This blog was written by XSeed Venture Partner, Jeff Thermond.
My last blog on the fact that a five-year projection of key financial metrics was a hard and fast requirement for any startup pitch deck drew a lot of engaged commentary.
The comments generally fell into two camps. The responders who provide services (e.g., legal, financial, etc.) to startups were all in rabid agreement and thought there was nothing else to be said.
The entrepreneurs tended to have a different reaction. They commented on just how hard it was to project meaningfully the third, fourth, and fifth years because they were so far out. That was a valid point.
This blog dives deeper down into what entrepreneurs need to be thinking about as they start to develop their five-year plan.
Here is the really good news for entrepreneurs: this task is far easier than they might think once they understand that investors only want to know if a company can generate venture-backable returns based upon reasonable assumptions. Investors do not need to know precisely how big a company can get in order to win. They just need to have conviction it can generate venture-backable returns.
What does that mean exactly? The last 20+ years of venture investing has shown that companies which can scale to $100 million in revenue in five-to-seven years have a high propensity to generate returns of 10X invested capital.
Think of that revenue goal inside a certain time window as being like clearing a hurdle in a track and field event. Once the athlete clears the hurdle, how high she cleared it does not matter. Similarly, no venture investor cares about the precision of the estimated revenue for years five through seven. We only care about whether the entrepreneur made the goal to get to venture-backable returns.
This understanding simplifies the entrepreneur’s task dramatically. In this case, she should start out with a plan which shows $100 million in revenue in year five and then work backwards to year zero. She should be thinking about the share of market she is assuming, her growth rates, her pricing, how her competition emerges and responds, what her go-to-market model looks like, and the capital required to make this all happen.
In each one of those areas there are levels of assumptions and estimations which will seem believable, some which will seem sketchy, and some which will seem absurdly optimistic. As an example, if the entrepreneur assumes a market share north of 30%, this will raise red flags for a lot of us. On the other hand, a market share of 5% which still leads to a hundred-million-dollar company is less concerning assuming the assumptions which lead to that are not out of whack.
Claims which raise investor eyebrows in negative ways occur when the claim is so far off what the history of the competitive market has been. Claiming sales cycles which are half as short as other vendors experience or that she can get ASP’s at double the size of established competitors or that her sales people will be four times more effective than the competition will run against the grain of most investors’ experience and sew the seeds of doubt.
The implication of this way of filtering through investment alternatives is that once an entrepreneur’s projection goes above one hundred million dollars in revenue, the investor stops looking at the projection and starts looking at the assumptions behind it. If the assumptions seem plausible and this is a market segment with which the firm has interest and experience, then I forecast future due diligence meetings and a good chance at earning a term sheet.
If the number is below one hundred million, or the assumptions necessary to get the idea to one hundred million are too fanciful, I forecast a quick “pass” decision from the firm.
As a last note, there are some who see the $100 million revenue goal as too arbitrary and simplistic. I think they do not understand that venture investors see hundreds if not a few thousand new ideas per year.
The only rational response for investors with that big a pipeline is to develop a simple rule of thumb which rules out most prospects efficiently and effectively so that when the CEO of a great company walks in the door, an investor can spot it quickly and work to win the entrepreneur over. When an entrepreneur meets that rule of thumb, investor interest shifts away from the precision of the estimate to the reasonableness of the assumptions behind it. The entrepreneur who can speak directly to her key assumptions and make them seem reasonable is going to do well. The entrepreneur who focuses on whether the business is at seventy or eighty million in year five has missed the whole point.
Don’t be that entrepreneur.