Entrepreneurs and venture investors as a whole are an optimistic (and perhaps delusional) bunch and that is why I love them. But like in Las Vegas, the odds tend to send most players home with less money in their pockets than when they arrived. To make sensible decisions regarding this playing field, every Latin American entrepreneur should understand a bit of “venture math.”
CB Insights, a finance industry journal, recently released a research report that showed that 70% of tech companies who had raised money from venture capital funds fail an average of 20 months after first raising financing.
Raising money sounds great. But most Latin entrepreneurs do not appreciate the game they are getting into. So let’s break the venture capital down from both sides: the VC and the Entrepreneur. These rules hold true whether the fund is US-based fund or LatAm-based.
What Returns are VC Funds Shooting For?
Often in their unbridled enthusiasm Latin American entrepreneurs forget that venture capital fund managers also need to show returns. A good rule of thumb is that a venture fund needs a 3x return to achieve a “venture rate of return” and be considered a good investment. Thus a $50M VC fund needs to realize $150M in returns to be considered successful.
The dirty secret of the venture capital world is that only between 5-10% of venture funds achieve a 3x return or better. Somewhere between 90-95% of all VC funds are battling to even return to their investors the original capital invested in the fund.
While a 3x return might sound great, most venture funds have a ten-year fund life. A 3x return means that a fund would generate an average annualized return of 12% a year to its investors. Most investors would be happy with a 12% ARR, but not overwhelmed.
If a fund manager is running an early-stage venture capital fund, they need to achieve at least a 3x return to be able to raise the next fund. It is likely that 70% of the companies that receive investment will fail. The VC fund will need to generate your 3x return from the 30% of companies that will survive.
These numbers suggest that a VC fund manager needs an average of a 10x return from the successful companies in its portfolio to achieve a reasonable return. Since any seasoned VC fund manager knows that not all the companies in the portfolio that survive will yield a 10x return, managers look for companies that could yield 20x or more. These are big expectations that every entrepreneur from Latin America needs to understand before taking on VC investment.
How does Venture Math affect Valuations?
Since VCs need to target companies that are likely to return 10x-20x, these fund managers place significant pressure on entrepreneurs to seek outsize returns. Most entrepreneurs from Latin America do not understand how these requirements affect valuations.
Since venture investors are seeking 10x-20x returns, entrepreneurs should expect that every time they raise money, the market will expect the pre-money valuation of their company to have increased by 3x. Thus the “typical” valuation trajectory of tech-enabled companies is to have their pre-money valuation triple every 9-18 months as the company raises successive financing rounds.
If a company raises a Seed Round of US$250K at a US$750K pre-money valuation, the company should expect to raise a Series A at a minimum $2.2M pre-money valuation. The market would then expect that same company to raise at an almost US$7M valuation in its next round. Valuation expectations continue to rise, which is not easy to achieve.
Raising money when the pre-money valuation is still less than $10M is not easy. However, at a sub-$10M valuation entrepreneurs can still sell the promise of good results at a lower price. At a valuation over US$10M, investors want to see real, measurable results.
To continue tripling from a US$7mm pre-money valuation to a US$21mm+ pre-money valuation is a daunting task, especially in Latin America. However, every entrepreneur needs to understand “venture math” before he or she takes money from institutional venture investors. I often advise my clients “Don’t take the money. And run.” Smile.
This post is also available in: Español (Spanish)