The Pitch:
We see a lot of presentations in which entrepreneurs say that they expect to sell their companies for a 10 times multiple. They believe that’s music to our hours. But it’s not enough.
The Reality:
Of course, if I can get 10X my money back in 10 years, that gives my an Internal Rate of Return of 26%. That’s good but as an angel investor, this will be from only one company in my portfolio. The others will not, on average, be that lucrative thereby dragging down my net portfolio returns.
Let’s not confuse company valuations with exit multiples. I had one company that exited in 6 years at a valuation that was 17 times the angel round valuation. Yet, those early investors only doubled their money. Why? It’s because the company did several subsequent investment rounds at just slightly higher share prices. Conclusion: what counts is not the overall valuation, but rather, the share price.
Early investors often get trumped by the liquidation preferences that subsequent investors may enjoy. Even if there’s a 10X exit with later-stage investors having preferred share liquidation preferences, especially those with multiple liquidation preferences and/or participating liquidation preference, those payouts will be squashed down.
Let’s also not confuse exit multiples and Return on Investment (ROI) with Internal Rates of Return (IRR). While 10X sounds good, what matters is how long it takes to get that 10X. A 10X in 10 years is 26%. But, as is often the case with startups, if it takes 20 years, the IRR is reduced to 12%. On the other hand, if it happens in 5 years, the IRR is 58%. The IRR is what matters. That’s how we compare angel investing to other asset class investments. Given the risk of early stage investing, we should be rewarded by at least a 15% return since there are many alternatives that can produce 10% without all the effort. Indeed, the seminal studies by Rob Wiltbank of Willamette University showed that angels with big portfolios could achieve 27%. That’s a motivator for sure but that’s where portfolio management comes in.
So, if saying 10X in 10 years is insufficient, what should we target? And how do factor in dilutive rounds and option exercises?
Because we are targeting a minimum IRR, let’s start there. Using a conservative 15% (put your own target in here), what should be our minimum goal on each investment? Keeping in mind that the odds are better the bigger portfolio, a portfolio of 10 is thin. 30 to 40 companies is better. On a percentage basis, out of 100 companies, angels can expect more failures than VC-stage ventures. Wiltbank showed that more than 50% produced negative IRR.