When I was an entrepreneur, it never crossed my mind to wonder how VCs measure their success — but I should have thought about it. Following the money can really help illuminate VC behavior and their incentives.
The #1 problem with the venture capital game, in general, is that actual success is measured over decades, not years. It means that investors will not know if they are any good at investing for decades. Any investor who tells you otherwise is BSing you.
So, as an entrepreneur, you might be pitching to people who may not even be good investors. I’ll be the first to admit that I don’t know if I’m a good investor or not, and realistically, I won’t know for at least another decade when I see how all my investments shake out. It takes a long time to see the results of a startup that does well.
This means that in order to measure milestones along the way, investors must come up with proxies for success. This is necessary but far from perfect.
So while I’m waiting for my portfolio companies to either die or go IPO, what am I looking at as indicators of success and failure? Primarily these things:
- Companies dissolving
- Companies exiting
- Companies raising equity rounds
All of these are concrete events that attach a numerical value to a company. Obviously, when a company dissolves, it’s typically worth $0 (in most cases, there are no sellable assets).
Companies that exit are valued at whatever the sale is. If it’s an all-cash deal, it is easy to understand, and the value is what it is. If a company sells for stock or partial-stock, then it’s more complicated, depending on whether the acquirer is a public company or a private company, and we don’t need to dive into that in this post.
And, lastly, when companies raise an equity round, there is another investor who has (in theory) done due diligence and assessed that a company is worth a certain amount. But as we’ve seen, these valuations can be hocus-pocus — even at later stage rounds, we’ve seen lots of companies of late fall from grace and become massively devalued overnight when they cannot raise their next round at a higher valuation. If a company raises a good round, it gets marked up to the new value. If a company takes a down-round, it gets marked down.
But what if a company is growing revenues but hasn’t raised a round in a while? Shouldn’t they get a bump up in valuation? Intuitively, you might think, “Yes! They are now worth more than before.” But let’s say we have a company that raised a convertible note round at $3m cap 12 months ago. At that time, they had no revenue, and now they are doing a $500k revenue run rate. When people invested in that round, there was an inherent assumption that the company would make money at some point and that the expected value of the company over its lifetime would be $3m. That’s what that valuation means (in theory): how much the company is expected to be worth over its life. Otherwise, there is no way investors would ever value companies that are making no money at $3m. So, now that the company is doing $500k run rate, should the valuation go up? Well, maybe not. After all, we expected them to make $3m over their lifetime — this was already baked into the prior valuation. Many investors would choose NOT to mark up the company at this point even though they are making more money. (For those who want a more sophisticated read on this, I highly recommend Scott Kupor’s post on valuations. However, these other methods do not apply particularly well to early stage investing, in my opinion.)
Now let’s say we have two portfolios of companies.
Portfolio 1:
- 3 companies
- Last valuation for all: $3m cap convertible note
- Recent raise: $1m for each company. Equity rounds of $10m pre.
- Traction at last raise: None have revenue.
- Current traction: None have revenue
Portfolio 2:
- 3 companies
- Last valuation for all: $3m cap convertible note
- Recent raise: none.
- Traction at last raise: None have revenue.
- Current traction: All are doing a $1m run rate
For simplicity, let’s say all companies in both portfolios are in the same industry so that we can compare apples to apples. You and I might say, “Wow. Portfolio #2 is crushing it. These founders are really selling.”
But at a VC firm, we would mark up the companies in portfolio #1 because they have all raised equity rounds at $10m pre. Portfolio #2 hasn’t, and for the reasons above, we would not mark them up even though they are making money. Interesting…
Now, let’s take this a step further. A common intermediary milestone for most investors is IRR (internal rate of return) of the fund. This is calculated based on the events above. Dissolutions and cash-exits are accurate representations of a company’s value, but most events tend to be fundraising events since dissolutions and exits only happen once in a company’s lifetime. So, there are a lot of unrealized gains built into the IRR of an early fund. Furthermore, we’ve established that companies don’t get credit for revenue — this does not get factored into IRR calculations. IRR calculations are based on two things: changes in a company’s value and the time-scale on which this happens. So, one way to maximize your IRR is if you have a portfolio of companies who are able to raise quickly and frequently and at higher and higher valuations. In many cases, companies that can achieve this are typically also making a lot of money (hopefully profitably), but this isn’t necessarily true. Also, think about the flip side. Companies that are making a lot of money profitably and don’t raise do not help an investor increase the IRR of his/her portfolio.
Let’s take this one step further. Typically, VCs raise a fund every three years. Investors in VC funds — referred to as Limited Partners (LPs) — look at a number of factors in deciding whether to invest in a VC firm, but the IRR of past funds is an important criteria.
Putting this all together:
1. VCs are incentivized to bring in portfolio companies who can boost their portfolio IRR quickly. This helps them raise their next fund. This is what keeps investors in business — raising fund after fund.
2. VCs mark up portfolio companies when they raise money at higher valuations, and these markups get factored into IRR. Company progress on KPIs, including revenue, typically do not get factored into IRR.
3. Therefore, VCs are incentivized, in the short term, to invest in companies that can raise their next round relatively quickly. This is easier for investors to achieve when they pick companies that:
- Are in hot spaces
- Have proven teams or teams with pedigree
- Have traction
- etc…
This is why investors like it when startups think about growing fast to raise the next round (as opposed to getting to profitability and growing more slowly on profits). This is why investors don’t want to hear about entrepreneurs selling early (sub $1B businesses). Obviously, in the long-term, investors do care about the actual outcomes of its portfolio companies because ultimately, that is what matters. Since that is so far off, however, this explanation should hopefully illuminate how the VC industry views the short-term — and you should care because VC incentives explain so much about why VCs act the way they do.