Why Market Matters Most to VCs
A lot of things can go wrong for a startup. In fact, the vast majority of startups ultimately fail. They fail because they didn’t find product-market fit, got beat by a competitor, were pre-empted by newer, better technology or were unable to figure out an effective go-to-market strategy. They also fail for all sorts of human reasons: cofounder breakups, bad hires, culture issues and the simple, heartbreaking realities of life.
As both a VC and former founder, I understand this all too well. And that understanding is fundamental to the decisions that I make as an investor.
It Starts with the Power Law
You’ve undoubtedly heard or read about the significance of power law distributions (aka “power law”) to venture investing, but most people don’t appreciate how fundamental a role the concept plays in the investment decisions that VCs make.
It’s long been understood that venture returns are best described by a statistical distribution known as power law, in which a small number of investments are responsible for the majority of the returns. (You may also have heard this referred to as the “Pareto principle” aka “the 80/20 rule”. Pareto distributions are, in fact, a type of power law distribution.)
My far more educated brother-from-another-mother, Jerry Neumann, once wrote a deep dive into the economic theory behind power law distributions in venture investing. If you want to go really deep on the topic, read this.
In 2014, Correlation Ventures released a landmark study of 21,640 VC investments that took place over the course of 9 years and the returns generated by their investors:
The study empirically confirmed that the returns of venture-backed startups indeed follow a power law distribution — although the distribution was far more skewed than many investors previously believed. What the chart above shows is that nearly 90% of all venture investments result in returns that are inconsequential to the majority of VCs. That might seem like an exaggeration (for most people, a 1 - 5x return-on-investment is pretty good), but if you’re an early-stage VC, it is indeed the case.
Seth Levine of Foundry Group wrote a great post shortly after Correlation’s study came out that explained why. In his post, Seth described the returns of a hypothetical $100M fund and noted that if the fund failed to invest in at least one company that returned more than 5x, it would ultimately fail to generate a positive return for its investors (i.e. it would lose investors money).
Going further, for a $100M VC fund to generate a positive (but not great) return for its investors, it typically must invest in at least one company that returns 10x or more. But here’s the thing: the target return for top-performing VC funds is 3x. For that to happen, a $100M fund must invest in at least one company that returns 50x or more!
So what does it takes for an early-stage VC to generate such a return? Let’s look at an example.
Evolution of an Early-Stage Investment
At Panache Ventures, we invest exclusively in Pre-Seed and Seed stage startups (conveniently for this post, out of a $100M fund that precisely matches Seth’s example).
Let’s assume that Panache invests $1M into a Seed stage startup at a $10M post-money valuation. Once that round has completed, Panache owns $1M / $10M = 10% of the company.
Our hypothetical company is doing quite well and 18 months later the founders raise a Series A. Assuming that Panache invests our pro rata (which we typically do in companies that are executing well), then we will remain with 10% ownership of the company following that round. Let’s assume that the pro rata investment for Panache is a further $1M, thus bringing the total investment by Panache to $2M.
Like most early-stage funds, Panache Ventures typically does not invest after the Series A, so our ownership in the company will dilute with each subsequent round. If we assume that each round dilutes the company by 20% (a reasonable assumption for a solidly-growing company), our ownership will evolve as follows:
After Series B: 8%
After Series C: 6.4%
After Series D: 5.12%
After Series E: 4.10%
(In reality, Panache’s ownership will almost certainly be lower than the above amounts, as this example doesn’t take into account non-finance dilution, such as when the size of the employee stock option pool needs to be increased, or other common situations where overall dilution increases.)
Like founders, early-stage investors see their ownership slowly but surely diluted over time
Let’s assume that our hypothetical company continues to grow and ultimately has a successful exit after the Series D (at which point Panache owns 5.12% of the company). Here are the returns to Panache based on various exit scenarios:
$100M Exit: $5.12M (2.56x ROI, based on a $2M total investment)
$250M Exit: $12.8M (6.4x ROI)
$500M Exit: $25.6M (12.8x ROI)
$1B Exit: $51.2M (25.6x ROI)
$2B Exit: $102.4M (51.2x ROI)
$5B Exit: $256.0M (128x ROI)
(Note that these scenarios are again overly-simplistic, in that they do not take into account multiple share classes, investor preferences and other terms and dynamics that typically come into play when an exit occurs.)
If we look through the above scenarios, we can see that our hypothetical company needs to exit for at least $250M in order for Panache’s return to exceed 5x. For the return to be 50x — enough for Panache to “return the fund” (i.e. generate a 1x ROI for Panache’s $100M fund) — the exit must be at least $2B.
This is why VCs are so focused on unicorns.
Isn’t This Post Supposed to be About Markets?
Given that the title of this post is “Why Market Matters Most to VCs,” you’re probably wondering why I haven’t talked about markets yet.
Because we needed to walk through the details of power law math in order to understand the significance of the following fact:
The vast majority of markets aren’t large enough to support companies that can credibly generate a $2B+ exit.
The uncomfortable truth is that a lot of effort is spent on companies where, even if everything goes right, the economic outcome simply isn’t big enough for investors. This doesn’t mean that those ideas aren’t important or worthy of pursuit. It does mean that the majority of startup ideas are fundamentally not a fit for VCs.
And, ultimately, it’s because of the size of the market that they’re going after.
Marc Andreesen of a16z noted this back in 2007 in a famous — though somewhat controversial at the time — post he wrote titled The Only Thing that Matters. In considering the variables of team, product and market, Marc noted that “in a terrible market, you can have the best product in the world and an absolutely killer team, and it doesn’t matter.” At the end of the day, if the market isn’t large enough to credibly support multiple multi-billion dollar companies, then it doesn’t matter how good the team or product are, the outcome will never be big enough to generate a return that is meaningful to VC investors.
In practice, this manifests in the fact that VCs spend effort analyzing the market potential for each-and-every startup they consider investing in as part of their diligence. At Panache, our analysts work to not only understand the target market as described by the founders, but also adjacent markets (so that we have a sense of what is possible if the company expands beyond and/or pivots into a different market). This analysis provides the foundation for a key part of our investment thesis: a set of calculations that describes various exit scenarios for the company, based on target and adjacent market sizes and historical exit multiples.
Our goal: to build confidence that, if everything goes right, the resulting return will be sufficient to “return the fund.”
If this sounds like an incredible amount of work for an early-stage investment, rest assured that top VCs are really good at it. In our case, we can go from first meeting to term sheet in less than a week, with a comprehensive market analysis and exit scenario map having been created in the background.
That said, the outcome of our analysis plays a key role in whether or not we invest in a startup. If, at the end of the day, there isn’t a version of the future where a company can generate a 50x return on our investment, then we will not invest. No matter how good the team is. No matter how cool the product is.
Because to VCs, market matters most.