How will they make money?
A question both founders and their investors should be able to answer for each other
I put together an investment memo at Dorm Room Fund this week in support of a couple of awesome founders building at the pre-seed stage.
One of the things I found myself doing that I didn’t do last year was assembling a bottom-up market sizing spreadsheet, and tying that in to a revenue model.
It’s not nearly as sophisticated as an LBO model — just a revenue model, a couple exit projections, and some assumptions for the Investment Committee to play around with that I think will drive the financial outcomes. But it is notably more than I’d have thought to do in 2023 when I started this Substack.
How the startup makes money
I generally expect that founders care about how their startup makes money because their livelihoods depend on it.
From the other side of the table, I’ve gotten a lot out of the models I’ve built, because they help me understand how the startup makes money.
At the highest level, that’s important because it drives how my VC firm makes money.
Early-stage financial models of startups are nearly always wrong, no matter who builds them. But the process of building them that reveals a good deal about the creators.
The founder-created financial model may function as a sort of proxy for both the quality of the market and the degree to which the founder demonstrates founder-market fit. There’s other ways to demonstrate both of those, but if I don’t see them both somewhere, it’s very hard for me to come to conviction on an investment candidate.
As an investor, reading a founder model helps me understand their perspectives on:
key levers for growth (and maybe, depending on the stage, profitability) in the business
potential scalability of the business — how big can this get?
A secondary effect is that it demonstrates on some level the degree of financial sophistication the creator has. That’s in no sense a requirement, but it is useful information for me to know as a VC.
Once I’ve come to conviction, the existence of a founder-built model lets me stress test this in a more sophisticated way. I can engage less on the level of “will this work?”, and more on the level of “why do you believe this assumption?”. I view questions of the later type as much more useful in developing perspectives on visions for products and markets — as well as the founders who have them.
Returning to the founder perspective, founders should create a model to understand the effects that their decisions during a fundraising process could have later on in the company’s life, because that’ll eventually impact how things play out during an exit.
Having just said all that, I think that while pre-seed founders should create a financial model, I also would encourage them to not go crazy spending too much time on it. There’s other ways to use time that are ultimately going to have a bigger impact on early-stage VCs’ willingness to offer a term sheet, like user/customer traction, and technical progress.
My view is that the best way to do think about a startup’s financial potential is by building a reallly rudimentary quantitative model, though there’s certainly other options.
Models of the startup from the VC perspective are not any more likely to be right than the founder models. But what they do is they let potential investors think quantitatively about the critical things they believe will lead to the startup’s success or failure.
They’re particularly helpful in scenario analysis. This can be critical because most VC incentives are aligned with their own investors so VCs only make money when the LPs make money when the startups are successful and exit.
How the VC firm makes money
I generally expect that VCs care about how their firm makes money because their livelihoods depend on it. The continued existence of the firm and its management fees, as well as any potential carried interest, are pretty clearly a function of this.
Michael Huseby wrote a great three part series on his beehiiv about how carried interest works, but it really boils down to two words: “profit sharing”. If there’s no profit, there’s no carried interest — so VCs had better understand how their employer makes money in order to execute the plan. Moreover, in order to benefit from it, they need to understand and agree with the founders’ plan to make money.
For founders, how the firm makes money is really important because it relates to the firm’s persistence into the future. Many VCs have a standard model of 2% management fees and 20% carried interest, but there are some with slightly different approaches.
When a VC invests into a startup, especially at the early stages, they’re really starting a 10+ year business relationship. That’s typically at least two new funds (each fund generally has an investment period of several years) beyond the fund containing the investment into the founder. If a founder doesn’t believe the VC as an institution is going to continue to exist longer than the startup will, it probably makes no sense to take the firm’s money.
The founder should want to make sure everybody’s incentives are aligned while getting the best deal possible for their startup over the long run. That may mean taking some small hits over the short run. Examples of this might include deciding to work work with the firm which has the deepest pockets for follow-on financing, even if not all the term sheet terms are the most advantageous for the startup. Or it may mean taking a term sheet with a lower pre-money valuation, but a syndicate that adds more value.
At the end of the day, each party in a VC investment understanding how the other makes money will prepare both parties to support the other over what will hopefully be a long and mutually beneficial relationship.
That’s why it’s worth understanding as deeply as practical how they’ll be successful.