It’s time for another pop quiz…
Can you guess where this line is from?
“A million dollars isn’t cool. You know what’s cool? A billion dollars.”
Who guessed Justin Timberlake from the movie, “The Social Network”?
Ding ding ding! Yes, Justin recited that line as he played the part of Sean Parker, co-founder of Napster and the first President of Facebook.
But for today’s pop quiz, it turns out there’s more than one right answer. Why? Because those same exact lines can often be heard echoing in the boardrooms of real-world venture capitalists.
In fact, in the world of venture investing, the point of view captured by those words – go big or go home – is the general rule of thumb.
And it’s not because Venture Capitalists (or “VCs”) are greedy. Sure, they want to do well financially – for their investors and for themselves. But that’s not what makes them go for a billion on every investment they make.
The fact is, to make real money in early-stage investing, they have to swing for the fences – and so do you.
How Venture Capitalists Earn a Profit
A VC – let’s call him Fred – earns a basic salary, about $100,000 per year. But Fred didn’t become a VC to earn $100k; he wants to earn millions. To do so, he has to generate serious profits for his fund.
This is no easy task. Historically, only 30% of venture investments return any profits at all.
Let me explain…
Fred spends 5 years investing a total of, say, $100 million into 50 different companies. Even if Fred is a “successful” investor, one third of his investments will eventually go to zero, and he’ll basically break-even on another third. This means that all of his profits have to come from the final third. That final third has to include a couple of big winners – so big that they’ll make up for all the losers.
Keep in mind that Fred won’t earn a nickel more than his salary unless his investments return more than $100 million. If he’s successful and returns a nice profit, 80% of those profits are given to the fund’s investors. For his efforts, Fred is entitled to receive 20%.
Some Attractive Math
Let’s look at an example. 5 years go by and a couple of the startups that Fred invested in have successfully “exited” by being acquired by bigger companies, or by going public in an IPO. Fred turned his $100 million dollar fund into $300 million.
(Clearly, Fred will have a nice payday. He’ll earn 20% of the $200 million profit – or about $40 million. Yes, $40 million.)
To pull this off, Fred needed $300 million in returns. Considering that VCs only own a minority stake in the companies they fund (maybe 10% or 20%), in order to get to $300 million, his startups needed to be acquired for billions.
And here’s the “billion-dollar secret” we learned from VCs and are now passing along to you – the secret to make sure you build a successful early-stage portfolio:
You can’t get a billion-dollar exit without going after a billion-dollar opportunity. The fact is, you need to invest in companies that are attacking huge markets.
It might be fun to invest in a company aiming to be the “biggest candy store in Peoria, Illinois,” but it’s not likely going to be a financial winner in your portfolio. It’s not attacking a large enough market.
But how can you tell how big an opportunity is?
Homerun or a Base Hit?
The quickest way to get a sense of market size is to review the company’s fundraising materials. Look at their presentation, or their description on one of the funding portals...
If they don’t articulate the scale of the opportunity – or if it’s simply not a big opportunity – it’s likely you should pass on the investment.
However, market size isn’t always an easy number to estimate – and could be difficult to verify. Reason being, many startups are focused on creating new markets.
For example, when Amazon.com first launched, there wasn’t an established market for “online book sales.” Their founder, Jeff Bezos, wasn’t able to tell investors that his company was going to take x% of an existing market.
However, he might have said something like, “We believe more and more people will make purchases online in the coming years, and books will be one of those purchases. Each year Americans buy over $20 billion worth of books. We believe we can capture 10% of that market online – making this a $2 billion near-term opportunity.”
That’s a believable narrative.
You should be looking for something similar.
Aromyx is establishing a new multi-billion dollar market – and they’re doing it by displacing an existing market.
Fill your early-stage portfolio with potential billion-dollar opportunities. That’s the only way to ensure that your winners outpace your losers – and provide you with venture-sized returns!