Only 9% of VC investments make a 10x return

Only 6% of the investment proposals received by VCs result in an investment. Of these, 45% eventually 'fail' and only 9% make the coveted 10x return. These are just some of the insights from the latest research into the practices of European VCs. This new report, undertaken by some of Europe's leading business schools and universities, studied responses from 885 European VCs. 75% were independent VCs, 12% Corporate VCs, 4% Family Offices and 9% Governmental VCs. Investors had an average fund size of €100M and receive on average 851 proposals per year (60% having an early-stage focus). VCs meet on average 37% of these startups. 20% then progress to Investment Committee (IC) review, and 12% then go through final due diligence. Term sheets are offered to 8% and 6% finally result in closed deals. 45% of investments made end up as failures or return less than 2x the invested capital. 25% make 2-5x return (note, the sweet spot for a VC fund overall is typically 3x), with 9% reaching outlier status (>10x return).

In terms of initial investment selection, VCs say the ability of the management team has by far the highest impact on investment decisions (93%). The second most important is the offering itself (62%) - particularly key to Corporate VCs who rated this the highest at 72% -  followed by the total addressable market (58%). At the other end of the scale, when reviewing the factors behind successful investments, the management team again comes out top (96%), followed by the offering (72%), then market timing (56%). Interestingly 'luck' is rated at 33%, ahead of the Board (22%) and the investor's own contribution (12%)! And when investors were asked about the value-added contribution they make, 83% said that they support their portfolio companies with raising follow-on financing and by providing strategic guidance. 72% say they help with connections to customers and industry partners. This self-assessment seems very exaggerated compared to how founders themselves rate investors.

One of the most interesting findings in the report related to the factors that affect valuation. The most popular valuation method used by investors surveyed is comparable transactions (71%). More than 60% of investors do not use any formal valuation method, such as IRR. Alongside this comparables method, the size of the investment round and the investor's target ownership percentage are also critical considerations (62%). In terms of ranking the various factors that affect valuation, the valuation of comparable investments comes first (74%), followed by anticipated exit outcome (64%), then the desired ownership fraction (58%). The importance of the likely exit outcome and how this links to relative expected performance in the peer group is now becoming elevated as market conditions worsen. This is why VCs are excited to now have an Exit Predictor tool where AI-enabled predictive analytics are taking the heavy lifting out of building and analysing comparative assessments. This places much greater onus on founders to study the investment market and look carefully at their peer group during investment preparation to understand where their startup sits in the stack.

Punitive deal terms returning

As venture markets slow, founders have reset their expectations on valuations for 2023. But Term Sheets can contain many other provisions that can impact the eventual outcome far more than today's share price. In deteriorating markets, the top 3 terms to look out for are: Liquidation Preferences above 1x, Participating Preferred stock, and anti-dilution provisions. Institutional investors usually insist on preference shares - that much is normal and accepted. But the devil is in the detail of the specific preference rights they hold. A 'liquidation preference' ensures that if a company exits with a lower valuation than expected, the company’s preferred shareholders will receive their money back before other shareholders receive proceeds from the exit. This is usually set at the 'industry standard' of 1x. When the liquidation preference goes above 1 - and we have seen 2x or more in previous downturns - this should be a big red flag. Even a reasonably priced exit could then leave the founders with nothing.

The second term to watch out for is 'Participating Preferred stock'. Preferred stock can be Participating or Non-Participating. Participating Preferred means that, when the proceeds from an exit exceed the liquidation preference, preferred shareholders will receive additional cash on top of their liquidation preference. An example, courtesy of Carta, is the easiest way to explain this: Say an investor invests $2 million in 'participating preferred stock' for 50% of the company. If that same company were to be acquired or sold for $5 million, the investor would receive their $2 million liquidation preference off the top, and then split the remaining proceeds with the common shareholders based on their pro rata ownership (in this case, 50%) - which would equal $1.5 million (half of the $3 million remaining after the liquidation preference has been paid). That means the investor walks away with $3.5 million, leaving only $1.5 million left to split between all common shareholders. Participating preferred stock therefore allows investors to “double-dip” and receive their liquidation preference PLUS their pro rata share of the remainder (instead of choosing between their liquidation preference and their pro rata, as is the case with Non-Participating preferred).

The third term to be wary about is anti-dilution protection. Such provisions adjust the number of common shares that preferred stock can convert into in the event a company later has a down round of financing. This gives investors some assurance that in such circumstances their percentage ownership won’t be excessively diluted by the new investment. Anti-dilution adjustments can be calculated in several ways. The most common is to take a "weighted-average" (which accounts for the number of shares being sold in the down round as well as the price). These adjustments can also take the form of what’s known as a “full ratchet,” which effectively reprices the shares of the existing investors with the anti-dilution protection at the down round price. (Carta also provides a worked example of this). The upshot is that such retrospective repricing can heavily dilute the holdings of other shareholders, including the founders, in the event of a down round. Whilst punitive terms like this are now creeping back into term sheets, the best way to repel them - as ever - is to ensure multiple, competitive offers. If FOMO rules, such terms can be much more easily negotiated down or out.

Founders should lead succession planning

In last week's piece, Your Board is probably going to fire you, we talked about how founders must ensure they effectively manage their boards. This stems from one of the big founder misconceptions that the VCs they bring onto the board are there to 'add value'. The reality is that they are on your board to monitor their investment so they can do something if things aren’t going how they want. We identified 5 actions that founders can take to 'carry' the board and lock in their support. But we need to add a 6th, and that is for founders to take the lead in CEO succession planning. As a start-up begins to scale, it is almost certain that the required organisational skill set will evolve, and hence possible that at some point the founder may not be the ideal CEO. This evolution tends to be resisted by founders and perceived as a failure; but if this transition happens with open and constructive dialogue, as a result of the changing needs of the business as it grows, then in should be just the opposite. Astute founders will move to lead this thinking and actively manage the succession process.

Self-awareness is a big factor in being able to reach and act on this decision. And that's why it's a founder trait that investors value very highly. It engenders a deeper trust which gives the founder greater moral authority to guide the board's thinking on the growth strategy, and when necessary, their own succession plan. One experienced UK founder we spoke to this week recently led their company through such a CEO transition: "My approach has been to have this topic on the table at all times, and indeed to force an explicit discussion with the board on a regular basis. As a result, we have arranged a well-planned succession, and it’s allowed me to create my ideal role which includes all the things I enjoy and am good at, while relieving me from having to manage a 250+ person organisation on a day-to-day basis – and putting in place someone who has far greater experience than me at the latter. Win/win for both me and the company."

And that's the big deal here - how to maximise the outcome for all. Research into 191 tech IPO’s by VC, Sammy Abdullah, shows that 1 in 3 founders weren't the CEO at exit. This is a strikingly high number. But what is notable is that in many cases the founders did extremely well. The new CEO clearly did a great job as the company did of course ultimately exit via an IPO. As Abdullah says: "As a founder, it’s important to recognize if the size and needs of the company outgrow your skillset as CEO. If it does happen, finding someone that can run your business will be a great decision. Staying in the position if you’re not the right person will at best stunt the potential of the business and at worst be fatal." By being proactive, many of the founders in this research not only created a positive personal outcome by successfully taking the company to a point where a proven growth leader could be attracted but they maximised the value of their own shares in the process.

Happy reading!