly (assuming more product leads to faster growth) or to increase paid

marketing (assuming it would generate a positive yield).

You often see subscription businesses like SAAS companies accelerate their
marketing spend as long as their cost to acquire a customer is less than their
average customer lifetime value. This acceleration may lead to significantly
increased short-term losses if the annual revenue contribution of an average
customer is less than the initial customer acquisition cost; over the long term,
however, it is highly worthwhile.
Lets look an example to illustrate this point. If we assume a companys average
customer generates a profit of $100 per year, 33% of the companys customers
churn each year and it costs the company an average of $150 to acquire a
customer, then it is highly worthwhile for that company to spend as much as it can
as long as those economics hold. Thats because the customer lifetime value of
$300 ($100/33%) is far greater than the customer acquisition cost of $150. However
each customer the company adds decreases its profits (or increases its losses) by
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$50 in the first year ($100 increased annual profit $150 customer acquisition cost),
so it may appear to uninformed outsiders that the company has made a stupid
decision. Over the long term the trade will prove worthwhile because the company
will continue to generate $100 per customer for three years (the horizon over which
the average customer churns).
As frequent observers of this phenomenon, VCs encourage this trade despite the
poor short-term optics as long as they believe their portfolio companies long-term

margins are likely to be attractive. Their point of view is reinforced by the research
we shared in Winning VC Strategies To Help You Sell Tech IPO Stock that found
technology companies performance post-IPO is most dependent on revenue
growth, not profitability. Accelerated revenue growth is almost always rewarded
with a higher valuation as long as management is able to convince investors that it
addresses a huge market and can easily generate profits in the future.
The most exaggerated example of this strategy is Amazon. You have often heard
Amazon say it could have much higher margins if it wanted to. This is no joke.
Management knows the smarter decision is to invest in growth and they have been
handsomely rewarded for it.

Technology Companies Are Valued Differently

There is a huge incentive to grow faster rather than generate profitability. This may
sound like heresy but its the way the technology business has always worked.
Almost every market leader could generate a profit relatively early in their life, but
that would leave them open to an aggressive new entrant that wanted to change
the rules on them. Its far better to defer profitability and cement your lead than try
to make a profit early.
Unfortunately people from outside the technology business dont understand how
technology companies are valued. As software continues to eat the world, youll
likely hear many representatives of old line or soon to be disrupted businesses
denigrate the disrupters by saying they have an unsustainable business model or
will likely go out of business due to their spending rate. They also might point out
how small the new entrant is; ignoring the fact that at its current growth rate it will
soon become very big. Psychologists have done many studies that have found
human beings have a hard time comprehending the impact of compounding. Ive
been to this movie many times and it always ends poorly for the incumbent once
an upstart achieves product-market-fit. Thats because momentum seldom
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dissipates quickly.

All That Matters Is Growth

The other knock the uninformed and threatened use against young companies with
momentum is their VCs must be nuts to have invested so much in them because
companies in our space arent valued like tech companies and therefore cant
justify the sizable capital invested. Professional public tech investors care a lot
more about the growth of the company in which they invest than they do about the
traditional multiples of the industry in which the company participates. Time and
time again weve seen new software-based entrants that disrupt an old-line
industry get valued at what, historically, would have been viewed as crazy
valuations. Its pretty clear the Internet-based winners in cars, clothing, recruiting
and travel, among others, command lofty valuations. Motley Fool has dedicated
numerous posts to the correlation between growth rate and the price to earnings
(P/E) ratio. The higher the growth rate, the higher the P/E, independent of industry.
Once again the top VCs understand that this relationship is unlikely to change any
time soon.
Economists believe the only way to earn outsized returns is to invest in highly
inefficient markets. The lack of common understanding around what constitutes
the ideal way to build a startup is one of the greatest examples of inefficiencies I
know which makes it a huge source of the premier venture capitalists
tremendous returns.

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https://blog.wealthfront.com/venture-capital-economics-part-2/

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