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]]>“Believe me, I empathize with your goal. The problem is that in entrepreneurial startups, as with life in general…there is simply no easy answer, no matter how much we’d like it. To put things in perspective, the country’s leading venture lawyers have gotten together and created an exhaustive set of complete, annotated documentation for venture-funding early stage companies, which the National Venture Capital Association has then put on the web, completely for free. On top of that, several of the firms have gone even further, and invested many thousands of dollars in creating on-line wizards and expert systems to walk you through the process of creating and structuring early stage debt and equity deals…and THEY have put them on the web for free. And then, not to be outdone, but entrepreneurs like Adeo Ressi of TheFunded have worked with counsel to create an alternative set of documents, and they’ve put their term sheet on the web for free.
With all that spectacular quality, freely-available stuff available online, for funding deal after deal in similar situations, you’d think that it was game-set-match and there shouldn’t be any need for any entrepreneur or investor to ever pay legal fees again to document a simple convertible note or Series A deal, right?
WRONG! I don’t believe that there has been a first round financing deal in the past decade that has not generated five figures of legal fees, in the process of taking these completely standard, completely exhaustive documents and tailoring them for the specific situation at hand. And while there are precious few situations where we can get away with $10K in fees (generally only if it’s a brand new company and the entrepreneur is willing to accept the investor’s standard deal with no negotiation) the typical cost of counsel for a Series A is between $25K and $50K.
Is this insane? In one sense yes, and that’s why everyone keeps working furiously to come up with alternatives. But because of the differences and nuances in each deal, investors and entrepreneurs, if they are smart, ultimately have no choice but to cough up the cash if they want to get a deal done. Believe me, it’s not because we’re stupid, or that the lawyers are holding our children hostage…but simply because we understand that there are no shortcuts.
To answer your question with an almost useless (but at least well-meaning) quick few paragraphs, let’s try this:
A Note (or loan) is where the investor ‘rents’ money to the entrepreneur in exchange for getting it paid back by interest. For the entrepreneur, the advantage is that he keeps any upside, the disadvantage is that he has to pay it back. For the investor, the advantage is that it is the first priority money that comes out of the company, but the disadvantage is that it takes all the risk (if the company fails) and doesn’t get the upside of appreciation if the company is a success.
Selling Common Stock (which is what you, the founder start out with) to an investor means that s/he is taking the risk alongside you. For the entrepreneur, the advantage is that it doesn’t have to be paid back if things go badly, the disadvantage is that you are giving up a piece of the upside in the case of success. For the investor, it’s the reverse: the advantage is that you share in the upside, but the disadvantage is that because you’re on an equal footing with the entrepreneur, if things go south and there’s only a little value at the end of the day, the entrepreneur gets most of it, even though the investor has put in all (or most) of the money.
Preferred Stock is much like a loan, except that it doesn’t have to be repaid if the company fails. It means if the company gets ANY cash at the end of the day, it first goes to fully pay back the investor, usually along with dividends (which is like interest). Only after the investor is taken care of does the entrepreneur get his/her piece of the action. For the entrepreneur, the advantage is that aside from the fixed dividend rate, all the profits are retained by the entrepreneur; the disadvantage is that because it comes out first, there may not be anything left after paying the investor back. For the investor, the advantages are, again, the inverse: it has the security of getting paid back first (after any debts or loan repayments the company owes), but it doesn’t reap any of the upside benefits other than fixed dividends if the company is successful.
The standard “Series A” deal which is almost universally used in venture and serious angel investments, is a combination of the above two, known as “Convertible Preferred Stock”. It starts out with the investor buying Preferred stock, thus ensuring that in a not-good scenario the investor will at least get his or her investment dollars back before the entrepreneur makes any money. But the ‘convertible’ provision means that if good things happen and the company ends up being worth a lot of money, the investor can choose to convert the Preferred stock into Common stock at a pre-negotiated valuation, and therefore benefit from the increased value. In tough markets this is sometimes tweaked into a “participating preferred”, in which the investor has his/her cake AND eats it, too. In a participating deal, the investor first gets back the original investment with dividends (like a regular Preferred), and THEN double-dips by converting the full amount into Common, thus sharing in the upside. For the entrepreneur, the advantage of all this compared to a note are that it is an equity investment and therefore doesn’t have to be paid back, and there are no specific advantages compared to selling the investor Common (until you realize that investor simply won’t buy Common, so I guess the advantage is that they’ll do the deal at all :-). For the investor, the advantage is that they are covered either way, getting their money back in bad times, and getting the upside in good times. That’s why investors do these deals!
Another variant on this is the Convertible Note, which starts out as a loan, and then automatically converts into Convertible Preferred stock at the time and at the valuation of a future investment. The advantage of this for everyone is that it is easier and cheaper to document. The advantage for the company is that it postpones the valuation discussion until the future found, thus giving the company a ‘free ride’ on the invested dollars during the startup period. This in turn is a disadvantage for the investor who takes the risk but doesn’t get the commensurate reward. For that reason, Convertible Notes typically convert into the next round at a discounted price to what the next investor is paying for the same stock. However, there are a lot of challenges doing this, which is why most professional investors won’t do deals like this, but it is usually the best way to structure a Friends & Family round.
Finally, royalties, which seem to be the preferred alternate structure on SharkTank, are used when the company isn’t really a “company”, but is instead a “product”. In that case, the creator of the product licenses someone else the right to make and sell the product, in exchange for getting a fixed percentage of whatever the product sells for. Advantages to the creator is that someone else does all the work and the creator sits back and gets paid. Disadvantages are that the percentage the creator gets are typically quite small (3-5%) with the bulk of the profits going to the licensee, and there are very big differences between gross and net royalties and all the different terms that can be included.
So, there you have it in a nutshell, but in each case there are more possible variations, tweaks and gotchas than there are hairs on Donald Trump’s head, so that’s why the best early stage lawyers on both sides of the venture table routinely bill—and get paid—more than $400/hour to read these things.
]]>On the other hand, it presents a very warped view of the way most professional angels (at least in my experience) act, think and invest. I’ve found that my reactions to the Sharks’ decisions seem to fall into one of three categories:
In particular, there are two unrealistic things that jump out at me on a regular basis: first, the Sharks often demand a majority share of the venture (if not buying it outright). This is counter to the first principles of angel investing, where you are investing in, and incentivizing, the entrepreneur to create a business…not trying to take it over. If an investor starts out with 70% of the company, in a very short time the entrepreneur’s share will be so small as to be insignificant. At that point, he or she is likely to walk away, leaving the remnants in the hands of the greedy investor. Which does no one any good.
The second unrealistic aspect of the show is that, in the interest of making ‘good’ television, some of the Sharks (particularly Kevin O’Leary) behave in such an egregious way that they would immediately be kicked out of any professional angel group of which I am aware. Not only do they denigrate and yell at the entrepreneurs seeking funding (which is NEVER acceptable), but they also try to push deals that are so one-sided that they verge on being both unethical and non-viable. In contrast, some of the other Sharks (particularly Barbara Corcoran) sometimes invest with their emotions rather than their pocketbooks, which is not completely unrealistic…but also not good business. Somewhat to my surprise, the most ‘realistic’ Shark is turning out to be Daymond John, who projects the appropriate blend of business savvy, fair play and entrepreneurial mentoring that I’ve found typical of the best professional angels.
So, let’s get down to a review of Episode 2, and look at the opportunities from the perspective of an experienced, active, US angel investor with 75+ deals under his belt:
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Craig French
CROOKED JAW
Crooked Jaw is a up and coming action sport/streetwear brand from Long Island, NY. We have worked with many professionals athletes and bands and are looking to be the next big brand in the clothing industry.
http://www.crookedjaw.net
Ask: $200K for 20% ($800K pre-money)
Shark’s Best Offer: Pass
The Angel’s Take: The Sharks were right. Daymond described this quite rationally: these decent, enterprising young men are likable and hard-working, but they’re just like ten thousand other wannabes out there. They have no products worth investing in, nor do they have the business experience that would lead you to take a gamble on backing them. I, too, would like to help them, but this is a non-starter, and I’m afraid they are going to end up losing a lot of their own money in this venture.
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Robert Allison
LIFEBELT
LifeBelt is a safety device that prevents the car engine from starting unless the drivers seat belt is buckled. It can also control other seat belts within the vehicle.
http://www.nobucklenostart.com
Ask: $500K for 10% ($4.5m pre-money)
Shark’s Best Offer: $1m for outright acquisition
Entrepreneur’s Response: Pass
The Angel’s Take:They are all certifiably insane. I still can’t get my jaw off the floor about this one! The inventor claims to “have a patent” on a seatbelt ignition interlock system. What!?! Does not one person in that studio have any recollection of the 1971 NHTSA regulations REQUIRING passive restraint systems in all new vehicles? Which led to many manufacturers building in seatbelt interlock systems? Before consumers nearly rioted and forced their removal? IF he has a patent on ANYTHING, it would be for a particular implementation of an aftermarket interlock…for which the market would be about…zero. The fact that any investor would offer anything for this is beyond my comprehension. The fact that he would turn down a million bucks for it is perfectly comprehensible (given my familiarity with dogged entrepreneurs) but a crying shame, since it is INFINITELY more money that he will ever see from his ‘invention’. What a cluster muck! (Now, ask me how I really feel :-)
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Susan Knapp
CLA PERFECT PAIR
Creators of Extraordinary Gourmet Food Products. Their productshelp the home cook prepare delicious healthful meals quickly and make them look like a 5 star chef to family & friends.
http://www.aperfectpear.com
Ask: $500K for 15% ($2.8m pre-money)
Shark’s Best Offer: $500K for 50% ($500K pre-money)
Entrepreneur’s Response: Accept
The Angel’s Take:The Sharks were in the ballpark.I had this one down for a $500-$1m pre money (ie, about 30-50% equity). The fact that she already has $800K invested is too bad, but that’s the reality of startups. She comes across as an impressive entrepreneur with a solid business and a good grasp on what she’s doing. I would probably have looked at putting in less money at the same valuation, leaving her with a majority interest, but that’s not the way this program works.
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Mary Ellen Simonsen
ATTACH NOTED
AttachNoted is the solution to that irritating problem of loosing those sticky notes while working at your computer. AttachNoted will keep all your sticky notes in place and organized. Also, place your precious pictures or favorite business cards in the 3 slots, that are provided on the front sheet. Now one can securely take all those important sticky notes to their next appointment without having to reposition them.
http://www.attachnoted.com/
Ask: $100K for 20% ($400K pre-money)
Shark’s Best Offer: Pass
The Angel’s Take:The Sharks were right.This is a silly solution in search of a problem that doesn’t exist. It isn’t worth $400K, and, as the Sharks noted, isn’t worth anything at all. But they were harder on her than they needed to be. ‘Nuff said.
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Mark Furigay
CLASSROOM JAMS
Classroom Jams is an educational record label & publishing house. We produce popular music that turns kids on to school curriculum. Our concept albums and teacher’s guides are the cutting edge in high-interest, high-minded teaching tools.
http://www.classroomjams.com
Ask: $250K for 10% ($2.25m pre-money)
Shark’s Best Offer: They take the company for free, commit to putting in $250K, and he gets 5% royalties with the right to use them to buy into an equal share of the business
Entrepreneur’s Response: Accept
The Angel’s Take:The Sharks were scumbags. A royalty structure might indeed be the appropriate way for this deal to work out, but there were so many problems with this ‘negotiation’ that it left me wanting to wash my hands. The entrepreneur came across as a classy guy with a good product and very decent head for business, and to some extent he got rolled by the Sharks. It will be interesting to see if this deal actually closes (most of these TV show investments, like on Dragon’s Den, don’t actually make it all the way). If I were in his shoes and prepared to accept a royalty, I would have taken the Sharks’ offer as validation of the concept, and then gone off and negotiated with real publishers about how to bring the product to market. Ah well, I wish them all luck on this one.
_________________________
So, there you have it. Stay tuned next week for my review of Episode Three!
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His main thesis is that ‘people’ have a very misleading view of that rare creature known as an “angel investor”, and that angels are far less numerous, generous, and active than ‘everyone’ thinks. In support of this he has extensively research the subject, pulling together all of the available statistics on the field, from the Angel Capital Association, the Center for Venture Research, and even us at Angelsoft (which we’ve been happy to provide.)
As I read his book, and many of his subsequent blog postings and commentaries, I am alternately baffled, bothered and bewildered by his conclusions. First, let me say that his research is legitimate and (as far as anyone, including me, can tell) accurate. So I am not disputing his facts. What I object to, however, is that he sets up straw men to demolish, in order to make lurid points that I believe lead his readers to draw inaccurate conclusions on the state of angel investing.
Take, for example, his contention that angels in America invested “only” as much money last year as venture capital firms. Is the fact of “angel investments = vc investments” accurate? Yes (to the best of our knowledge.) But phrasing it as “only as much” somehow implies that someone is maintaining it is much more. Hunh?
What we and the facts all agree on, is that LAST YEAR ANGELS INVESTED $26 BILLION IN US COMPANIES!! Who on earth is claiming it is anything higher than that??
Meanwhile, in a recent blog post on Small Business Trends, Scott opines that so-called “active investors” are a myth, because even among the cream-of-the-crop angels, the self-reported average time they spend with their portfolios is a miniscule 41.9 minutes a week [gasp!] Once again, I can confirm his facts, but substantively disagree with his conclusions!
I’m one of his “cream of the crop” active angel investors. I’m the Chairman of New York Angels (one of the largest and most active angel groups in the country, with 22 deals this year alone), have 70+ companies in my personal portfolio, and spend my full business time on angel-related activities. That said, it would be absolutely correct to say that there are some (indeed, many) ventures in which I have invested on which I spend less than 41.9 minutes per week. And the problem with that is??
I’m not running the business, the entrepreneur is! The last thing he or she wants is me looking over his or her shoulder and micro-managing the company. If that’s what I need to do, then I shouldn’t have invested in this venture in the first place.
Think about it this way: if, after pulling together an investment round of half a million dollars for a company (including corralling the investors, structuring the deal terms, and doing due diligence analysis, all for no compensation, and then investing $100,000 of my own money), I followed through by serving on the company’s Board of Directors (which would be active involvement indeed), kept updated by asking for and reading weekly management reports (which is way more than most CEOs want to provide), referred the CEO to a dozen high-level sales and business development prospects from my network during the year, and then introduced them to five top-tier venture capital firms for potential participation in a follow-on investment round…would that be the kind of “active” angel investor you’d like to have?
I think the answer from any entrepreneur I’ve ever met would be “yes, in a heartbeat!”
Now, let’s look at my time involvement post closing:
Total time spent annually = 36.3 hours
Total time spent weekly per venture = 41.9 minutes
And this somehow proves that “active angel investors” are a myth? I’m confused…
]]>That was when we instituted mandatory pitch coaching for every single company that was selected to present to our membership. The result? Our investment rate more than DOUBLED, and we have funded over $35 million into more than 50 companies during the past six years. In that time, I have handled most of the coaching duties on behalf of the group, and have gotten pretty good at helping entrepreneurs refine their Powerpoint presentations to meet the need of their target audience: early stage investors. Word began to spread about these sessions, and soon BusinessWeek came by to do a story about them, giving me the moniker of The Pitch Coach. The next thing I knew, there seemed to be even more demand for presentation training than there was for my investment dollars!
These days, I spend quite a bit of my time teaching entrepreneurs how to clearly and persuasively get their message across. Most of this happens for New York Angels, at business schools like Yale, Columbia or NYU, or for institutions like the National Science Foundation. However a couple of years ago Chris Anderson, the Curator of the renowned TED conference (and a fellow New York Angel member) asked if I would do a session during the “TED University” event before the main conference. I agreed, but wondered how I would be able to compress what is usually an hour long presentation into the allotted 12 minutes. The answer? Talk faster! [grin] So, with the compliments of TED.com, here is The Pitch Coach, in the super-express-version of “How to Pitch an Angel (or VC)”. I hope you find it useful! (The ‘expand’ button in the corner will bring up a full-screen version.)
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I propose that it is time to reject the notion of the “business guy” (or “business gal”) entirely. The underlying problem is that there are really three different components here, and like the classic three-legged school, they are all essential for success, albeit with differing relative economic values. What gets things confused is that the components can all reside in one person, or multiple people. And what gets people upset is that there are different quantities of those components available in the economic marketplace, and the law of supply and demand is pretty good about consequently assigning a value to them.
Perhaps surprisingly, the components are NOT the traditional coding/business pieces; nor are they even coding/UI/business/sales, or whatever. Rather, here is the way I see it, from the perspective of a serial entrepreneur turned serial investor, listed in order of decreasing availability:
1) THE CONCEPT
A given business starts with an idea, and while the idea may (and likely will) change over time, it has to be good on some basic level for it to be able to succeed in the long run. How excited am I likely to be when I see a plan for a 2008-model buggy whip? another me-too social network? The 87th investor-entrepreneur matching site with no investors? The base concept has to make some kind of sense given the technical, market and competitive environment, otherwise nothing else matters. BUT good ideas are NOT hard to find. Not at all. There are millions of them out there. The key to making one of them into a home-run success brings us to:
2) EXECUTION SKILLS
It is into this one bucket that ALL of the ‘traditional’ pieces fall. This is where you find the superb Ajax coder, AND the world-class information architect, AND the consummate sales guy, AND the persuasive biz dev gal, AND the brilliant CFO. Each of the functions is crucial, and is required to bring the Good Idea to fruition. In our fluid, capitalistic, free-market society, the marketplace is generally very efficient about assigning relative economic value to each of these functional roles, based upon both the direct result of their contribution to the enterprise and their scarcity (or lack thereof) in the job market.
That is why it is not uncommon to see big enterprise sales people making high six figure, or even seven figure, salaries or commissions, while a neophyte coder might be in the low five figure range. Similarly, a crackerjack CTO might be in the mid six figures, but a kid doing inside sales may start at the opposite end of the spectrum. Coding, design, production, sales, finance, operations, marketing, and the like are all execution skills, and without great execution, success will be very hard to come by.
BUT, as noted, each of these skills is available at a price, and given enough money it is clearly possible to assemble an All Star team in each of the above areas to execute any Good Idea. That, however, will not be enough. Why? Because it is missing the last, vital leg of the stool, and the one that ultimately–when success does come–will reap the lion’s share of the benefits:
3) THE ENTREPRENEUR
Entrepreneurship is at the core of starting a company, whether tech-based or otherwise. It is NOT any one of the functional skills above, but rather the combination of vision, passion, leadership, commitment, communication skills, hypomania, fundability, and, above all, willingness to take risks, that brings together all of the forgoing pieces and creates from them an enterprise that fills a value-producing role in our economy. And because it is THIS function which is the scarcest of all, it is THIS function that (adjusting for the cost of capital) ends up with the lion’s share of the money from a successful venture.
It is thus crucial to note that the entrepreneurial function can be combined into the same package as a techie (Bill Gates), a sales guy (Mark Cuban), a UI maven (arguably Steve Jobs), or a financial guy (Mike Bloomberg). And that it is the critical piece that ultimately (if things work out) gets the big bucks.
Who do you think got the biggest relative return from the development of Trump Tower? Architect Der Scutt (the IA)? Engineer Irwin Cantor (the coder)? Broker Louise Sunshine (the sales gal)? EVP George Ross (the biz dev guy)? Or whomever happened to be The Entrepreneur in that deal?
The moral of the story is that for a successful company, we need to bring together all of the above pieces, realize that whatever functional skill set the entrepreneur starts out with can be augmented with the others, and understand that the lion’s share of the rewards will (after adjusting for the cost of capital), go to the entrepreneurial role, as has happened for hundreds of years. ]]>
“In the 1970s, Dr. Bennett introduced a popular undergraduate course for humanities and social-science students at Yale, intended to show the problem-solving promise of nascent computers. A colleague, Werner P. Wolf, a professor emeritus of engineering and applied science at Yale, said the course proved to be both prescient and persuasive, and “made the whole concept of computers exciting.”
It so happens that I was one of those social-science students who took Professor Bennett’s course, in 1976. Our textbook, which he had written himself, introduced us to the BASIC language, and painted a picture of all sorts of uses for this amazing new technology. Now, I had never been a science jock in high school, in fact I had never touched a computer before that class. But inspired by the obvious passion and vision of this world famous inventor, I began to see the extent of the change that these then-unwieldy devices might engender.
I never took another computer course in college and graduated with a degree in Urban Planning, but as soon as I got out, almost the first thing I did was to buy an Apple II computer (with a cassette tape drive, no less!) and start writing a program to balance my checkbook. And then one to catalog my book collection. And then others for both personal and professional use (one of which actually got a full page write-up in InfoWorld in 1983).
Now, some 30 years later, my coding skills are so rusty as to be completely useless in this day of Java and Objective C, but the vision, enthusiasm and inspiration of William Ralph Bennett live on, and at least in my case was the first step in a lifelong career that has led to startup investments in over five dozen entrepreneurial tech companies. Wherever he is, I hope Professor Bennett is looking down with some degree of satisfaction. ]]>
Before the question can be answered, however, there are several different numbers and theories involved, and it’s important to understand each of them in context:
IRR (Internal Rate of Return) is the return on an investment OVER TIME, usually expressed as an annual percentage rate (that is, if you invest $10 on January 1 and get back $11 on December 31, that would be a 10% IRR.)
ROI (Return on Investment) is the return on an investment REGARDLESS of time, and is usually expressed as how many times the original investment is returned (that is, if you invest $10 and get back $30 at some point in the future, that would be a 3x ROI.)
PORTFOLIO TARGET RETURN is the IRR that an investor hopes to receive in total, taking into account ALL of the investments, profits and losses made in a given time frame.
ASSET CLASS TARGET RETURN is the IRR that an investor hopes to receive from all investments of a certain type (such as CDs, stocks, bonds, venture capital, angel investments, etc.) TARGET ROI is the ROI that an investor hopes to receive on any one particular deal, taking into account the typical holding period for an investment of that type.
TIME VALUE OF MONEY is a fundamental economic concept that means $1 in your hand today is worth more than $1 a year from now (because you can put that dollar to work during the year, and make more money with it.) As such, ROI calculations are meaningless without an associated time frame. A 10x return that an investor would be ecstatic about if it came back in six months, would be a major disappointment if it took twenty years to come back.
RISK/RETURN TRADEOFF is the principle that the more risk there is in an investment, the higher return there needs to be to compensate for it. As such, an investor willing to take a 2.3% annual return on a US Treasury bill (essentially risk-free), might require a 12% annual return to be enticed to invest in a higher-risk corporate ‘junk bond’. (See tinyurl.com/6fby2v)
PORTFOLIO BALANCING means that most investors aim to diversify their risk/return profile by investing in several different types of asset classes, because in any given year one class will do better than another…but it’s difficult to predict which. It is therefore not unusual for the same investor to hold both US T-bills AND junk bonds, as well as several other asset classes. (See a fascinating historical chart of the relative returns from different asset classes over the past 20 years: tinyurl.com/5jygn2)
VENTURE/ANGEL INVESTMENTS in early stage companies are considered (for good reason) among the riskiest possible investments one can make. A majority of startups, no matter how promising, fail completely within a couple of years, losing 100% of the money that was invested in them. On the other hand, there is no way that an investment in T-bills (or General Motors) could ever have the potential return of an investment in a company like Google or Facebook.
Sooo…all of the above leads us into the following scenario: Mr. Typical Investor would like to get a somewhat higher total return from his investments than he would get by investing only in T-bills, and is therefore prepared to take some risk to get it. He decides to create a diversified portfolio with an overall annual target return of, say 5%. Since this is more than double the return of the average money market fund over the past five years, Mr. Investor’s safe (but low return) investments have to be balanced by some higher risk investments, such as small cap growth stocks, or international funds. But for investors who have an appetite for real risk, and the consequent ability to lose some of their investment if things go wrong, they can go even further up the risk/reward scale to…venture capital.
VC funds in general target a 20% or so annual return to their investors, which can certainly bring up the overall average return on Mr. Investor’s diversified portfolio. That sounds great, but with that high return comes equally high risk. Last year, a majority of US venture funds actually lost money and had negative returns, let alone not making their 20% IRR target!
Indeed, venture capital is only one part (the riskiest part) of an asset class called “alternative investments” that include things like private equity buyout funds, commodities, hedge funds, etc. And most institutional investors (the university endowments, pension funds and insurance companies who provide the majority of money to VC funds) nevertheless put only 2-3% of their capital into alternative investments as a whole…because they’re so risky.
Let’s look, therefore, at what it takes a VC fund to get that elusive 20% IRR. Well, it turns out (in case we didn’t already know) that investing in entrepreneurs is indeed a Risky Business. VC’s fund fewer than one in 400 deals they look at, but even with that discriminating judgment they are resigned to the fact that between 30% and 50% of their prized investments will crash and burn. Completely. And another 30% or so will end up being “walking dead”, that is, making just enough money to keep themselves alive, but not enough to provide any return on the investment. Indeed, statistics over many years have shown than virtually ALL of a VC fund’s returns will come from fewer than 10% of their investments. It’s the one home run with Google that makes up for all the WebVans, Pets.com and eToys.
Thus, continuing with our math lesson, and taking into account the facts that: one in ten companies in a VC portfolio need to come up with all the return for the portfolio; the average holding time for a VC investment is 5-7 years; and the return for the whole VC portfolio needs to be 20% or so, we can calculate at the end of the equation that ONE company needs to deliver an ROI after six years of something north of 20X! And therefore, since the VC doesn’t know WHICH of his investments is going to be The One (otherwise, of course, he wouldn’t invest in the other nine!), EVERY one of his investments must have the potential to hit a 20X return.
It’s because of all the forgoing realties, concepts and math that there is typically an enormous disconnect between entrepreneurs and investors. The former figure that ‘risk adjusted return’ means that an investor should be delighted if his/her/its investment brings back a 20 PERCENT profit (which is five to ten times the return from less risky asset clases), while the latter realize that if they don’t aim on each deal for a 20 TIMES profit (which is required on a deal basis to deliver the 20% return on a portfolio basis), they will be out of business.
The result? A two-order of magnitude misunderstanding. ]]>