Calculating your expected return on a startup investment 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 estimate your potential return based on how much you expect the company to sell for. Most investors expect a liquidity event such as an acquisition or IPO within 5-10 years after investing. We will use our best estimate of a future acquisition to envision this scenario.
You can estimate the company’s potential future value 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 or EBITDA to be at year 5. For this example, 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 around 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 pre-money valuation; therefore a $10 million post-money valuation. So, $100 million divided by $10 million equals 10x. Which means, the expected return on your investment is 10x. If this were realized within 5 years, it would mean your investment produced an IRR of 58%. This also just happens to be the target return for most Series A stage investors.
But, 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 access a free startup investment return calculator on 1000angels.com.