What’s more important to a VC? Return Multiple or Cash on Cash Return?
by GREG FOSTER
One of the more interesting conversations I have from time to time with early stage entrepreneurs relates to the real goals of a VC when they make an investment. Oftentimes, the entrepreneur can show how a meaningful, albeit small (call it less than $20 mm) exit can produce a great return for a VC willing to invest in the business. The logic goes like this:
1) Invest a small amount of capital (call it $500 k) in my business
2) Even though I have a limited addressable market, I will own that market and
3) we will get a quick exit which could produce a high multiple for you, Mr. VC. $500 k to buy a 25% stake in a start-up that presumably doesn’t raise any more cash means a 10X return to the VC if the company sold for $20 mm in cash.
If the exit is achieved within a year or so, the VC would achieve a 200+ IRR. Who, the entrepreneur argues, would turn that opportunity down?
Makes a lot of sense until you look at what some VCs consider to be the more important metric – so called Cash on Cash Return. The $500 k invested in that start up produced $5 mm in cash. Again, not a bad return, but let’s look at another example:
1) VC invests $5 mm in a business and gets 15% of the company
2) Company sells for $150 mm in 3 years
3) Assuming that the VC’s equity converts to common (so the VC’s take is a straight 15% of the proceeds), the VC would get $22.5 mm in cash, yielding a 4.5X return that translates to roughly a 65 IRR
So our first investment yielded $4.5 mm in proceeds while our second investment yielded $17.5 mm in cash. So what would be the considerations a VC would make in looking at these two deals:
1) Is the tradeoff of cash-on-cash return vs. time spent on the investment a good one?
2) Which is better – doing a bunch of small investments with limited upside but short time to exit or doing fewer deals with bigger upside and longer horizons to exit?
3) What does all this mean for VCs? Does it become a game of small ball (lots of small exits) or is the key to dig in hard with a few companies and place big bets to more efficiently achieve high cash-on-cash returns for every deal?
Thoughts?
Stay tuned…
