Most entrepreneurs simply approach venture capitalists asking for money “hat in hand,” without educating the investor on how they will get a 10x return on their investment. They need to see this return for your idea to break through the clutter of other startups that approach them every year. This lesson is designed to help you build that bridge to a 10x return for your investors.
An example of Series A venture financing may look something like this: You raise $1MM in exchange for selling 20% of your company. That implies a $4MM pre-money valuation and a $5MM post-money valuation of your business. The new investors will need to see a financial model on how you are going to build them $50MM of value (10x growth) over the next 3-5 years with the monies you are raising.
Let’s say you have $2MM in revenues today, implying your business was valued at 2x revenue on a pre-money valuation basis. In order to build a $50MM valuation 3-5 years from now (to achieve the required 10x return), you need to show a financial growth plan that leads to $25MM in revenues by the end of that period (using that same 2x revenue multiple). The plan needs to be credible, with enough sales and marketing support to rationally justify that size of a business can be built. That size of business has to be reasonable in relation to the size of your industry (e.g., growing to 5% market share, is a lot more believable than growing to 75% market share).
If a Series B transaction requires additional fundraising down the road, you need to take the resulting dilution into account for the Series A investor. Let’s say that Series B transaction raises $5MM in exchange for selling another 20% of your business, implying a $20MM pre-money valuation and a $25MM post-money valuation. Your Series A investor got diluted down 20%, taking their original 20% stake, down to 16% stake. Make sure their 16% stake in the new model can still keep their total returns in excess of 10x.
If you cannot achieve a model similar to the above for your business, you will have very low odds of getting the attention of most typical venture capital firms. Before making those first calls to VC’s looking for money, make sure you have fully thought through this investment from their perspective (not yours) to see if you can reasonably achieve their 10x ROI goals and communicate such credible plan to them to get them excited about your business. This also gives you credibility as an entrepreneur that understands the goals of the venture investors and of having thought through the model that far ahead.
This article was originally published on RedRocket VC, a consulting and financial advisory firm with expertise in serving the start-up, digital and venture community.