Venture Capital

Venture Capital

Venture capital firms are considered private investors, as contrasted with institutional investors described above. As we discussed earlier, venture capital has become a widely-known source of capital as a result of the software industry boom. Most tech companies will chase venture capital funding at some point or another. But eCommerce businesses are unique, and it’s important to understand the pros and cons of leveraging VC funding as a DTC ecomm.

First, let’s explore some critical information about how VCs make money. VCs have to make bets on companies that are relatively early in their lifespans. That means usually they have to wait years before a big payday. So VCs have to think not only about which companies they believe will make it big, but also about how they’ll sustain themselves until that happens. 

They obviously don’t know in advance which investment is going to pay off big, and they know from experience that only a small percentage of investments actually pay off.  In fact the rule of thumb in the industry is one out 10 investments hit a home run in terms of exit. As a result, VCs use portfolio math. They make enough bets to diversify their portfolio, so they can increase the chances of getting one of those home runs. The more bets you make, the higher the chance you have of hitting it big.

But what about those 9 losses? Great question. That money is usually gone or, at best, returned with some small return. So that means those home runs have to be big enough to not only cover the losses, but give the LP’s (and the partners) the monster returns they want to see.

Adding to that big return pressure is time. It takes time for companies to grow into something really big. So venture funds need a time horizon to match. The average venture fund has a lifespan of about nine years. As a result, VCs need really big payoffs to make the annualized returns look attractive to investors. For example, doubling your money sounds like a great investment, right? But what if it takes nine years? That’s an 8% annual return… and there are plenty of less risky ways to make that kind of return.

To raise money from LPs, VCs need to produce much higher annual returns than what the LPs can get elsewhere. And to get those higher annualized returns, they need their big payoffs to be 10X, 20X, or even 100X returns.  

What does all this mean for you? When you reach out to VCs, keep in mind that they are constantly trying to assess whether or not your business will earn them massive returns.

Market size is often the biggest factor in answering that question for them.  Are you in a market large enough to support a big company? VCs may have different market size assumptions, but they are going to assume that, even if you kill it, you aren’t going to win the majority of the market. To be safe, they may ask themselves how big the company will be if they end up with 10% of the market. And then they will want to know if that is a large enough company to produce a worthwhile return for them.

That poses an issue for eCommerce companies. Consider this scenario:

• A VC invests $1 million in Company X at a $10 million post-money valuation.
• The VC now owns 10% of Company X.
• The VC wants a 20X return which is $20 million.
• In this simple scenario, let’s say Company X raises no more money. So in order to provide the VC with $20 million in returns, the company needs to be worth $200 million ($20 million is 10% of $200 million.)
• Using the Bainbridge DTC Benchmarks, we know that many public companies are valued between 1X and 2X of their annual sales. So let’s give Company X a 1.5 multiple. 
• In that scenario, Company X needs to do $133 million in sales in order to get a $200 million valuation.

Can you name an eCommerce company that raised only $1 million and got to $133 million in sales? Let us know if you can! 

eCommerce companies have to fund inventory, working capital, and ad spend — which means they need a lot of capital to reach that $133 million mark. And if each subsequent VC is doing the same math on returns, this number is even more amplified by follow-on rounds.

Bottom line: VC can be a difficult path for eCommerce companies for two main reasons:

1. It’s hard to capture or build a significant share in multi-billion dollar markets.
2. The capital intensity of eCommerce businesses means you need a lot more capital (than, for example, a software company) to drive high sales. 

All that said, VC is right for several sub-segments of eCommerce, and there are multiple active and specialized investors in the space chasing those opportunities such as Cowboy Ventures, Forerunner, Lerer Hippeau, Bling Capital, and Lyra Growth Partners. If you fit the criteria of addressing a huge market and believe you have the ability to capture it with capital efficiency, definitely look at VC. Think: market disruptors who introduce a new way of supplying commodity goods — like Dollar Shave Club.

Pros:

• You can get money when you are losing lots of money. VCs don’t want to hear about how you eked out a profit by cutting your Facebook ad spend, reducing your inventory buy, and getting your niece to do the books for free. They want to hear about growth, scale, and market domination.
• There is a well-trod alphabet road of future rounds. As long as you execute (and the market doesn’t fall apart), you can make it down that road.
• Networking: By definition, VCs know a lot of people and companies. VCs compete on how much additional value they can provide companies. Take advantage of it.
• Discipline. This cuts both ways. When they are on your board (which they will want to be), they will require a level of reporting, financial, and management discipline that is likely new to you.

Cons:

• Once you take VC money, you are committed to the VC path. VCs hate lifestyle businesses. You must provide rapid growth and an eventual exit.
• In general, you will steadily sell more of your equity and lose more ownership of your company as you follow the VC path. Counter-examples like Zuckerberg and Facebook are out there — but far more common are the stories of founders being left with less than 10% of their company and eventually being fired. So, enter VC Land with eyes wide open.
• While there is always another round ahead on the alphabet road, the dirty secret is that many companies don’t reach that next round. This is the cruelest drawback. You commit to growth above profits, and so you need the next round to survive. But what if you can’t get the next round, which can happen for a variety of reasons? Many companies either close up shop or go through a long process of scaling back, scrambling to focus instead on profits and self-funding. 

Best For:

• VC is great for companies that are going after huge markets with credible capabilities to capture significant market share. 
• Founders who embrace the mindset of rapid growth.
• Founders who are good at telling their story and pitching, pitching, pitching!

Pairs With:

• Earlier stage: Credit cards, new banks (Brex, Ramp et. al.), working capital lenders, MCA
• Mid-stage: Venture debt, sponsor-focused banks like SVB or Bridge Bank
• Later stage: Just about everything (if profitable)

‍