Much has been written to help high growth companies think about whether they are suitable for venture capital or not. I like simple models that are easily consumable and was thinking about how companies that are considering raising growth capital could assess the decision to grow organically, sell or raise growth capital to grow more rapidly.
When thinking about growth capital I think of 2 buckets:
venture-backed businesses that are growing rapidly and are now of a scale where they are at Series B stage -> with proven business models etc.
businesses that are growing at more modest rates typically in a smaller niche, having raised modest or no funding
My focus here is on the latter. While venture investors have become more transparent about their investment parameters – growth investors have typically not.
Let’s assume your target growth investor is targeting an IRR of 30%+. Your ideal scenario is that your investor is looking to invest pure equity so that your interests are fully aligned. In order to offer an attractive return they will need to see:
Opportunity for growth in excess of 40% p.a (to allow some slippage to 30% p.a). Note your historical performance against budget.
Acceptance of being valued on a multiple of EBITDA or strong evidence of comparable exits based on revenue multiples or a business model that implies positive operating leverage.
This is just maths.
If you come up short on either front you have two main options – either you find an investor that can enhance their returns through their tax structure, or they can enhance them through financial engineering.
Often terms from growth investors contain a debt component. Founders are driven to minimise dilution, and investors are bound by target returns. Introducing debt into the investment structure provides the opportunity for compromise as it lowers the required rate of return on equity for the investor without pushing up the equity requirement, increasing the probability of closing deals as well as retaining incentive for the management team. It also reduces risk.
This framework leads to a few conclusions:
The optimal alignment happens when growth capital can be used to generate and sustain growth in excess of 30% p.a
You should aim to raise enough capital to enable sustainable growth >30% p.a
If you’re unable to generate an IRR in excess of 30% for investors, they will be looking to enhance their returns in other ways – by investing at a multiple below their expected exit multiple, through using debt or using their tax status
Work to justify exit multiples and operating leverage is important in steering terms.
If you don’t anticipate being able to grow faster than ca 20% per annum with growth capital, you should consider an organic growth plan or selling