In an earlier article (https://pitchingangels.com/2021/01/08/revenue-projections/), I mentioned that startups need projected revenues of at least $25 million by Year 5 for angels to consider investing. This article explains the reasons for this seemingly arbitrary requirement.
Like everything else in venture financing, it all comes down to the exit. Until the company is acquired or completes an IPO, the investment has no actual value. It generates no interest, no dividends, no royalties, no rent. That million dollars an investor handed you is nothing but a number on a spreadsheet. Legally, the investor owns a fraction of the business, but since she gets no revenue and can’t sell that ownership stake, it’s dead money. So she’s hoping for an acquisition or IPO as soon as possible, and at a high multiple of what she paid.
The usual investment timeframe for venture financing is 5 years. In other words, you need to plan for an acquisition or IPO within 5 years to be an attractive investment. An IPO is an outrageously expensive and disruptive process, and once the company is public, there are large, on-going costs associated with being a public company. As a rule of thumb, $100 million in annual revenues is the bare minimum to go public. If you’re not expecting revenues of $100M within 5 years, then an IPO is not a feasible exit.
If you’re projecting less than $100M, the question then is who will acquire the business? In almost all cases, it’s a large, public company. The giants have the cash to make acquisitions (and their stock is the equivalent of cash since unlike a private company, it can be freely bought and sold.) Most giants struggle with innovation, but need growth to support their stock price. Further, if you’re doing well, you’re starting to steal their customers and they have to respond somehow. They may have even tried to build a competing functionality and floundered badly. But they have a huge customer base, a worldwide sales team, a network of distributors and retailers that reach every customer, and a marketing department that’s larger than your entire company. They can increase sales of your product by 10x simply by making it one of their own. They have the cash, the need, and the financial incentive to acquire your business. So the plan of almost every startup is that after a few years to be acquired by one of the giants. At least, that’s the plan. Simple, right?
Here’s where things get complicated. You develop a great new product. Your customers love it. You generate $5 million in revenue. Time for Google or Microsoft to acquire the business? Unfortunately, not.
For big companies to do an acquisition, even a small one, it’s a major undertaking. The diligence process costs millions in legal fees and eats up executives’ time. Once a deal is consummated, integrating your business is a huge distraction across many different departments. If they can turn your $5M business into a $20M business, that seems like a big win but it isn’t. It takes almost the same amount of time and effort to do a $100M deal as a $10M deal, so that’s what the M&A team will focus on.
The M&A team can only do a few acquisitions per year. The bigger acquisitions move the needle financially; the little ones don’t. And let’s not ignore the ego factor—the billion dollar blockbuster acquisition lands the CEO on the front page of the Wall Street Journal where he’s declared a visionary transforming your industry. The $5M acquisition is too small to even disclose in the company’s financial documents. In most industries, $25M is the borderline where your startup becomes interesting to acquirers.
In addition, $25M is a key metric in a few other ways:
- At $25M revenue growing at 2x per year, it’s easy to see the business quickly reaching $100M.
- The product has been proven useful to a wide audience beyond a small niche.
- The product has reached a level of maturity and stability well beyond beta or MVP and is ready for the big stage. Big holes in functionality have been filled, glitches fixed, suppliers locked in, manufacturing kinks worked out. The software architecture has been rebuilt at least twice for scalability and maintainability, and the back-end infrastructure which used to be held together with duct tape is solid now. You have a QA process and a testing regiment to ensure the software works.
- The company has a full team of executives and employees who can keep the operations running after the founders leave.
In other words, at $25M, you’ve got the type of operation that a big company knows how to integrate without flailing around trying to finish building a half-baked product.
While $25M is a good rule of thumb, the actual minimum depends on the industry. For consumer products, the threshold is $50M while for pharmaceuticals, acquisition is a function of regulatory stage and efficacy data rather than customer revenues. Also keep in mind that $25M is the minimum. Many investors won’t look at deals with expected revenues of under $50M since that opens a wider range of acquirers and adds a safety factor in case, like most startups, you struggle to reach even half your projected revenues.
Under $25M doesn’t mean an acquisition is impossible, just that it won’t be the type of acquisition that venture investors are targeting. Acquisition by private equity, for example, are typically at 5x profits instead of 5x revenues, which means its around 1/5 to 1/10 of the valuation of a successful exit. Acquisitions by a smaller company or another startup are also possible, but the valuations are too low and often include exchanging one non-tradeable stock for another non-tradeable stock that are only considered when the company has failed to meet its promise.
Now that you’ve revised your business plan to focus on a larger market to get you to revenues of $25M, are you ready to send your pitch deck to Kleiner Perkins or Sequoia? Unfortunately, no. While angel investors will invest in any business that has a lucrative exit, VCs have their own constraints that require revenues of at least $100M.
Imagine a VC fund with $50M in capital to invest. Given the time required to review thousands of pitch decks, listen to hundreds of pitches, go through a comprehensive diligence process with candidates, negotiate investment terms, coordinate with other investors, and work through legal documents before funding a company, then working with every portfolio company going forward, the number of startups the fund can invest in is limited to around 10 per year. That means the average check size of the fund is $5M. If the $5M buys 10% of the business (the lead investor usually takes about half a round), that sets a minimum valuation of $50M. If they target a minimum of 20x return for an early stage investment, the company needs to be acquired at exit for at least $1B. To get to a billion dollar acquisition, the company needs to have at least $100M of revenue and growing quickly towards $250M. If your revenue projections aren’t at least $100M and ideally $250M, you won’t get much traction with the VCs. There are smaller VC funds, but those below $50M are too small to have full-time employees, so they act similar to angel investors.
If you have a great product for a small market, is all hope lost? Should you give up your dreams and go back to trudging through a career at Big Bank? Fortunately, there are many alternatives to venture financing. You may have to settle for being a multi-millionaire instead of a billionaire, but your chances of success with a niche product are far higher. The next article will cover how to finance your business without venture funding. Stay tuned.
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