VC Moneyball

A few years ago I read Moneyball, which is another Michael Lewis book, and the “Aha” moment was his discussion of walks in baseball.  It seemed counter-intuitive at first, but players who get on base a lot, even through walks, are valuable assets.  Most managers had overlooked this and were focusing on the wrong attributes, like players who hit a lot of home runs.  This not only caused teams to lose games, but it also inflated the price of athletes who were, in fact, not that valuable. 

In the VC business we are focused on dollars, but we often talk about our investments in baseball terminology.  A Greycroft investment that returns 2-3 times invested capital is a “double.”  A 5x investment is a “triple”.  Collective Media and Buddy Media are homeruns.  There is really no such thing as a walk, but I suppose if you have a deal that is not doing well but you manage to recover your investment that could be called a walk.  There is no glory in walks and they inevitably eat up all your time.  We all try to avoid them.

The moneyball moniker is not really about baseball though, it is about using statistics and data to drive decisions.  In that respect I thought it would be interesting to share some stats about the venture capital business. 

For starters, at Greycroft we have spent a long time researching the exit market for venture capital investments.  We did a study of all the companies in the Internet space during the post-bubble era, and there are a few stats that jump out:  1.) successful companies are over 10 times more likely to exit via an M&A event than an initial public offering, 2.) M&A events generally happen at modest multiples of either revenue or EBITDA (sector averages tend to be 2-3x trailing twelve months revenue), and 3.) there are companies every year that exit at high multiples (over 10x revenue) but they are few and far between.  Like home run hitters in baseball, these deals get everyone’s attention, but if you try to pick a portfolio full of them you are bound to be disappointed.  There aren’t many companies that can pull this off, and it is unlikely that a fund manager can pick enough of them to return even a single fund. 

One solution to this problem is that VCs need to build big, profitable companies.  If we succeed in doing that we can generate returns at even modest multiples, and every successful fund has a few big, profitable companies in it.  The second conclusion, which I think is less obvious, is that we need to be laser focused on capital efficiency.  That way you can still make a venture capital return with a lot of $50mm to $100mm exits.

On the point of capital efficiency, one of the things I look for when I evaluate companies is the ratio of revenue to paid-in capital.  Take a digital media company that has $25mm in revenue and sells for $75mm.  If you had put $50mm into this company you would be lucky to get one of the “walks” I mentioned above.  On the other hand if you put in $2mm it would be a home run.  Same thing is true for companies on a smaller scale.  The start-up market is filled with businesses that raised $10mm and have less than $10mm in revenue.  These are typically not good investments.

My math says that you need to target an “annual revenue to invested capital ratio” of at least 3:1 in order to make a VC return.  At that rate you end up with “doubles and triples” according to my analogy above.  This is not a perfect science because not all revenue is equal – recurring revenue/SAAS companies can get away with 2:1 because they tend to have higher exit multiples.  Low margin companies, like supply side platforms and yield optimizers, will likely need 4:1 or 5:1. 

For reference, the best company in Greycroft’s portfolio is currently at 30:1.  At the time we invested it was at 5:1 based on the angel round before us.  It is worth pointing out that the best predictor of future success is past success, but that’s a post for another day.

The last point:  I see a lot of investors chasing after businesses without a revenue model, looking for those outlier exits.  I don’t believe that is going to end well.  My recommendation for people who are serious about making money is that they should focus on how their companies will generate revenues and ultimately cash flow, because at the end of the day an acquirer is going to be concerned with those numbers.

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