VCs want your company to be worth a lot of money – but that’s a bad thing.
HR and recruiting, historically, haven’t exactly been hotbeds of innovation; instead, these back office functions have often found themselves consigned to the dustbin of obsolete enterprise technologies and a legacy of failed systems, on premise and otherwise.
This has created a deepening capability (and credibility) gap in terms of technology between talent acquisition & management and the business they serve.
With over half of all enterprise employers planning on investing in HR or recruiting technology this year, with overall spend in the category, estimated in 2014 at nearly $11 billion in North America alone.
This staggering number looks likely to continue its growth in the coming years with North spend projected to exceed $17 billion in 2019 – a boom market that shows no signs of letting up. With the seemingly insatiable demand for what’s new and what’s next in this increasingly competitive, increasingly lucrative category, venture capital has been flowing to emerging and established players alike.
VC firms have already poured an a record setting $811 million in HR and recruiting technology related investments in the first half of 2015 alone, according to the Dow Jones Venture Wire (see chart). So why are VC investors making such a big deal about what’s been such a frequently overlooked category? And, more importantly, why should HR and recruiting professionals care about VC in the first place?
Breaking Down the Basics: VC in A Nutshell.
For the uninitiated or blissfully unaware, venture capitalists supply funding to early and growth stage companies, giving these startup businesses much needed cash in exchange for equity in the company, typically in the form of preferred stock.
This means VC investors only make money when they can cash in on their share of returns if the business is either acquired outright or merges with another company (M&A), or else becomes publically traded through an IPO event.
These high risk, high reward investments are generally hedged, with returns tending to follow what’s referred to as a power law distribution. This means that even the best funds will see 30% of their investments come up completely empty, and even for those companies that don’t go completely belly up, another 50% will end up with the VC taking some sort of loss (inclusive, of course, of the aforementioned 40).
In even the best case scenarios, only 5-10% of VC investments generally return more than 10x the initial investment, with some major outliers returning entire funds.
Oh, and they’ll miss a few too.
For entrepreneurs, those VC investments can come with some pretty significant strings attached; generally, VCs will try to take a 20% position (or more) in the companies in which they’re investing, to take a board seat, and retain some special privileges, such as the ability to block any potential sale of a company if a certain valuation target hasn’t yet been met (while an entrepreneur may get rich from a $30 million exit, that cost is often not even worth the board seat at most VCs.
More Money, More Problems: Return Profiles and HR Technology
The equity a VC generally owns in a company typically increases in direct proportion with the overall volatility – and thus, the assumed risk – of the businesses in which they’re investing. If, for example, there’s a 30% chance that a VC is going to take a total loss on an investment, then that risk has to be balanced by potential rewards; while VCs may be willing to risk it all, then those same investments also need to represent a decent chance for a return of 10x.
And even if there’s only a minimal 1% chance of an ever elusive 100x investment, then as a VC, I’m doing myself lots of favors by putting my money where my mouth is.
So how, exactly, do investors value companies? Let’s take a look at one of the most commonly used models:
In the above table, each row represents a potential exit scenario. In the first row, the company is worth $0, and therefore, the investor gets nothing – pretty much the worst case scenario for any VC. In Row 2, the company is valued at $10 million. Now, I know that looks like I made an error here; after all, doesn’t the investor only get 20% of the proceeds of the sale of a company?
Well, usually, that’s true, but remember: VCs are using a lot of preferred security to invest in companies, and therefore, have safeguards in place to ensure that they get paid before you do and get all their money back, first.
So, this means if a company sells for $5 million (seems like a lot, right?) but the VC had put in a total investment of $5 million, that company’s other stakeholders – such as its founders and current employees – would make a grand total of nothing. Zero seems like an awfully small sum for the amount of work that generally goes into an exit event for a startup.
Of course, in practice, most VCs will throw some money into the pot to create some sort of incentive to sell the company while requiring the principal talent (who are generally a startup’s principal shareholders, too) to stick around for a while after the acquisition and help protect the VCs investment – and maximize their own payout, too.
Hopefully, this is illustrative of how money actually gets divided after a “mediocre” sale actually closes.
Only raise venture capital if you’re OK with selling your company; even if the price tag is less than you expected, it’s only a failure if you and your investors lose money. The greatest success you can have is to generate a positive return.
Now, I know most of you are already bored to death with this oh so exciting spreadsheet – but the one last thing I’d like to point out is the final row, which shows that there’s only a 5% chance of this company selling for $500 million.
Despite these slim odds, however, that minimal possibility drives real results when it comes to the projected value of this business – a full 50%, in fact.
I know a lot of this is pretty hard to understand; I know many of you out there are thinking, “OK, buddy. I get that you have some fancy MBA but c’mon, man. This is complete BS – no one ever bets on a number that almost never hits.”
You’re right – investing for a VC is a lot like putting down everything on a 00 bet on roulette. While hitting that number doesn’t happen very often, play it 100 times, and there’s at least a 93% chance of that thing that’s probably never going to happen having the probability of actually happening.
This is why, if I’m a VC, I’m so careful to hedge my bets – many of the larger funds may have their investments spread out across a portfolio of 150 different companies. So, with 150 different investments in play, there’s a 99% chance (literally, I’ve done the math) that at least one of these 5% chance scenarios will hit across all my companies.
VCs, unlike entrepreneurs, who almost always only have their eggs in one basket (sorry, sucks to be you), build and maintain portfolios to increase the probability of hitting the 5% chance scenario almost 100% of the time.
To go one step further, I’m willing to take outsized risks across my portfolio to increase the probability of these massively outlier outcomes. If I increase the overall chance of zero by 10%, but increase my chance of an outlier by 1%, I create a TON of value. For every 1% increase in the chance of that outlier, I increase my expected return by a full $1 million dollars.
Talk about a favorable risk-reward ratio.
Something Ventured: What VC Really Means for Recruiting and Hiring.
As an investor whose portfolio inherently provides me with enough assumed risk to misfire on many of my shots on goal, I would be smart to increase the relative risk of each of my companies; the more risk represented by my overall investment, the bigger the overall increase will be to the overall value of my portfolio.
Of course, realizing this return means not only taking large risks, but making sure they’re calculated risks, too – such as burning cash on stuff that’s going to drive business and bottom line growth forward, like aggressively reinvesting in experienced sales forces or launching new and innovative product extensions, for example. For the entrepreneur, this associated risk increases their theoretical value along with the VCs, but of course, they are taking their chips off red and putting them on the proverbial 00.
They may hit it, but there’s a 95% chance your numbers won’t come in – and entrepreneurs, unlike VC investors, only get to spin once.
I know what you’re thinking by now – there’s probably no way that, as an entrepreneur, you’d even think of raising VC – but the point of this post isn’t to discourage you from seeking investments – instead, it’s to provide a very straightforward, very honest look at what, exactly, you’re getting yourself into if you do decide to raise venture capital. Now, not all VCs out there are looking to screw you or your company over.
In fact, most of the investors I know are shrewd company builders who are passionate about partnering with entrepreneurs to grow their business while transforming – and taking over – a market. They will open doors you never even knew existed, help you find the perfect executive team to help your business grow, negotiate and facilitate your exit, and generally, sweat the small stuff so you’re free to worry about your company’s bigger picture.
No matter how supportive or sympathetic an investor might be, however, remember that at the end of the day, they are capitalists with a fiduciary duty to their LPs; this means, by law, that they’re required to do whatever it takes to make as much money from their investments as possible.
Sometimes, these ends might conflict with your own personal incentives as an entrepreneur, but the thing is, the means never really mean anything with a VC – only the ultimate goal of making as big a profit off of your business as possible.
Consider yourself warned.
The Recruiter’s Guide to Raising Venture Capital: A 2 Part Series.
Next week, we’ll take a look at when a company should raise VC, what to look for in an investor, and a checklist to help determine whether or not you’re really ready to take on venture capital – and the many risks (and rewards) that come with it.
Stay tuned to Recruiting Daily for more tips, tricks and trends on what every talent pro needs to know about HR and recruiting technology and raising venture capital.
About The Author: Phil Strazzulla is the founder/CEO of LifeGuides, a recruiting and HR technology startup which builds software to help make it easy for employers to create the content that explains why their company is a compelling place to work – and effectively attract top talent.
Before LifeGuides, he was a venture capital investor at Bessemer Venture Partners, the oldest VC in the world which has made investments in companies such as LinkedIn, Cornerstone On Demand, Skype, Yelp, Pinterest and many others.
Phil started investing at the age of 11 when he opened his first brokerage account and hasn’t stopped since.