Posted by Erica Duignan Minnihan on Aug 2, 2016 2:03:50 PM
One of my clients, Jeff, is a high net worth individual who has worked in finance for years. Although he is very familiar with stock market investing, he was a little stumped when it came to understanding the nuances of startup investing.
He was looking at two different deals. Both had great founders, a great market opportunity and some good initial traction. One was raising $2 million at a $10 million valuation and the other was raising $1 million at a $5 million valuation. He wasn’t sure what to do.
“How do I calculate the PE ratios? How do I know what the market cap is going to be?” In short, he needed to know how to evaluate this very special asset class that is a startup investment. And the tools he learned to evaluate public market investments weren’t going to be very helpful to him in this case.
Public market investors buy a stock because they think price is going to go up. They are hoping that if they buy shares at $100 today, then within a year the shares might trade at $105 or maybe $110 if they are lucky. They are looking for return on equity, which is typically between 5-10% annually for blue chip stocks.
But startup investors look at things much differently. They focus on “internal rate of return” (IRR) and “cash on cash return”. These metrics are useful for investments that are illiquid and have long term holding periods. Startup investors are looking for investments that have the potential to return $10 for every dollar invested, but understand that they might not realize the return for years.
In order to determine whether a startup can meet your desired rate of return, let’s say a 50% target IRR or 10x cash on cash return in 5+ years you need to evaluate several aspects of the investment. Objective factors that can affect return potential include:
- Expected Revenues
- Gross Margins
- Size of the Current Round
- Valuation of the Current Round
- The need for employee option pools
- Future expected capital requirements
- Future round valuations
- Industry exit multiples
And a variety of other factors....
Whether or not the startup WILL be successful is another matter. What we are trying to establish is simply IF the startup is successful, does the investment have the potential to produce the desired returns under the terms of the investment and given your best assumptions of these other factors.
Trying to answer this question can be a real challenge for someone who does not do this professionally. That’s why we created the Startup Investment Return Calculator. In just a few easy steps Jeff was able to determine what the return potential of the two investments he was evaluating without having to perform complicated excel functions or create a model.
Using the analysis provided by the return calculator, he decided to pass on the deal with the $10 million dollar pre-money valuation that would have provided a 3x return on a capital at best. Instead he elected to invest in another startup he thought had a similar risk profile but the potential to produce a 12x cash on cash return from investment at a $5 million dollar pre-money valuation.
Why overpay for startup equity? Try the return calculator and start making better startup investment decisions today. Even more awesome is that you can use this tool with the investments we have live on our platform. See which deals you can add to your venture portfolio by trying our 14-day free trial.