Saturday, February 18, 2006

Raising Capital: Fundable Businesses

The notion of raising venture capital is appealing to most entrepreneurs because it means millions of dollars and very smart people are validating and backing their businesses. However, very few businesses are actually fundable with venture capital. This is because most business really can't achieve the types of return necessary to make the venture capital firm's own business model work.

In the startup world businesses get divided into two categories: fundable and lifestyle. Fundable businesses have 3 key qualities:

1) Can create value of at least 10X (and preferably 15-20X) the venture money invested
2) Can lead to a liquidity event
3) Can do both 1 & 2 in 5-7 years

A lifestyle business is essentially anything that doesn't have all 3 of these characteristics. Common lifestyle businesses are restaurants, franchises, or any type of professional services/consulting businesses. Professional services businesses simply can't grow quickly enough because they are dependent on hiring new consultants to work on more projects and generate new revenue. Restaurants and franchises have growth problems because the logistics of creating and staffing new outlets doesn't scale quickly enough. Furthermore, exits in these businesses are less clear and generally don't command high valuations.

There are also many types of lifestyle businesses in technology. This is primarily because the market being served isn't large enough or the business is really based on a feature rather than a stand alone product, which in some respects is essentially the same thing. The reason why investors place so much emphasis on the size of the market is to determine how big the exit could be. Software to automate shrimp farming could be a category killer, but if that market is only worth $25 million it will be impossible to achieve a meaningful exit for the venture firm.

Features also aren't fundable. There are a lot great extensions to Firefox and Outlook, but while these "products" aren't necessarily created by Microsoft or the Mozilla Foundation, they are features rather than stand alone products. The growth of a feature business is totally dependent on the product they compliment. Furthermore, it's rare that features have deep enough IP to be protectable or valuable. For example, if a company produces a great new feature for Outlook that everyone has to have, how long would it take Microsoft to build on its own? M&A is fundamentally a question of build, borrow or buy. If the feature can be easily reproduced than the startups leverage to convince Microsoft to borrow (license) or buy (acquire) is greatly reduced and the valuation lowered.

Knowing what a meaningful exit for the firm is key to understanding whether or not the business will ultimately be considered fundable and should be a part of the due-diligence done by the entrepreneur prior to meeting with the VC. A $20-30 million exit won't be enough to move the needle of most venture funds, however, it may be meaningful to smaller funds. As a general rule the size of the addressable market for venture fundable businesses is $500 million and most VCs prefer billion dollar markets.

The good news is that lifestyle businesses can be very lucrative to entrepreneurs. In some cases, a $20-30 million lifestyle exit can better for the entrepreneur who creates a successful venture backed startup. For instance, owning 75% of a business sold for $20 million would net the entreprenuer $15 million. It would take an exit of at least $150 million from a venture backed business where the entrepreneur is unlikely to own more than 10% to create the same $15 million net. Also, there are many lucrative oportunities that produce great cash flow that simply don't have predictable enough liquidity events to entice venture firms.

1 Comments:

At August 15, 2008 6:40 PM, Blogger Tony said...

Mr. Fife,

Great post. Knowing this type of information saves entrepreneurs a lot of frustration.

You mentioned business opportunities where venture capital would be inappropriate but are ripe for exploitation by others. May I ask what some of these possibilities are?

Anthony E. Russell

 

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