Why you have to build companies for less

I've written in the past about why we like bootstrapped businesses and why we focus so much on capital efficiency when evaluating investments.  In the next few weeks I will try to post more practical notes on questions we get a lot from entrepreneurs: how much capital to raise, when to raise it, how to view dilution, etc.

Before we get there, however, here's another interesting data set that ought to affect how both VCs and founders think about capital efficiency.  A few years ago I wrote in Real Deals that investors should recalibrate their views on how much capital is too much capital.  My anecdotal view was that it should be possible to build a globally successful enterprise software business with €10-15m of external capital, rather than the €20-30m which had become quite commonplace.

Every time you pile on the cash you reduce the probability of a decent return on investment -- this is obvious. But to fully appreciate the rate at which this effect occurs, take a look at this chart: 

The vertical axis shows the total number of European tech companies acquired since January 2004 within the value brackets shown on the horizontal axis, in $10m increments.   Obviously, smaller transactions happen more frequently than larger ones.  But look closely and you will see that above $80m the number of transactions flattens out entirely.  In fact, four times as many deals occured in the $30m-80m bracket (125) vs the $80m-130m bracket (32).

We don't know how much capital was raised by these companies to get to their exit values, but you can be sure that some of them made their investors good money, while others barely returned capital.  If a likely exit for a successful enterprise software company is $65m, and we assume the investors own just over half the company following multiple rounds of fundraising, then their take would be $38m or so.  On this basis they will have tripled their money if they invested $12m, which is a reasonable outcome.  But if they had invested $25m, the return would be a pedestrian 1.5x.

The point is that it is very wortwhile to target venture investments on the basis of an exit in the above range, if only because it hugely increases the probability of a decent return.  This doesn't mean giving up on the ambition to reach for a $200m home-run exit.  Europe has been holding its own with a number of spectacular trade sales lately.  But the 'base' of venture portfolio returns are likely to be made with exits below $100m, so both entrepreneurs and investors ought to weigh the benefits of incremental capital on this basis.

The good news is that the noughties are the age of low-cost communications, cheap capital equipment, open-source Web technologies and offshore development resources.  It is entirely possible to build a world-class business with half the capital it took only 5 years ago.   The weight of too-large-funds notwithstanding, this basic arithmetic is worth bearing mind.

Comments

[Frank Felix]

I like the points that you make, and fully support your positive view of bootstrapping and cash-efficiency.

However, I wonder about the role of Venture Capital here. If a founder grew a company to significant revenues and profitability, and seeks an external investment, e.g., to enter foreign markets: where is the real risk for the VC investor? No more "venture" ... just an investment in a company's stock with high potential. This may not work, because first, there is no free lunch, second, it will attract competition from banks, wealthy private investors, and others.

[maxbley]

You're quite right - this is where "venture capital" becomes a misnomer. We call investments at that stage "growth equity" and the investor's intention is clearly not to take venture risk, but only execution risk. Such an investment may be less risky than an earlier-stage venture investment, and in exchange the investor accepts lower returns (on average). This really represents a disaggregation of risks, with investors of different risk appetites choosing to invest at different stages. There is competition in growth equity already, just as there is in venture investing, and in public markets investing.