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VC Math – Or why you’ll never get funding…

Yet another cleaned up post from a startup thread on LinkedIn. ┬áThis one is about VC math and TAM’s.

One thing that’s very much missing in most entrepreneur’s understanding of the fundraising process is the notion of total addressable market (TAM) and it’s relationship to fund size. Basically, it’s the understanding that fund size vs number of partners drives the available investment size.

An overview of how this works

Since partners can only typically manage at most 10 companies simultaneously, 2 partners at a $100million fund will invest in a maximum of 20 companies. Usually, the first five years of a fund are devoted to new investment, and the last five to supporting existing portfolio companies. Money is usually allocated 50/50 to new vs support, so this hypothetical fund would have about $50m to invest in 20 companies. $50m divided by 20 gives you roughly what the investment amount would be about $2.5m.

The flip side of this are rough calculations about TAM and exits. If the TAM of a company is $100 million and you assume they can capture 10% of the market in 10 years, then their revenue will be around $10m, with a valuation of somewhere between 3x to 15x revenue depending on the vertical. At the lower end of that, it would be a company worth $30m if everything works out.

Going back to fund size, if the fund is targeting a 10x return, then investing $2.5m in a company that might be worth $30m at exit is just about right, assuming no other dilution. Of course, this leaves out a lot of details and is uber-simplistic, but I can guarantee that every VC you talk to is doing these sorts of rough calculations in their head.

However, what’s really important about all of this is understand your company’s TAM and doing your homework about size and lifecycle of funds investing in your vertical. If your TAM is $100m and you approach NEA ($2b raised for their latest fund), then you will likely never get funding. A lot of entrepreneurs don’t seem to be willing to do the legwork in researching investors/funds/etc, but that’s one of the keys to success. I would add that the VC tool of choice for doing research is VentureSource – yes, it’s not cheap, but if you are looking for funding, it’s a goldmine of information on valuation and fund status

This is a very common mistake made by a lot of entrepreneurs, even experienced ones. I’ve given a presentation at a bunch of conferences about this very topic and it’s always shocking how many people don’t understand these dynamics.