Startup Pre-money Valuation: The Keystone to Return on Investment
William H. (Bill) Payne, Senior Program Consultant, Kauffman Foundation
Luis Villalobos, Managing Director, Angel Venture Partners
For decades, experienced angel investors have intuitively used the following rules of thumb for investing in seed and startup companies:
Home runs provide all the return on investment. In a typical angel investor's portfolio of ten investments in seed/startup companies, half the companies perish with no return to investors, and an additional three or four companies return some capital or provide a modest return on investment. Investors hope these three or four companies will at least return the capital for the entire portfolio—all ten investments. Ultimately, only one or two of ten investments will strike it big and bring virtually all of the return on investment to the portfolio.
A large, diversified angel portfolio should provide an IRR of at least 25 percent per year. That's because an angel portfolio is high-risk investing. Rather than track IRR (internal rate of return), however, most angels look at ROI—return on investment or cash-on-cash return. Over five to eight years, angels expect an ROI of 3x to 5x for their portfolios, which is essentially what one would expect for a 25 percent IRR.
Angels must invest only in high-growth companies. Again, because of the poor odds of success, angels look for companies that can scale—that is, companies that show promise of growing ten, twenty, or even one hundred fold in value over a typical five-to-eight-year investment. Companies without the opportunity to show such scalability need not apply!
Reducing scale does not reduce risk. Investing in restaurants that offer 2:1 ROI is just as risky as investing in software companies that scale to a 10x or greater return.
Angel investors cherish their privacy, so there is little data available on the performance of their seed and startup portfolios. Recently, however, one of the authors (Luis Villalobos) assembled and analyzed the portfolios of four experienced angels who have collectively invested in 117 companies and harvested many of those investments. While not statistically significant, the investigation showed interesting results.
The bottom row summarizes the basic facts of this study. A total of 117 ventures received total investments of just under $10 million and provided a total return for the portfolio of just over $50 million. The average time to exit was four years (far lower right cell). Significantly, the cell just above the average shows that "home runs" took more than twice as long to mature—8.6 years—than the average for the complete portfolio.
As the first column shows, the data are grouped by ROI. For example, the first row contains data about the companies that failed and returned nothing to investors: Thirty-one ventures receiving $2.3 million in total investment lost everything in an average of 2.6 years.
The second row of data shows twenty-six companies returned less than all of the invested capital to investors. The third row (ROI = 1) shows twenty-three companies, which have not had a subsequent pricing round, and are valued at the invested amount (i.e., ROI = 1x); the two years in Average Time to Exit is NOT really exit, but is holding time. The fourth row shows twenty-one companies returned more than1x and up to 10x to investors.
Especially important are the following observations:
- The fifth row shows 84 percent of the total return from these portfolios came from just 14 percent of the investments. This number is similar but somewhat better than the rule of thumb that one in ten portfolio companies provides all the ROI.
- While the average time to exit was four years, the home runs took an average of 8.6 years to harvest. Lemons sour quickly but plums take longer to ripen.
- The average home run yielded 33.3x return to investors, as shown in the TVPI/>10x cell. This data support the assumption that angel must invest in companies that demonstrate high scalability of 10x, 20x, or even 100x.
- The total cash return from the companies showing less than 10x return on investment (see column seven: $0 + $1,878,426 + $672,422 + $5,614,653 = $8,164,501) was less than the total invested ($9,936,534 = total of fifth column). This data confirm the empirical assumption by angels that the best that can be expected from investments that are not home runs is that, in total, they will essentially return the capital for the entire portfolio.
Message for Entrepreneurs
Investing in seed and startup companies is very high risk: Perhaps 10 percent of portfolio companies will provide all the return.
Valuation Axiom #1: Angel Investors seek only scaleable investments—companies that can grow revenues to $50 million or $100 million or more within five to eight years.
Valuation Axiom #2: Building companies with revenues sufficient to create $100 million in market value in five to eight years requires much more capital than is normally invested in seed/startup rounds and substantially more cash than can be generated from earnings. Consequently, the ownership of early investors will be diluted substantially as the company raises the capital necessary to fund growth. (See Luis Villalobos' article, "Valuation Divergence" included in eVenturing's Collection titled "Valuing Re-revenue Companies.")
Valuation Axiom #3: Seed and startup investors learned an important lesson during the Internet bubble: Placing a high pre-money valuation on seed and startup ventures limits upside and increases the likelihood of a down round as the company raises the capital necessary for growth.
Valuation Axiom #4: The first professional investment rounds in seed and startup companies should be made at a valuation of between $1 million and $3 million, depending on the quality of the management team and the size of the opportunity.
© 2007 Luis Villalobos and William H. (Bill) Payne. All rights reserved.
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