What Comes Next

VC Confidential has an interesting post up today talking about Multiples vs IRR. The closing statement

So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).

reminds me of the importance of the differences in risk model between VCs and entrepreneurs, something I’m going to explore a bit here. One example of a VC model is described in the post, so I’ll use those numbers for the comparison.

Bases loaded

The VC risk model is based on a portfolio of investments, and the VC should choose each investment on the basis that a 40% risk of negative return is justified by a 10% chance of 10x+ return and a 50% chance of a zero to 5x return. This model, along with its countless variations, is designed to accomodate the high risk of failure of startup companies. VC Confidential has this to say on the subject:

In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR’s, don’t return enough multiple to pay for the 4 tube shots and 2 break-even deals.

So, VC-funded startups fail at a high enough rate that the target outcome for each investment needs to be a 10x return in order to pay for the investments necessary to deliver that one return with confidence. In fact, even a high confidence investment in a company targeting a 5x return is a hedge: overall, it decreases the chances of a very low rate of return for the fund but also decreases the chances of an on-target rate of return.

To stick with my tenuous baseball analogy, as a VC you start with no outs and no strikes, so while each swing is unlikely to yield a home run, over all of the swings you will probably have at least one. Also, you only swing for the fences with runners on base, because the value of a successful home run needs to more than cover the outs and strikes used.

Two outs, two strikes

Unlike the VC, the entrepreneur runs one company at a time. This means that the entrepreneur can’t use the same risk model to achieve a high confidence level in a given rate of return. All other things being equal, the entrepreneur can’t target the 10x return desired by the VC risk model without having a lower confidence in the outcome.

From this, it seems like the entrepreneur is incented to target lower returns in order to achieve a higher confidence. Of course, entrepreneurs have a much larger range in their tolerance of risk than VCs. Some entrepreneurs will target a 100x return with a small chance of success, while those at the other end of the spectrum are happy to run lifestyle businesses.

Focusing on businesses that need institutional funding, how does the entrepreneur, with only one swing at the ball, manage risk and still target a return that works in the VC model? One approach is to look for businesses that have a real swing at the fences, but can be turned into triples or doubles along the way. Not every business can work this way: many startups are based on predictions about the future and won’t have exit opportunities until the core assumptions or predictions are validated; at the other end of the spectrum many are really trying for a single or double and could get very lucky with a triple. The ideal situation for this approach, which involves a real risk/reward decision between exit and growth at each stage of funding, doesn’t come along very often.

Wins vs. RBI’s

If a company has the opportunity to decide between exit and growth, the alignment of risk models comes to the center of attention. There has been a lot of discussion lately about founder liquidity as a means for aligning incentives between VCs and entrepreneurs, but in the context of this post, founder liquidity is a mechanism for aligning the risk models by hedging the founders’ risk at the expense of upside.

I think there is value in looking for companies that have a swing at the fences, but can be turned into triples or doubles. Hopefully, recognizing that as a target will help in choosing, and running, businesses that have a real addressable market from the start, can divide market risk over time while decreasing execution risk, and are able to validate their assumptions and predictions early. When it comes to decisions on exit vs. growth, the combination of discount/premium of the exit and alignment of risk models will come into play. Even if those decisions all favor growth, it seems to me that managing toward exit opportunities makes as much sense as managing every startup toward eventual IPO.