Should I give an arm and a leg to the VCs?

Bringing VCs on board can be an emotional (and sometimes traumatic) experience. It always seems that you’re giving a lot for what seems little in return: cash. Using simple maths may prove a powerful tool to set some context before taking the dreadful decision of accepting foreigners’ money. In this case, we can rely on the notion of discount rate to shed some light to the debate.

 Let’s first take the theoritical case of a startup doing a seed round of €500k on Year 1, a first round of €2M on Year 2, a second round of €6M on Year 3, a mezzanine round of €2M on Year 4 and a brilliant exit of €30M on Year 5. If VCs use a discount rate of 50% to define the shares they want with a target exit of €30M, they’ll dilute you from 100% ownership to 91.5% after seed-round, 71% after first round, 39% after second round (ouch!) and leaving you 35.1% ownership of the company after mezzanine round (where we keeped a 50% rate for the sake of simplicity). So you’ll end up with €10.5M in Year 5.

Not bad! But wouldn’t have you been better not taking VCs’ money and maybe take 10 years to exit with 100% of the final €30M? This is where using discount rate can bring some rationale to the decision. Let’s forget all the details of the different rounds that were there just to set the stage for: am I better owning 35% of the exit value in Year 5 or owning the entire exit value in Year 10? This is where it all depends on your own discount rate. If your own way to assume the discount you apply on years between 5 and 10 is below 23.3%, then you should go all on your own and shoot for the big prize; just be prepared for a long, long trip. If it is above 23.3%, then settle for the “quick” route and pocket the %35.1 percent faster (still 5 years).

 When we compare this 23.3% with the 50% of the VCs, it could seem obvious that the decision should be: pocket the money on Year 5 and then,..become a VC. In fact, the 50% holds only for specific projects: The successful ones. VCs invest in a portfolio of projects and as the old saying goes: Out of 10 invesment, 5 go down the drain, 2 become zombies (projects with no exits), 2 give back less than what was disbursed and only 1 is a superstar offering the famous 50% or above. All in all, a fund is very happy if it can provide an Internal Rate of Return (IRR) above 12%. So you could assume that you’re finally better off keeping your investment in your own startup and make it blossom at a rate superior to 23.3%. But remember that your investment is tied to one “single” project, and that the risk is exactly what is making the transition from a discount rate to an IRR.

In fact, from an option point of view, it is always very positive to get cash out sooner than latter. What the little example illustrated was just that faster exits are actually made possible by the cash that the VCs bring in: this provides the acceleration needed to reach more rapidly the way out.

So when taking the decision, remember the paradox: Giving an arm and a leg can help me run faster.

Advertisements

1 Response to “Should I give an arm and a leg to the VCs?”



  1. 1 We applied to SeedCamp | Friendsclear Trackback on September 9, 2010 at 2:19 pm

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s





%d bloggers like this: