As you probably can imagine, I get asked this question a lot. So let me take you behind-the-scenes on how I evaluate which companies to fund.
Venture capitalist usually set up limited partnership funds and file a Reg D form with the SEC. Typically, they raise capital from limited partners.
But here’s two major problem facing a new VC fund. Until you have a track record, you have no track record. Without a track record, why would any limited partner want to invest in you. In addition, with a limited track record, you’re asking limited partners to park their money with you for 10-years while investing in high risk startups.
The challenge is that only 10% of the VC funds end up getting 90% of the limited partner funding. Why is that? Because for a limited partner like an endowment to park money for 10-years, they want to earn internal rates of return between 70% and 90%. So they prefer to invest in the top 10% of VCs.
So what happens to the other 90% of VC funds that are not in the top 10% of returns? Well, they die. In fact, the average VC fund only gets a return of 18% to 20% IRR. It’s called “One fund (for 10-years) and done.”
I look for companies with the potential for 100x returns. If I invest a $1 million, I’d like your business to have the potential to get back $100 million in 5-7 years. A single “hit” with a 100x return can set-up a VC fund for life. For example, Accel Partners made over 1,000x funding Facebook’s seed round. Just one investment caltipulted Accel into the top 10% of VCs for life.
I’ve been pitched by over 1,000 companies this year. Only 3 companies seem to have the potential to fit my investing criteria.
What do other VCs look for? The VCs that are likely to be “one and done” tend to settle for 10x on a series A for companies with proven traction and 20x on a seed round. But VC general partners will likely not last beyond 10-years if they don’t hit a 100x company in their portfolio.
I’ve been pitched by some super promising companies but the problem was that the founders wanted something like 20% equity for $20 million. For a company with no revenue! Without getting into the details of pre-money versus post-money (which I’ll discuss in a future post), we’re in the vacinity of a $100 million valuation. To get a potential 100x return, the valuation would have to jump to $10 billion.
Even if successful, how many companies reach a $10 billion market capitalization?
So now that I’ve discussed the math problem for VCs, you’ll understand why VCs look at the market size as their #1 investment criteria. It’s not a secret that successful VC investments are 70% market and moat, 20% founders, and 10% product. However, the types of companies that realize 100x returns are likely to be in markets whose future size is presently unknowable. As a result, I believe that metrics like TAM (total addressable market) can be deceptive. In my opinion, VCs are simply taking wildly imaginative guesses when it comes to market size. Peter Thiel articulates another complicated factor in guessing. Thiel says, “Build a monopoly in a small market and expand into adjacent markets.” So a company may start in a small market but end up in a bigger total market.
Thiel also calls out the elephant in the room. What does every VC seek but will never admit in public? Hint… it starts with “mono” and ends with “poly.” 🤫 The greatest tragedy for a VC is to guess the right market but fund the wrong company. Silicon Valley is a winner-take-all world. Sustainable differentiation (aka “Economic Moats” as termed by Warren Buffet) is absolutely required to become the winner-take-all. Interestingly, Warren Buffett doesn’t like to use the evil “M” word either.
Finally, I’ve been around the tech scene in Seattle for sixteen years but now “snow bird” (well without the snow) between Las Vegas and San Francisco. I’ve often wondered why the Bay Area companies have dominated the 100x exits. Unlike most Bay Area VCs that only invest within a 20-mile radius from their Palo Alto office, I travel around the US and talk to companies everywhere.
So I’ve been able to compare the difference between founders from a variety of states. My observation is that the Bay Area has one thing that other areas don’t have… technical product managers who have experience in “100x Exit” companies.
Don’t get me wrong. I’ve met with experienced technical product managers (who do for example 5-Day Design Sprints) in other states but they just don’t have experience in companies that have had a “100x Exit.”