The Equity Problem
From the investor's side

pc-equity-problem-graph-newpadding1When we describe Why Polus Exists, we refer to “market structure” as the reason traditional capital options are poor fits. Below is an example of how this structure inhibits traditional equity firms (VC and PE) in addressing companies that are $5M-$15M in revenue.

Presume you encounter a hypothetical $100M equity fund. Whether they are a VC or PE, their goal is to return $300M – net of fees – to their limited partners (LPs) at the end of 10 years, because that is the return the market demands for firms to stay in existence. Because the firm gets a 20% carry, they will need to achieve $350M in total investment returns to net $300M back to LPs (i.e. 20% of $250M profit on top of $100M is $50M).

Out of an original $100M fund, 20% will go to management and deal fees over 10 yrs. Depending on the riskiness of their bets, between 10%-40% (i.e average of 25%) will be lost to companies that go out of business. That means on average, the fund will have only $55M to achieve $350M in 10 years.

On average, let’s say this $100M fund invests $7M over the life of each company. That means roughly 8 companies need to produce an average of $45M each in returns to get to the $350M target. In reality, according to the National Venture Capital Association, in this situation VCs would depend on only 2-3 of those companies returning >$100M to achieve their returns.

When the VC or PE is making investment decisions, this math forces them to consider three primary questions:

Assume you are a $6M revenue, profitable business that equity investors believe can grow to $30M revenue in 5 years.  Yours is a super hot market so your type of company can expected to be purchased at a 3x multiple of revenue, or $90M.  That means the equity investor will need to own 50% of your company to make their target $45M return.

From the equity investor’s perspective, they will have to invest $5M while valuing your business at $5M, so that after the investment they own 50% of a $10M business (the additional $2M is in reserve to preserve their position down the road).  This business now valued at $10M needs to increase its value 9x for the equity firm to make their target return.

From the company side, at minimum they are thinking their company’s value should be $18M and really only need $3M. Such a scenario would only result in a 15% dilution of ownership, which they are willing to take.

50% dilution versus 15% dilution – how do companies and investors bridge that gap?  Statistically, most do not – the vast majority of such companies walk away from equity investment.  Even if there is some movement and flexibility on this term, valuation is the least important part of the deal to investors – other preferential terms are what investors use to increase the probability of achieving a target return.

This is just an example of how an equity deal may work.  It’s clear that both sides are acting in rational self-interest without any predatory inclination – their respective situations result in misalignment.  Equity behavior is directionally similar in all cases, but different firm styles may vary in the following ways:

Finally, traditional equity firms are contractually obligated to return investment proceeds to LPs within 10 years.  This means their deals must allow for forced sales and other terms that remove control from entrepreneurs.  Even though funds allow extensions of this 10 year life if, for example, it takes longer to liquidate companies, to do so is not the goal for firms or LPs.

If equity firms fail to achieve their target 3x net returns, they have difficulty raising another fund – which means they are out of jobs – so they are very motivated to hit this target.  As you can see, it’s the structure of the institutional investment industry that dictates how equity firms create the deals that – to entrepreneurs and company owners – seem to be one-sided bargains.