How to calculate your expected return can be a complicated process, or as simple as something you can do on the back of a napkin. The simple rule of thumb is to figure out how much you expect the company to sell for. You can estimate this by looking at the company’s 5 year financial projections. If you would like to assume the company sells in 5 years, see what they expect their Revenue of EBITDA to be at year 5. Let’s assume we would like to value this company based on EBITDA, a figure typically used to approximate free cash flow. Most non-strategic acquirers will pay 10 times EBITDA for a company with relatively stable cash flows and some growth potential. So if the company you are thinking about investing in is expecting to be generating $10 million dollars a year in EBITDA by year 5, you can reasonably estimate the potential exit valuation at $100 million. So, in order to calculate your expected return, you need to divide that by the post-money valuation of the current round. For this example, we will assume the company is raising $2 million at an $8 million dollar pre-money. So, $100 million divided by $10 million equals 10X. Which means, the expected return on your investment is 10X cash on cash. This may or may not be attractive to you depending on how much risk you think is involved with the company actually reaching $10 million in EBITDA and how likely someone is to actually acquire the company at that time. Another major factor to consider is dilution, which means that if the company needs to take in significant additional capital to get to $10 million in EBITDA, your potential returns will be greatly diminished due to liquidation preferences and dilution. If you are interested in learning more about how to use scenario analysis to evaluate the return potential of a startup investment you are considering, you can download a free startup investment return calculator at 1000angels.com.
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Topics: Venture Investing Academy