“Venture Capital Efficiency” and fundraising success

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I had a great conversation with one of our Founders Co-op LPs today and thought the core points were worth sharing.

(This post gets pretty far into the weeds of venture finance, so if that’s not your bag please skip this one and come back around for the next one).

The heart of our exchange was how ironic it is that the entrepreneur community — including both startup founders and the bloggers and media pundits that write about them — loves to celebrate big fundraising events. Most of the time these big raise announcements don’t include information about the pre- or post-money valuations at which the deals were done.

And that means the “successes” that get celebrated the most are often not the ones that create the most wealth for founders and investors.

Now for a quick side trip into the basic mechanics of venture finance (if you already know this stuff just skip ahead).

When a startup raises equity capital, there are three key numbers that determine how much of the company is sold by the founders and purchased by the new investors (yes, I’m ignoring the option pool for simplicity’s sake):

  • The “Pre-Money Valuation” is the notional value of the company before the investment is made.
  • The “Investment Amount” is the actual amount of new cash that comes into the company in the raise.
  • The “Post-Money Valuation” is just the sum of the first two numbers, reflecting the increase in enterprise value produced by adding the Investment Amount to the company’s balance sheet.
The least intuitive part about this math is that the ownership stake purchased by the investors in any given financing round is calculated based on the Post Money Valuation, NOT the Pre-Money Valuation. So a $1 million Investment Amount applied to a $4 million Pre-Money Valuation purchases a 20% ownership stake (1:5), not a 25% stake (1:4).
This means that a startup’s enterprise value is actually the accumulated sums of two very different inputs — the total capital raised over the life of the company, plus the total enterprise value created over the life of the company. 
The first is a relatively weak signal for the firm’s capacity to create wealth, the second a very strong signal. But because the second value is usually kept secret by the firm and its investors, the broader community tends to place a disproportionate weight on the first value — capital raised — when handicapping a startup’s “success”.
In my experience these two values tend to change at radically different rates in different companies — with massive impacts on the economic outcome for founders and early investors.
When it comes to creating startup wealth, founders and early investors care much more about “Venture Capital Efficiency” than they do about total capital raised.
The Venture Capital Efficiency of a startup — the rate at which investor capital is turned into shareholder value — can be expressed as the ratio between total capital raised and total enterprise value (which for privately held companies is typically equivalent to the most recent Post-Money Valuation).
As a general rule, the less capital a startup raises, and the bigger the delta between the Post-Money Valuation of the prior raise and the Pre-Money Valuation of the next raise, the more effective that startup can be said to be at turning investor capital into “real” equity value.
Instagram was the VC deal of the decade NOT because it sold for $1 billion (actually more like $750 million after the post-IPO decline in Facebook’s share price is taken into account), but because the company only required $57 million in venture capital to produce that billion-dollar outcome ($50MM of which came in at a huge valuation just before the deal closed).
Without even discounting for that late and expensive $50MM raise, the raw Venture Capital Efficiency (VCE) of the Instagram deal was 17.5 — 1 billion divided by 57 million.
And if that late money came in at a “fair” price (i.e, in the context of heavy M&A interest from both Twitter and Facebook) — say $500MM — the VCE of that final raise for the founders and early investors was more like 67 ($500MM divided by the $7.5MM that had come in previously). THAT’S the kind of return that investors get out of bed for.
For startup founders and early investors, “winning” isn’t measured in terms of capital raised but in Venture Capital Efficiency. The real value creation occurs between fundraising events, and the measure of success isn’t how much you raise, but how much daylight you can put between the Post-Money Valuation of the last raise and the Pre-Money Valuation of the next one.