There has been a lot of healthy discussion about the true implications of VC investments. Markus Frind (plentyoffish.com) wrote about it a year ago and Basil Peters (AngelBlog) has been analyzing how VC math influences a startup’s DNA.
In a nutshell, a $50 million exit = a $5 million exit when you factor in two things: risk and payout (the cash you actually take home). In the example below, the upper tree shows a $50 million exit and the bottom shows a $5 million exit:
The $750k represents the expected value in both cases. How come they are the same?
The VC-backed example represents a “home run or bust” investing philosophy. The exit is bigger ($50 million) but so is the risk (only 1 in 10 will make it). Also, your portion is smaller, only 10% at exit in my example. So if there is only a 10% chance you’ll earn your $5 million payout, the expected value is only $500k (10% X $5 million). Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.
The other example is a startup done lean or with some friends, family and Angel money. The exit may be much smaller because the funding isn’t there to go big. But nor is there the desire to “go big or go home”. So out of a much smaller $5 million exit, you retain $2 million (a bigger chunk) plus your chance of success is now 25% instead of 10%. So 25% X $2 million = $500k. Add to this a 50% chance of a “sideways” exit, i.e. not much, and you get $750k.
Some people may object to the numbers:
- 10% ownership at exit is too low – Actually, you may own less these days given lower valuations. See this presentation from Union Square Ventures.
- 90% chance of failure is too high – I agree this may be pessimistic but there are a lot of VCs out there who don’t have one home run every 10 investments.
- The success rate is too high for modest exits – Few people would claim they could get higher rewards with lower risk…
I’m definitely not suggesting that the numbers I’ve used are the right ones for you. But they are a revealing way to explore alternatives when funding your company. Every option has pros and cons and it’s up to you to understand them. This method gives you a way to quantify those options.
You may be surprised to find out that bigger is not necessarily better, at least not in terms of how much money you take home when you exit your company.