💡 How to Determine if Your Startup is Venture Capital 'Backable'...

Last week we covered how CatalyzU is equipping the next generation of founders for the inevitable rise in VC in Africa. Well, Co-founder Luke Mostert is a reader of the newsletter and reached out to help us put together this week’s Builder’s Corner. Let’s dive in…

I’ve reviewed over 4’000 startup pitch decks in the last 6 years. The most important question I ask myself each time is . . .

“Does this Founder understand what is required for their startup to be a successful outcome for a VC Fund?”

You see, VCs like to talk about “moon shots” or “fund returners”... the unicorns. These terms aren’t just trivial jargon, they’re what determines a VC’s success.

For example, in 2012, Y Combinator calculated that 75% of its fund’s proceeds came from just 2 of the 280 startups it invested into – 0.7%!

It’s this phenomenon that Sebastian Mallaby coined as “The Power Law” in his book by the same name.

Opposite to a normal distribution curve, The VC Power Law distribution sees 5% or less of the inputs (in this case startups 🚀) bringing about 95%+ of the outputs ($ returns).

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But what does this really mean for startup founders pitching to VCs?

At a minimum, it means funds would like each startup they invest in to have the potential to return their fund.

Here’s how this plays out at a Pre-Seed Fund like Future Africa:

Let’s assume a VC Fund has a total fund size of $10M. Then every investment must have the potential to return at least 1x the total fund size, thus $10M. And let's assume on each deal the fund invests is $200k in the Pre-Seed round at a $5M post-money valuation.

• This means the $200k investment needs to multiply in value 50x to return the Fund (200k * 50 = $10M) and for them to at least break even. But one also needs to factor in dilution…
• 3 additional fundraising rounds (Seed, Series A, Series B) will each add a dilution of ∼ 20% to existing shareholders. So, instead, the investment’s exit valuation must reach a multiple of 50 * (1.2)^3 = 86x in order to accomplish the “fund returner” goal.

In monetary terms, this means:

• $5M post-money * 86x multiple = $430M exit value (meaning the company needs to list on a stock exchange or be sold privately for that value).

If we extrapolate, a software business with annual recurring revenue is typically valued at 10x its annual revenue, hence the startup would need to reach $43M in revenue per year. Thus there should be a path to $43M annual revenue within a VC funds (usually 10-year) lifespan.

For instance: if the startup sells software subscriptions to businesses for $1’000 per annum, is there a clear path to 43k customers?

More granularly, at what intervals (growth rate) does the number of users have to increase each year to achieve this?

Is this rate of growth possible?

And how probable is it?

And if there is such a path, these 3 core considerations come in:

• The Founders can pull this off
• The Market can support it
• The Product/Competitive Advantage is big enough to capture enough market share.

Ultimately, though, if a founder can’t demonstrate that their startup is capable of generating a VC-level return, then they will likely struggle to maintain investors' attention for the rest…

If you enjoyed this piece and want to learn more from me and other startup founders who have done it before — such as 2x unicorn founder Iyinoluwa Aboyeji — then apply to our “How to Startup” Fellowship.

Applications close on 14 May 2024, with the program kicking off on 23 May 2024.

Today’s Builder’s Corner was written by Luke Mostert from CatalyzU who is an expert in venture capital and entrepreneurship.

Connect with him on Linkedin here.

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