Unicorns from a VC's Perspective

 2019-07-17 By: InnoVEX Team

The speaker of the final keynote speech in InnoVEX 2019 which covered VC perspectives on startups and the startup ecosystem is Mr. Ravi Belani; the co-founder and Managing Director of Alchemist as well as lecturer in Stanford University. Mr. Belani's keynote speech discussed VCs' perspectives on startups and the key tools for startups to achieve a USD 1 Billion valuation.

Understanding VCs

As an industry, VCs are worth only 0.2% of the US GDP, but they are responsible for approximately 20% of the companies in the US that are now driving the GDP of US. VCs make money through 2 methods: management fees and carries. Management fees are paid annually to the VCs as a fixed percentage of the funds they manage regardless of performance; usually 2%. As most funds go for 10 years, this means in the duration of a fund, 20% of the funds will not be used for investment purposes, but paid to the VCs. In contrast, carries or carried interests are tied into the performance of the fund and VCs are rewarded more when the startups they invest in can exit with high valuations. Generally the VC will receive 20% of the returns gained from the exit.

In his experience, any startup that has been invested in will need more funds in addition to the initial investments. If the startup is doing well, they will need more money to scale; however if the startup is doing poorly, they will need more money to survive. That is why usually a total of double the initial investment will be prepared for the startup to anticipate for future developments. With the initial investments given and double the value prepared for the future; in general most funds are already fully committed by the third year. If a particularly impressive company were to appear on the fourth year, they will have to wait until the VC has successfully raised another fund or join another fund.

At any given time, VCs usually manage 3 different funds worth USD 50 million each and receive management fees from all of them. Even with potential costs factored into the equation; VCs are almost guaranteed a USD 1.5 million annuity for 10 years of their foreseeable future.

Mr. Belani stated that one of the keys to successful fundraising is to convince the VCs that the startup is already on a path to build a billion dollar venture. In addition to fulfilling a certain number of heuristics or metrics, the founders will need to agree with the VCs that invest in them on the exit strategies. However, VCs and founders might see an exit valuation differently.

Different Perspectives on the Same Result

An example he gave was if a startups wants USD 1 million from a VC in exchange for 20% of his company; promising 5x return in the next year. In the initial stage, this means the startup is worth USD 5 million and will exit for USD 25 million. Generally founders and CEOs of venture backed companies make USD 150,000 per year and if this prediction were to come true, the founder's payout will be USD 5 million; 30 times their annual salary. However, the situation is completely different for the VC. A 25 million exit means the funds make 5 million; 5 times the original investment. Of this, the VC will only receive 20%, which is USD 1 million which they will then need to split with their other partners. In the end, the final payout for the VC might only be worth USD 100,000.

For the same outcome of a 5x return valued at USD 25 million, the founder and VC receive significantly different results. The founder received 30 times their annual salary, while for the VC; they received 2 weeks' worth of work in 1 year. The VC also cannot pay back the funds through such relatively low multiplier. The incentives align more easily when the exit is worth USD 500 Million or even USD 1 Billion because at this stage, the VC can pay back the fund more realistically. As VCs' main motivation is to fund companies that can be worth USD 1 Billion.

Disproportionate Return to Break Even

Historically, out of the 30 companies in a typical VC portfolio, only 3 companies will be responsible for their disproportionate returns while the 27 other companies mostly will not work out and this is a generally accepted outcome. Mr. Belani quoted Archimedes on the situation: “Give me a lever long enough and a fulcrum on which to place it and I shall move the world”. The idea is that for the same amount of effort, founders can have a disproportionate return depending on how they architect their strategies.

Mr. Belani also quoted Ben Horowitz of Andreessen Horowitz that “It takes as much work to build a mediocre company as it does to build a big company, so you might as well go big”. Founders will need to put in the same effort no matter if they are aiming small or big; so they should go big instead. The big difference between architecting a company worth USD 1 Billion and 10 Million is in whether they can grow exponentially.

3 Metrics for Exponential Growth

Mr. Belani pointed out the three metrics that startups need to focus on to achieve exponential growth: gross margin, new technologies, and network effects. Gross margin means startups need to be able to achieve higher profits. Every incremental decrease of cost or increase of profits can create a non-linear effect on the growth of the startups. This is also the reason why VCs prefer to invest in software companies to hardware. Software development is usually low-cost and generally the cost involved is the electricity used; but hardware companies need to pay their own materials and are generally capital intensive. Mr. Belani suggested hardware companies to focus on the software side and monetize on services. The startups need to think about how to reduce their costs and increase customer segmentations to increase their margin.

New technologies follow Moore's law which in itself is a natural exponential curve; where the power of processors doubles for every 18 months. This is also a natural advantage to have as a startup has the leeway to find new technologies that did not exist 3 years ago. It is only logical for startups to exploit it to achieve their exponential gains.

Network effect increases the value of the product as the number of users increase. It is a metric that VCs particularly prefer and also the final source of multiplicative exponential advantage. This is seen in social networks and marketplaces such as Facebook, WeChat, and Skype.

To watch the full forum session, visit our YouTube channel here.