Angel investors and early-stage VCs invest in companies at a stage when the assumptions around the business and the entrepreneur’s execution capabilities are yet to be proven.
While investors review shortlisted companies very, very diligently based on their perspective of the opportunity; their assessment of the business case; and their perception of the entrepreneur’s capabilities; quite a few of the companies that they invest in will fail for a variety of reasons. Some of their portfolio companies may do well, but the investors may not get an exit i.e. they may not get a buyer for the equity they hold in some reasonably successful ones.
Not only will the investors not get any returns on these investments in ventures that don’t succeed or where they do not get an exit, they will most likely lose their capital as well. Only a few of the companies that they invest in will be successful to the extent that they had assumed they would (or much more than that in rare cases). And therefore, to cover these losses and to make money on their portfolio as a whole, they need at least a few multi-baggers in their portfolio i.e. companies that will be sold for 10 – 20 times the capital they had invested in.
Lets understand this with an example.
Let’s take the case of an investor who puts $200K in 10 startups at the beginning of 2017, and so overall has made an investment of $2 Mn. If this investor is seeking 20% annual return on his capital, then in 5 year’s time, this $2 Mn should have appreciated to around $5 Mn by 2022.
Now, of the 10 companies that he/she has invested in… It is likely that 3-4 companies will fail and shut down, or continue to struggle along.
May be 3-4 companies do reasonably well, but not to the extent that follow-on investors are interested. They MAY be generating profits that keeps the entrepreneurs reasonably happy with the outcome, yet the investor has not yet got any returns because they have not been able to offload the shares they hold in these companies. In other words, their investment is still stuck with no returns.
Over time investments in 1or 2 of these reasonably well doing companies may fetch 2-3 times the return on investments. i.e. the shares bought at $200K may be sold for $600K. Not a bad outcome on that individual company. But still not enough to cover the losses in the others and provide the required return on investment on the overall portfolio.
So, out of the 10 companies that the investor had invested in, it is now up to the remaining 2-3 companies to return $5 Mn; and so, unless 1 or 2 of these companies do not return 10-20 times the capital deployed, it does not make sense for the investor to invest in startups. And because you do not know which companies will do well and which won’t, when they invest, investors seek companies that they feel have a reasonable chance of returning capital multiple times.
So, what kind of companies can return multiple times the capital invested?
Companies that can scale massively: Smaller companies, even if they are profitable, cannot give the 10 – 20x returns that investors will need.
Think about it. For a $200K investment to return $2 – 3 Mn, the venture will have to be in a position to raise substantial follow-on capital for the next round of investor(s) to offer an exit to the earlier round investors. And, the next round of large investments will be available only if the company is in a dominant position in a market that still has significant headroom for the company to grow further.
Companies that are in a commanding position in their markets: Why else would someone pay a premium for the company if it is not in a commanding position and is an also-ran in the category?
If you consider the factors above, it is no surprise that investors focus on companies that have the potential to be a dominant player in a very, very large market. Modestly sized businesses, though a healthy outcome for entrepreneurs, may not yield a good return for the investors.
So, if your VC funded venture fails, remember, someone else is covering up for these losses. And if your venture is super successful and provides VCs with healthy returns, you are also covering up for the other losses in the VCs portfolio.
About The Author
[Prajakt is the founder of Applyifi and the founding partner of The Growth Labs. Before starting Applyifi, Prajakt was the head of operations at IAN, and the Asia-Director for TiE (2004 – 2007). Previously Prajakt had co-founded Orange Cross, a healthcare services company, and was part of the founding team member of Idealake Technologies. Also, he is author of the book, ‘Starting Up & Fund Raising’.]