How much does Venture Capital really cost?
Have you ever considered what equity really costs the entrepreneur? Historically, relying on venture capital (VC) has been one of the only options available to entrepreneurs seeking seed capital, but the cost of this model to founders is far greater than most realize, and it’s not the only option.
As a venture capitalist with over a decade of experience, I know the real cost of equity and what drives that cost. Let me give you a breakdown of the hidden cost of Venture Capital to entrepreneurs, based on my experience. SaaS business founders and early investors need to understand these costs, and what their other options are, before seeking that first institutional round.
- Venture capital funds need to provide significant returns, after all costs, to their own investors.
Typically, VC’s advertise to their own prospective investors that they will provide a 25% return on the investor’s capital over a period of 10 years. On top of this return, VCs deduct management fees, audit, and legal costs, which can amount to as much as 15% of the total capital of the fund over the life of the fund. The capital that’s actually available for investment ends up being approximately 85% of the total capital raised.As a consequence, a typical venture capital fund will seek to achieve a return of 3 times the original capital raised, in order to earn the 25% net to investor return as well as cover the operational costs of the fund. A VC having raised a $100 million fund will seek $300 million in exits. Keep in mind that only $85 million of the $100 million was actually invested, while the rest was consumed by management fees, audit and legal costs.
- The assumption that 8 out of 10 startups will fail or break even (and that your successful startup must pick up the slack) is built into the way venture capital funds structure their investments.
The typical VC is operating under the rule of thumb that only two out of every ten companies in a portfolio will actually be successful. It’s assumed that four or five of the companies in this same portfolio will return only the capital invested, and three or four will likely fail, bringing no return at all.So, in our example, where does the actual burden of returning the $300 million to a VC fall? If we’re using the assumptions that most VCs are making, this burden falls upon two companies in the portfolio, not ten. Of these two companies, each likely received a total investment of $10 million from the venture fund, over multiple funding rounds.
- The returns expected from you as an entrepreneur are far higher than you think.
Together, then, these two hypothetical companies in the VC’s portfolio received $20 million, and are now expected to collectively return $300 million to the VC.That’s a return of approximately 15 times the amount invested.
That equates to a cost of over 100% per annum for your equity.
My example might seem like an extreme scenario, but it gives you an idea of what the VC investing in your business is thinking, assuming, and expecting. Returns need to be much higher than 5 or 10 times the original investment, and all board decisions will be driven by this framework. which is often invisible to entrepreneurs.
There is another option.
- Revenue financing allows you to retain precious equity in your company.
In some cases, finding the right VC partner can certainly provide added value, especially if that partner can help maximize growth by providing certainty of capital, international connections, customer introductions, or strategic relationships. However, it’s crucial for entrepreneurs to understand the true cost benefit ratio of selling their equity to venture funds. One of the CEO’s primary jobs is to chart the company’s course of growth, and if this growth requires raising capital, #CapitalEfficiency should be the top of mind concern for entrepreneurs.
The team at TIMIA Capital includes several former VCs that have successfully designed and executed another option: revenue financing. Revenue financing is an alternative model that providing funding to entrepreneurs without requiring them to give up equity in their companies.
When you connect with us at TIMIA, you can be assured that you’re assessing all the options available to you.
Mike Walkinshaw is a reformed venture capitalist and the CEO at TIMIA Capital.