by Charles Plant
Read the first post in this series on how the growth rates of Shopify and Real Matters have impacted their valuations.
Venture capitalists invest in many companies, knowing that some will fail, some will be also-rans or sell in merger transactions, and a very few will go public with high valuations. Of course, the big objective is to either sell or go public at ridiculously high valuations, because VCs need those high-value companies to make up for the failures and also-rans. They also need high returns to meet their promises to limited partners, so that they’ll be able to raise another fund.
Let’s look at how growth rates and revenue multiples affect a venture capitalist’s rate of return.
We’ll imagine a hypothetical company which raises $15 million in two rounds of venture capital and drives revenue to $10 million (which is about industry average for capital efficiency, but we’ll get into that later). By acquiring 25% of the company in each of two rounds, the VCs now have 44% of the company when it sells. If they put their $15 million in participating preferred shares with a single liquidation preference and an 8% coupon (these being standard terms for VC investments), they’ll earn a positive return in all growth scenarios.
Internal Rate of Return
VCs measure results through the internal rate of return or IRR, which shows their average rate of return by year. The next exhibit shows the effect of growth rate on IRR using private company numbers for the relationship between growth rate and revenue multiple.
The Effect of Growth Rate on IRR
In our scenario, with a growth rate of 100%, our imaginary VC will earn a 50% IRR. With growth rates in the 34% range the IRR will be around 28%.
Let’s look at this another way. People often speak of VCs wanting to earn a 10- bagger. A 10-bagger is an investment that returns 10 times its purchase price. Similarly, an outlay of $15 million that returns $60 million is called a 4-bagger, but people don’t like talking about those so much. With this in mind, let’s look at the effect of growth rates on the investment multiple:
The effect of growth rate on investment multiple
We can see that a company growing at 100% per year will just about give us a 7-bagger. Now, this may seem to be a great return, but let’s remember that this is the return for only one company and a successful VC has to spread her risk by investing in multiple companies.
So, let’s say that she’s invested $15 million in each of ten companies. Two of them are 7-baggers, four of them return the investment amount, and four others fail totally. In this case, $150 million turns into $240 million over five years. If you do the math, you’ll find that the IRR is only 10% over the whole period. And 10% isn’t enough to get anybody excited.
This is why growth is so important to venture capitalists. Your company has to be growing wildly to generate enough of a return to make up for the duds. As a result, venture capitalists really only look at companies that are growing at 10% to 20% a month in the seed stage, and at 60% a year in the expansion stage. In reality, many VCs will say that they only look at companies with growth of 100% a year.
Active Rate of Return
You may be surprised by VCs’ actual rates of return. The following chart shows, by vintage year, the rates of returns earned by a sample of VC funds. The median return over this period is only 11%. This data was provided by Pitchbook in their report Pitchbook Benchmarks (Q3, 2017).
Venture Capital Rates of Return
Github was one deal that significantly added to the returns of its investors. Github was founded in 2008 and the founders earned enough revenue in the first years that they didn’t need venture capital funding. They first raised money in 2012, four years after founding, when they got $100 million from Andreessen Horowitz and SV Angels, based on a $750 million valuation. In 2015 they raised a further $250 million (when sales were only $15 million) at a $2 billion valuation. There may bestructural issues, such as liquidation preferences, that would change the ownership percentage, but the math says that the VCs owned about 25% to 30% of the total company.
When Github was sold to Microsoft, revenue was $300 million, giving a 25 times revenue multiple. The sales growth from 2015 to 2018 was an average of 265% a year, so it’s not surprising that they got a 25-times multiple on revenue as a private company. The investors earned a 72% IRR or a 20-bagger. That is worth getting excited about.