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VC’s care about the upside case, not the mean

August 31st, 2009 | startups, venture capital

The biggest mistake entrepreneurs make when pitching VCs is to argue that their startup is likely to succeed.  Instead, they should argue that there is a small probability their startup could be a billion dollar or greater exit.  There is a big difference between these arguments – the mean of the return distributions might be the same but what VCs care about is right side tail of the distribution.

Investor sentiment, the old saying goes, is a horse race between fear and greed.  The fear and greed in venture capital is all about investing in or missing out on the next Google.  No VC stays up at night worrying about missing the next startup that’s flipped to Google.  The way you get VCs interested is to convince them there’s a small but non-negligible chance you’ll create a billion dollar (valuation) business.

I’ve learned this lesson first hand on both sides of the table.  One example:  A good friend of mine was starting a company a few years ago.  I was excited about the idea and tried to help him raise venture money.  After the entrepreneur pitched some VC friends of mine, I was surprised when the they came back to me to say they are passing because “it seems like a smallish, ‘lifestyle’ business.”

The entrepreneur had made a very good pitch for why his product was valuable, why he could create a profitable business, that he was very smart and well prepared, and so on.   What he needed but failed to do was leave the VC with the nagging thought that this could be the “the next big thing.” Part of this was because of the entrepreneur’s natural modesty.  Some people don’t have the chutzpah to aggressively assert that their idea is the next big thing, even when, deep down, they truly believe it.  In everyday life, this kind of modesty is a virtue. When pitching VC’s, it is the single worst thing you can do.  (If deep down, you don’t believe your idea will be the next big thing – don’t raise VC money.  Once you raise VC you are committed to going for the billion dollar exit whether you like it or not.)

I don’t know if this obsession with the upside outlier case is a good strategy from the VC’s perspective or not.  Granular VC return data is hard to come by.  I tend to think it is a good strategy – one Google or Facebook (and a lot of other billion dollar exits that aren’t nearly as famous) can make up for a ton of misfires.  And the anecdotal return numbers I’ve heard from VCs suggests it works.   But I don’t really know.

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  • I agree with you but I also wonder how much of a relationship there is between being a good big vision promoter and being able to run and grow a startup. I've seen plenty of entrepreneurs who have the needed chutzpah but can't manage or lead their way out of a paper bag. Remember the movie startup.com?
  • Totally agree with you Elie. Sorry to keep citing myself but I talk about that a lot here http://www.cdixon.org/?p=452
    "The current early-stage VC process is optimized to favor people who are good at pitching partnerships, not necessarily people good at creating successful startups."
  • Citing yourself makes sense when you said it well :-)

    This whole thing is why I think that it's critical that new entrepreneurs learn early and often that fundraising is not actually an accomplishment in and of itself - all you've done is raise money that you have to pay back (it comes out first) but that you can't ever remove from cap table. Raising money - even at a big pre-money valuation - is meaningless if you don't ultimately create liquidity and 99 times out of 100 liquidity comes to those who are good at building companies that make money. (wow - that's simple, right?) Expecting it to happen any other way is choosing luck as your strategy...

    I've seen entrepreneurs spend a lot of their - ostensibly incredibly valuable - time chasing relatively small increases in pre-money prices on fundraising rounds forgetting all the while that the time they were spending promoting and pushing the price up on the price of money they were raising (money that comes out first) could have been used to actually build the company and create liquid (read real) value for them and the other shareholders. It's good for an entrepreneur to know how to negotiate and sell a deal but it's only one of many talents. I'd like to believe that if more VCs had been entrepreneurs in a previous life, they'd be less wowed by a talented promoter. That being said, I know nothing at all about being a good VC and have no idea what it would take to be a great one.
  • bthoskins
    Chris, what are your thoughts on the theory that the old venture model is dead? Obviously, it's great to swing for the fences and get the billion dollar exit, but are there going to be enough of those to sustain the industry? Business Week had an interesting article about First Round Capital, Maples, and others who are having success at picking companies earlier in the lifecycle with smaller rounds, expecting a higher than average failure rate, and being content with the sub $200 million exit (which is a lot more frequent and easier to obtain, especially in today's economic environment). I met with these guys a few weeks ago and was impressed with their approach and the companies they are picking.

    http://www.businessweek.com/magazine/content/09...

    Are "traditional" VCs going to continue to generate the returns of the past, or are we entering into a cycle where VCs will raise mega-funds, rely on management fees for their sustenance, and product marginal returns that are not commensurate with the level of risk?
  • My guess is the top 10-20 or so traditional VCs will continue to do well because they really do have better deal flow, are better at picking companies, and better at helping them. The rest of the big ones will generate poor returns and probably not be able to raise future funds. I am very much a fan of angels and micro-VCs like Maples & Baseline (but note I am not disinterested because I do this type of investing myself). The danger is always that small VCs have success and then raise bigger and bigger funds and then start living off the management fees.
  • Rob K
    The baseball analogy is a good one because VC is a slugging percentage business and not a batting average business. A "home run" in venture is worth a whole lot more than 4x a single, more like 10 to 100x. I'm not sure, though, that you need to convince them it will be worth a billion dollars. A big big thing, yes absolutely.
  • Spot on point, Ourial, with respect to smaller shops having the luxury of exiting earlier and still generating attractive returns (on an IRR basis, albeit not likely on an absolute return basis).

    Chris's post is also an observation on the early stage. There is a notable distinction between stage-specific VCs as mid- to late-stage shops tend to look for singles, doubles and triples more than home runs.

    Anecdotally, most of our own early stage portfolio investments offer more conservative risk/reward. They are super solid companies that have the potential to turn many multiples on the investment, but are unlikely to become the next billion dollar tech superstar. I raise this point simply to note that there is diversity amongst early stage investors. That said, Chris's point definitely captures the general rule.
  • I think you have a point here but it does not apply with medium and small size funds (less than 100m in management) where returns expected per deal can be lower and successful exit could be considered in the sub 200m USD range.

    Your point applies more to "traditional" VCs. makes sense?
  • yeah, i'd agree. which is one reason I think smaller funds make sense - gives a lot more flexibility. although as I commented above: Even smaller funds have the problem of having to depend on bigger VCs with "home run" mindsets for further financing. - unless the company they fund gets to profitability or acquired - a risky bet.
  • and this is why they're blossoming all over the world. not only in america.
    in Europe for example a couple have grown in the UK. in Germany, in spain,
    in italy. I am actually helping setting one in France which should be
    operational in a few weeks hopefully
    Maybe entrepreneurs should try to be honest with their project and try to
    "evaluate" what kind of funds make better sense for their project before
    they get to the big guys.
  • Ouriel, how would your average entrepreneur obtain the needed information to properly evaluate the different funds? that seems very difficult in practice, especially as most entrepreneurs are first-timers
  • eran i am not referring to evaluating the funds but evaluating themselves.
    If an entrepreneur is unsure about the value of his company or by lack of
    experience or by absence of metrics he should go for a convertible note...
  • Thanks Ouriel, I got what you meant now. Definitely, entrepreneurs should make sure they really need the investment before taking it up with a VC, perhaps bootstrapping or going with an Angel instead
  • precisely
  • robchogo
    Great post! I'm curious though about your own experience at SiteAdvisor. How was that exit perceived by your investors - given that it was a great IRR but not a right-tail outcome? Was there a conflict between your incentives when it came to the decision to sell the company vs. swing for a bigger outcome?
  • Good question. You'd have to ask my VCs (who I think you know)... :)

    But I think the important distinction here is: VC's want to invest in companies that have a chance of being billion dollar exits. That doesn't mean they won't sell a company for (far) less than that if the offer is attractive enough.
  • Most VC's definitely have a "swing for the fences" mentality to their investments. The strike-outs in their portfolios don't matter so long as as they knock a few balls out of the park.

    But it leaves an interesting funding gap. Where do companies seeking investment go if they aren't the next big thing? Most tech companies don't have the kind of collateral that banks demand, and VCs aren't interested in steady growth businesses.
  • Good question. Even smaller funds have the problem of having to depend on bigger VCs with "home run" mindsets for further financing. - unless the company they fund gets to profitability or acquired - a risky bet.
  • Chris, I am neither a VC nor entrepreneur, but have sat on the sidelines reading your blog for some time now and am a big fan. From my extremely limited knowledge (near 0) I am thinking this may be true for some VCs, but not all. Nothing is ever 100% one way. Granted my thinking is based mostly on reading Fred Wilson and Bijan Sabet whom I admire most notably for their personal ethos not just their approaches to business. Looking at their companies respective portfolios (and others like YCombinator for instance) I'd say there are quality VCs open to the non-billion dollar exit company. And sure, while all VCs and entrepreneurs dream of the billion dollar co (and why shouldn't they) I have to think there are numerous other considerations made during early stage funding of equal importance.

    One other way to look at it is like baseball, wouldn't you take 9 singles in a row rather then 8 outs and one homerun. You end up with a lot more runs the first way.
  • Kirk - You'd *think* they'd take 9 singles in a row instead of a homer and 8 outs, but in my experience that's just not how most VCs think (at least, as Ouriel points out, bigger funds think).
  • A quick question - are VCs really focused on exits only? if you suggest attacking a market that has the potential to generate huge revenue a few years down the road, isn't that enough? no VC is willing to partner for the long haul with a real revenue generating business?
  • In almost all cases, revenues are just a means to and end (acquisition or IPO - i.e. an exit). In some rare case VC's will exercise their "redemption rights" and get paid back via profits generated from the business, but almost never the goal for early stage VCs.
  • However, common knowledge indicates that promoting the IPO strategy to VCs is the wrong way to go about it, as it not something you can count on. I thought VCs want to hear about sound business models and how to generate revenue, and not how it would appeal to google as a purchase opportunity. IPO should be a favorable possibility, but a low-proability one.

    Don't investors want to know you're in it for the long haul and not just targeting a quick exit?
  • yes, they want to hear about sound business models and how to generate revenue. Investors definitely want to know you're in it for the long haul. But they also want to hear a story about how you can be the next big billion dollar exit. All of the above are consistent.
  • Thanks Chris, another tweak to add to our next pitch :)
  • joshuakarp
    This has always been a challenge for me. Is it realistic for anyone seeking venture capital to say, "we can have a billion dollar exit in 5 years?" Or is it better to present information with the goal of having the VC come to that conclusion themselves? It seems to me (and I've pitched quite a few, but never successfully) that VCs need to hear enough to convince themselves that it is a billion dollar opportunity... you can't tell them anything. It's not my term, but you need to illustrate a "frictionless" path towards making a ton of money, where people working at the business do not need to grow at the same pace as the people using the business (that was a key problem for The Printed Blog - and the fact that we started a newspaper, of all things).

    This idea of "frictionless" growth is one of the most important takeaways for me for the next time I'm pitching a VC on an investment.
  • Yes, you need to say you will be the next billion dollar company outright and you need to describe how the future in which you are will look and back it up with great arguments.
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