VC Audience - Don't Play to the Crowd

I'm currently sitting in a room wading through piles of due diligence materials for a possible investment. I've come across the plan from last year and lined it up with the actuals for the year. Way way off.  I ask the obvious question: What happened.

The answer was disturbing:

"Basically, the plan didn't really reflect reality.  We put together what the VCs -at the time- wanted to see so they could show an amazing opportunity from a revenue projection and close the deal with the partner group.  The actual revenue we did was pretty much what the internal consensus was all along."

I've heard this story a number of times.  You don't get financing unless you show an amazing 'hockey stick' of growth which lets the VC folks make magic on an IRR spreadsheet so you show 1000% ramp against you and your team's own judgement.

This is a deadly trap. You place your creditability, future financing, and potential long term viability of your company on the line when you get sucked into this nonsense of telling me and the VC junta what you think we want to hear.  

Faced with the blown numbers, the old guys won't put money in, blaming management for not making the numbers.  They now have to scramble to explain why the new guys -moi- should believe the forecasts on a go forward basis.  All of this impacts value which isn't good for anybody.

Under promise and over deliver is one way to put it but the larger issue is that you know your business and playing to the swain song of the VC community where it takes you off plan and off what you know to be true is not a winning strategy.

If a VC (or any investor) is pushing you to goose the numbers, run from the room, they are not doing you any favors.

Comments

[Braydon JM]

Rick - as always, I appreciate your refreshing perspective and good advice - thanks. I have heard from investors "we are going to wait until you're about to climb the hockey stick" (which is of course really a statement about risk), but have not had anyone ask to tweak our projections.

Here is the key question for you: when you don't see that 'hockey stick' growth curve - what is your response?

[Mike Popovec - Recruit U LLC]

We originally had an advisor that wanted us to show a market strategy that had Recruit U grabbing 75% of the market. At the time, it seemed like a viable goal to plan around and of course build into our business plan. Our advisor's direct comment was that VC's only want to see companies and numbers with that type of growth potential.

A few months later, and no longer working with that advisor, we have come back down to earth, put together a stable plan of market growth and the numbers still make us wildly profitable.

I believe a common link to this type of hockey stick scenario is trying to drum up a phantom valuation for a start up or early stage company. If you can sell the idea of a billion dollars in sales on your new widgets - good for you. Is it realistic? Probably not.

I prefer the Calloway Driver over the hockey stick anyway.

[Bobby]

It's good advice.

At the same time, the game is played on both ends. VCs will discount whatever numbers are in the plan by 50% to 80% (just a guess), probably as a matter of experience and prudence.

So, in lieu of a 'we won't inflate if you don't haircut' agreement (sorry, mixed metaphor) on the numbers, there is an impasse.

The best approach to due diligence, it seems to me, is for the VC and the founding team to work together on the assumptions and projections in the plan, looking for both upside opportunities and downside risks.

At the end of the day, in a very early stage opportunity, there is a lot of educating guessing and definitely over optimism (anyone out there interested in investing in a team of pessimists?), rather than intent to mislead, in most cases.

[Brooks Moses]

Bobby: Yeah, I'd imagine this is easy to get as wrong as software delivery-time projections, for much the same reasons. It many ways, it's all based on emotional estimates anyway -- what other things in our experience does this feel similar to, what feel like reasonable estimates for market share and uptake, et cetera -- and so it's easy to start negotiating the estimates. To mistake "this feels like an accurate assumption" for "this feels like an assumption that will get me closer to the answer I want". And to pick things that, while within the (very broad) range of reasonable possibilities, tend to be on the optimal end of the probability distribution.

And, I suspect the solution is the same in both cases: The more hard data one brings into the equation from past experiences where one made careful notes about what one expected and why and how that compared to reality, and the more careful one is to avoid "negotating" one's estimates to make the numbers better ("Well, maybe if we can get 60% of the market instead of 50%? Do I think we can do that? Well, it's not unlikely ... so, yeah, I'll say 60%."), the better the results are.

IIRC, Rands in Repose had some good things to say about this on the software-estimation end of things, and some of that's likely to carry over.

(After a bit of Googling: Hmm; http://www.randsinrepose.com/archives/2006/11/22/the_truth_versus_spin.html seems relevant, but maybe I'm thinking of someone else.)

[Anthony Kuhn]

Rick:

A short, but telling post. Telling people what they want to hear in hopes of influencing the outcome of the negotiation smacks of used-car salesmanship. How about just telling it like it is, and sleeping well at night, as my Mom always advised me to do. So far, so good!

Thanks for your thoughts.

Anthony

[Pete]

Please, with all due respect to you and other VC's things need to be considered from both sides.
1. It is VC's fault that things like that happen:

[Jessica Livingston's interview with James Currier]
"I remember saying to them, "Look, in 4 years, we'll be doing $18 million in revenue with $4.5 million of profit. After that the sky's the limit. I'm an ex-venture guy; I'm telling the truth. We can get to $18 million in year 4, and 30 times $4 million is $120 million valuation for the company at that time. You'll get 20 times your money.

They all told me $18 million wasn't interesting. And I'd say, "But most people will tell you $50 million, and you know they're lying. I'm already discounting it because I'm a venture guy just like you are," And they'd say, "Yeah, but $18 million just isn't interesting."

So I changed my spreadsheet to say $50 million. And they said, "OK, that's pretty interesting."
[end of quote]

2. It is VC's fault that they invest in companies that can't pull such revenues.
3. Companies are given the choice, "you change your spreadsheets to 50 or you don't the deal and your company dies"...uhm, what should they do? Run from the room or take the money? Maybe they won't need a second round, who knows - if they don't take the money no one will ever know?
4. Yes, there are VC's like you that don't do that, but aren't the companies like the one mentioned by you a product of the VC's that do do that?

[Rick Segal]

Pete,
I'd love to tell you: WRONG! But, sadly, I can't. It's a shame but you are right the reality of today's world causes the scenario you describe.

Thanks for stopping by.