If you haven’t heard, Facebook bought Instagram for $1 billion dollars. One interesting aspect of this story is the fact that Instagram just closed a round of investment from top VC firms two days earlier that valued the company at $500 million. According to this article by Techcrunch, Instagram received a $50 million dollar investment just two days before selling the company to Facebook for $1 billion. This means that the investors literally doubled their money in just a few days. You might think the investors would be thrilled, and I am sure they didn’t complain too much, BUT I believe they were less than thrilled. I think there is a valuable lesson for entrepreneurs to learn about VC firms in this story, so I want to explain why these investors may not have been ecstatic when they heard the news about the Instagram acquisition.
Key Point: Venture capital is a swing for the fences game.
A great VC firm will expect their portfolio to look something like this:
- 1/3 of investments go bankrupt
- 1/3 of investments breakeven
- 1/3 of investments are homeruns
So let’s look at the math a bit closer. Let’s say a VC firm has a 90 million dollar fund that they split between 9 companies. Each company receives a $10 million dollar investment.
Right off the bat, you assume that $30 million is lost and another $30 million will return to the fund over the next 5 years from the 3 breakeven companies. That leaves 3 companies left that you hope return 10X the initial investment.
The Instagram investors were hoping for a 10X return. VC firms don’t put capital at risk, if they don’t think there is potential for a 10X return, so we know that the Instagram investors thought there was big time potential with this company.
Let’s say that those remaining 3 companies from the original portfolio all do what Instagram did. Let’s say they all double the investor’s money. At the end of the day you end up with the $90 million that you started with because 3 went to zero, 3 broke even, and 3 doubled. That just isn’t the kind of return a VC firm is looking for.
One think we must consider in the case of Instagram is time. The investors doubled their money, and now have the chance to take their $100 million and invest in more high potential companies. It is exceedingly rare for a VC firm to double their money overnight, and I am sure they were not angry, BUT we must remember that VCs want to hit homeruns; otherwise they wouldn’t play the game.
So next time you are pitching your company to potential investors, just remember that most investors are not looking for the next Instagram, they are looking for the next 10X return. Good luck!
About the Author: Adam Hoeksema is the Founder of ExecutivePlan. ExecutivePlan helps entrepreneurs write powerful business plan executive summaries in order to raise capital. Check out Adam’s Venture Capital Executive Summary Here.