A nice young man contacted me recently with an investment opportunity: a nude resort in Mexico.
I declined. But not for the reason you might think.
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Are You a Venture Scale Business?
My decision wasn’t a moral one. I passed because this is not a venture scale business.
Venture scale businesses are companies that can grow at massive rates. They also have very high profit margins.
Why isn’t the nude resort a venture scale business?
Because you would have to build hotels, pools, restaurants (ew) and whatever else a nude resort has. And you’d have to do it at impossible rates.
Because it involves physical items, it cannot grow at the same rate as a software business.
A Typical Venture Scale Business
Venture scale businesses are almost always software companies.
What’s our obsession with software? You can build a software product and then make it available to as many people as you want.
Building the product costs a lot. But making it available to one more person costs very little.
Of course, it usually takes some sales and marketing dollars to land a new customer. And customer support also costs money.
But a good Software as a Service (SaaS) business generally has a gross margin of 80% or more. This means that for every new customer they get, 80% of what that customer pays them falls to the bottom line as profit.
Yum yum! 😋
But Not All Software Companies Qualify
You can have a software startup with a killer product and great margins…and still not be a venture scale business.
Why? Because in order to interest VC’s and angels, you have to do more than grow fast with high margins. You have to grow big.
Really big.
Venture investors are looking for billion dollar companies. To get there, you have to generate massive revenue.
The current valuation multiple for high-growth SaaS businesses in the public markets is about 8. This means that for every dollar you make in revenue, the markets give you 8 dollars in valuation.
So, to be a $1 billion business, you need to hit $125 million in revenue.
Let’s say you’re making software for wedding planners. No matter how good your software is, it’s unlikely to ever be a venture scale business.
Assume the most you can charge the wedding planners is $50/month. There are about 23,000 wedding planners in the US.
So even if you got every wedding planner in the entire country as your customer (impossible), your revenue would be only $13.8 million. Your valuation would be about $110 million in the public market.
Realistically, you’d probably top out around $40 million at best.
Why Do Venture Investors Need $1 Billion Companies?
I can imagine what you might be thinking.
“Why are venture capitalists so greedy? What’s wrong with a $40 million business? That’s a lot of money!”
It is! To understand why VC’s are so insistent on getting big, you have to understand how they make returns.
Most of the investments they make will go to 0. Meanwhile, the few survivors have to become Godzillas in order to make up for all the losers.
This is the only way they could avoid losing all their money. And if they lose everything, there will be no venture capital for anybody.
Becoming Godzilla
Since I usually invest at seed stage, let’s take that as an example. At seed stage, you’re usually 7-10 years from an exit by acquisition or IPO.
Let’s say the seed stage company has $250,000 of revenue a year. To reach that $125 million of revenue in 10 years, the startup has to grow at about 5.3% monthly.
That means you nearly double every single year for a decade, on average. In reality, you probably grow even faster than that early on, then taper off.
Can you imagine the nude resort doubling its business every year? First year 1 resort, next year 2, and 1,024 resorts by 2032?
Not really.
Wrap-Up
I hope this helps explain some of the reasons you get a no from investors.
It may be frustrating. But they have their own people to answer to: their investors!
Venture capitalists won’t be able to keep raising funds if their returns are bad. So they have to make sure they pick only the best bets.
For more on this subject, check out this excellent segment of the This Week in Startups podcast with Jason Calacanis and Molly Wood:
What questions do you have about venture scale businesses and what venture investors look for? Leave a comment at the bottom and I’ll try to answer!
Have a wonderful weekend everyone! 👋
More on tech:
Talking About Today’s Startup Market on The Accelerator Podcast
Managing a Crisis the Sequoia Way
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Photo: “Godzilla ゴジラ” by kirainet is licensed under CC BY-NC-SA 2.0.
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