Discussion with Friends on Startup ROI for Investors

With all the buzz about the struggling "startups and scale-up ventures", this brought my memory back to year 2021 when one of my friends contacted me, asking for a meeting. He wants to introduce me to his friends who just started a venture, considered as a start-up. He might want to get my comments about that venture.

I met up with them, two young entrepreneurs, and personally I am quite happy that younger generations are now becoming more venturing-spirit and passion to start something from scratch.

They came with fascinating presentation deck to show me what they are doing. It is after office hour and I was a lot tired to go through that slide deck together with them. So to make my life a bit easier, I just asked them a couple of questions, simple ones, but they are "meat" ant not "bones".

First, a bit shocking them by politely them that I was not too interested in the slides to be presented. To me the real case, is always, about talking with the REAL people, and it means they who are sitting in front of me. They are the ones that are running the business! So it is good to sit with REAL people with the REAL business and with REAL story. I don’t want to skip this opportunity by only reading those slide deck.

I leisurely started the conversation to ask them, whether they sniff the REAL need being present in the target customers.

This first question is so crucial, since if there are no REAL need that the business might not go anywhere.

Putting the word of REAL is to emphasize that the product or service of that venture is what the customers really need, able to pay and willing to pay, to provide some returns to the investment being made.

The product or service might fall into 3 categories:

• Must have; or
• Nice to have; or
• So What?

I am trying to reframe my questions: is the product or service is just VITAMINES or is it PAINKILLER ones?

Or is it simply better, faster ones compared to what are already in the market?

They claimed to be the first to market to introduce this product/service. I just put down my pen saying that being first-to-market in this VUCA environment, now seldom matters. The more important is to be first-to-market-fit, in most of cases, will almost be the long-term winner. When Facebook was launched in early 2004, there were already other social network sites, such as Friendster and MySpace.com.

We continued our discussion to the investors’ expectation in funding such business.

I stressed out to them that for early stage venture, they might need to rely on 3 Fs’ money : Founders, Families and Friends, or 4 Fs money: Founders, Families, Friends and Fools (or even 4 Fs + Fans if you are KPop admirers).

The expectation from the investors might sound shocking to them. For serious early-stage investors, they might target to in between 10x or even 30x returns on their invested capital in risky startups. Which this mean that the investors must be convinced that the venture has the possibility of between 10x to 30x cash-on-cash return (or anticipated ?ROI, Return on Investment). Of course, ROI concept has no time element and we need to find it out by asking the investors what they are typical investment horizon before they expect their money back to them (either having the venture being acquired by larger strategic company or being exited through IPO to capital market).

Typical early-stage investors might put reasonably that the venture might take 5 to 7 years for a successful venture to get big enough (GROW and SCALE UP) to be seen in the market’s radar for a healthy exit. However, the typical investment fund being raised by Venture Capital (VC, which generally speaking would enter in the later stage of the venture, through their funding series, called Series A, B, B+, C, so on) has a life of 10 years, with money being committed and made during the first 5 years and then the harvest time to be made in the next 5 years.

I am trying to explain this ROI concept using return concept which might be easier to understand and accept.

The anticipated ROI of 10x might scare off the new fledgling business, which might mean, if they got USD 1 million money, then the venture itself is expected to return to the investor’s pocket US$10 million (= cash-on-cash ROI).

Upon knowing that the expected time to exit is 7 years, then we could calculate the anticipated or expected Rate of Return.

So now we have:

• ROI : 10x
• Time to exit : 7 years

With these 2 information, we could compute the rate of return on an annual basis.?

The easier way to depict this is to get the help from Microsoft Excel, as shown below.

?

?So with ROI of 10x within 7-year exit period, the annual rate of return is approximately 39%.

This 39%-annual-return rate hopefully might not come as a shocking surprise to those young entrepreneurs. The investors here are dealing with private company with its private information. They might SPRAY the money and then PRAY, hoping for the money to be returned (at least for its principal). In the market, all investments that are based on public information, such as investing in public company or public bonds, will have only average rate of return. However, investing in a private company with private information should have potentially higher return (and of course the flip side of this high-return investment, there is lurking at every corner of the venture path, the high risk of losing money).

#Startup #Return on Investment #Exit #Cash-on-Cash return #Startup Funding #Market fit #Annual return #Venture Capital #Rate of Return #ROI #IRR #Internal Rate of Return