Why is Acquisition Equity more expensive than VC Equity?
July 31, 2024
by a searcher from Georgetown University in Boulder, CO, USA
Hi all-
I'm a recent vc-backed tech founder. The state of funding in the very risky 0-to-1 startup market seems to be less expensive than equity funding in the much-less risky going-concern market - and I'm curious why.
In the VC funding market, there is typically no annual dividend, and often no preferred return. We raised our round at a $25MM valuation cap, with no discount, no dividend, and no preferred return or return multiple. When I hear that these have become standard acquisition equity terms, I'm bristling at the potential cost of it. Can anyone explain to me why there are so many Investor dollars chasing deals, but entrepreneurs have been unable to push back against these deal terms for much less risky ventures?
from Harvard University in Nashville, TN, USA
Short answer: startup vs. trad cash-flowing asset classes play two very different games with very different distribution of investor outcomes, which leads to very different investor price sensitivity, esp. at the earliest stages.
Metaphor - VC game is about buying lotto tickets vs. trad is about flipping items on eBay. You've gotta be much smarter about your entry price when you're flipping items.
Long answer:
VC is the most extreme game of binary outcomes where 70% of time, investors go to zero. 20% of the time an investor will be lucky to see 1-3x. It's the top 10% drive 10x-100x. This means that VCs are highly price insensitive because whether you enter the deal at $20M or $25M, it won't make a diff when the winners will exit for billions. It's so much more important to get in the right deal rather than getting in at the precise right price.
In SMB world, the outcomes are much flatter. Your ceiling is much lower, but your floor is much higher given that it's cash flowing. It's very important that you get in at the right price.
Side note: Btw, the SAFE you raised on might make you think you have no pref hurdle - but as soon as you raise from institutionals and those SAFEs convert, you'll still have to deal with liquidation pref (usually 1x). This means if you've raised $25M, and you exit for, say, $30M, you as the founder will barely see anything. Many founders realize too late the true nature of venture game b/c no one tells them how they can get screwed.
Also...the VCs you now bring onboard are playing the venture game. For them, it's mostly go big or bust. Even if there's a path towards a 2x for the investment, that's a loser for them when they underwrote your deal at 10x exit. They're incentivized to push you and the C-suite for the 10x.
Most founders realize too late the cost of what it means to be on the venture path, thinking VCs are suckers for giving them free money.
from University of Tennessee in Nashville, TN, USA
A more explanatory answer: the best capital partners are those that you establish relationships.
I, too, had sticker shock when building an investor pool last year. What I found was that the best and most reasonable capital providers are not usually the ones on this medium or others and generally don't promote their capital as available. Further, it surprised me (but it really shouldn't have) that so many individuals with big checkbooks behind them talked down to me with numerical analysis to justify their expensive capital when I questioned the return rates for me versus them after servicing growth and debt, guarantor obligations, and levels of engagement. For many offers of capital, it is excessively lopsided in the favor of the marketed capital providers and is readily comparable to VC-expected rates of return.
The disconnect of expected going concern returns versus startup returns is a reality in the micro-SMB space for many capital providers. Remember though, this is an open market. There is excessive dry powder that is waiting to be deployed.
Reasonable capital, specific to the industry targeted, is available. Unfortunately, like all actions associated with a successful search, it is the Searcher's task to locate it. The search for the acquisition target is sometimes easier than locating the right capital partner. However, I will tell you that your confidence and comfort level in financing and cash-flowing your deal is substantially higher once the right capital partners have been identified.
Please note, this free advice is sourced from an individual whose runway ran out after a broken deal and no replacement target! ;)
Happy hunting!