Draper: It’s all about the X

“X” serves a wide range of functions in the English language. It often represents the unknown, an uncertainty, masked in mystery and intrigue. Which is why the “X” factor, in its various forms, is frequently the hottest topic within the venture capital industry. The mystery of “X” touches everything from assessing the opportunity, to the valuation, to the potential financial return on investment.

This past Tuesday was Venture University Cohort Three’s first Partners Meeting and it was insightful and thought-provoking to see two of the best General Partners in the business fire away with questions that cut straight to the core in dissecting each investment opportunity. Each of the five deal sourcing teams, made up of 4-6 investors per vertical focus (Consumer, Enterprise / AI, FinTech / Blockchain, Healthcare, Frontier Tech), had the opportunity to pitch their top two deals sourced from the prior week to the General Partners. The General Partners reminded the team that “we will be playing the ball, not playing the person”, preparing us for the kinds of constructive questions and criticisms that separate transformative investments from complete losses. Our “newbie” deal sourcing team had a laid-out plan for presenting to the partners, but that plan quickly flew out the window as the interruptions started and assumptions were challenged.  We had to defend the key strengths of each company, explain how they would overcome key risks, and why it would be an opportunity worth investing up to $1,000,000.  It all came down to the “X” factor for each company.

First, “X” — the Fund. In Venture Capital, the General Partners must have a belief that every investment can “return the fund,” which means that a company must have the potential to be sold for 10X the capital invested within 5-7 years. For a $100M fund taking a 10% ownership stake, getting “enough” to return 1X the fund means we must believe we will be able sell any investment for ~$1B. Now venture returns are highly asymmetrical, meaning most companies will not hit these targets, while an extremely small number will significantly outperform these expectations. We cannot “X” the Fund unless we invest in huge opportunities.

Next, “X” — the Valuation. A company that raises $2M of Seed or Series A capital will often be valued at around $10M using the rule of thumb that a company will sell a 20% stake of their company during each round of financing, since the valuation is not based on revenue traction or key metrics in its early days.  As a company develops a track record, the valuation becomes a multiplier of net revenues or EBITDA (earnings before interest, tax, depreciation, and amortization). While many funds use many different techniques for developing multipliers for companies – from EBITDA growth to market growth, category dominance to competitive moats – a company’s multiplier will typically be grounded upon “what did someone else pay for a similar company?” For example, if a potential investment looks and performs like comparable companies or “comps” that rarely fetch more than 5X-10X of revenues, the investor should not expect more than those comps. So, if an investor needs a portfolio company to exit for ~$1B, and the comps indicate that a buyer will pay between 5X-10X revenue for that type of company, “X” the valuation means that the company is only investable if it has a path to generating at least $100-200M of annual revenue in less than 7 years.

Lastly, “X” — the Team. Venture University trains our investors to evaluate 14 core factors for each startup: Market, Problem/Need, Solution, Team, Traction, Revenue Model, Strategy, Financials, Competition, Competitive Advantage, Key Risks, Exit Opportunity, Investment Terms, and the Strategic Value VU could add beyond just capital. Now there are an infinite number of paths that lead to a variety of outcomes across the spectrum from success to failure. In the startup space, your path will not only be unpredictable, but it will never be to plan. Accepting this uncertain reality is where the most important “X” comes into play. Successful companies and investors are teams that find purpose in uncertainty. A team’s ability to deliver certainty in the face of change is the “X” whose value never shows up on a term sheet, a financial statement, or a sensitivity analysis. It is the “X” that is almost unique to venture in its reliance upon tangential experience, inter-personal relationships, and gut feelings. Though no metric can reliably define it, no deal is ever done without it.

Even when the math works out, convincing investors is about demonstrating “X.”

Chris Draper is the Managing Director of Trokt, and has been selected as one of 25 VC Investor Apprentices from around the world to join Venture University’s Third Cohort. Draper has been a part of the Iowa startup ecosystem since moving back to Des Moines in 2010.