The Entrepreneur/Investor Disconnect on Returns

Perhaps the single biggest area of confusion in the world of early stage investing is the answer to the question “what should an ‘appropriate’ return be for a VC or angel investor in a startup company?” This is crucial, because the answer directly affects the valuations that investors are prepared to give early stage companies, and the assumptions that underlie the answer are the context for the long term relationship between the investor and the entrepreneur.

Before the question can be answered, however, there are several different numbers and theories involved, and it’s important to understand each of them in context:

IRR (Internal Rate of Return) is the return on an investment OVER TIME, usually expressed as an annual percentage rate (that is, if you invest $10 on January 1 and get back $11 on December 31, that would be a 10% IRR.)

ROI (Return on Investment) is the return on an investment REGARDLESS of time, and is usually expressed as how many times the original investment is returned (that is, if you invest $10 and get back $30 at some point in the future, that would be a 3x ROI.)

PORTFOLIO TARGET RETURN is the IRR that an investor hopes to receive in total, taking into account ALL of the investments, profits and losses made in a given time frame.

ASSET CLASS TARGET RETURN is the IRR that an investor hopes to receive from all investments of a certain type (such as CDs, stocks, bonds, venture capital, angel investments, etc.) TARGET ROI is the ROI that an investor hopes to receive on any one particular deal, taking into account the typical holding period for an investment of that type.

TIME VALUE OF MONEY is a fundamental economic concept that means $1 in your hand today is worth more than $1 a year from now (because you can put that dollar to work during the year, and make more money with it.) As such, ROI calculations are meaningless without an associated time frame. A 10x return that an investor would be ecstatic about if it came back in six months, would be a major disappointment if it took twenty years to come back.

RISK/RETURN TRADEOFF is the principle that the more risk there is in an investment, the higher return there needs to be to compensate for it. As such, an investor willing to take a 2.3% annual return on a US Treasury bill (essentially risk-free), might require a 12% annual return to be enticed to invest in a higher-risk corporate ‘junk bond’. (See tinyurl.com/6fby2v)

PORTFOLIO BALANCING means that most investors aim to diversify their risk/return profile by investing in several different types of asset classes, because in any given year one class will do better than another…but it’s difficult to predict which. It is therefore not unusual for the same investor to hold both US T-bills AND junk bonds, as well as several other asset classes. (See a fascinating historical chart of the relative returns from different asset classes over the past 20 years: tinyurl.com/5jygn2)

VENTURE/ANGEL INVESTMENTS in early stage companies are considered (for good reason) among the riskiest possible investments one can make. A majority of startups, no matter how promising, fail completely within a couple of years, losing 100% of the money that was invested in them. On the other hand, there is no way that an investment in T-bills (or General Motors) could ever have the potential return of an investment in a company like Google or Facebook.

Sooo…all of the above leads us into the following scenario: Mr. Typical Investor would like to get a somewhat higher total return from his investments than he would get by investing only in T-bills, and is therefore prepared to take some risk to get it. He decides to create a diversified portfolio with an overall annual target return of, say 5%. Since this is more than double the return of the average money market fund over the past five years, Mr. Investor’s safe (but low return) investments have to be balanced by some higher risk investments, such as small cap growth stocks, or international funds. But for investors who have an appetite for real risk, and the consequent ability to lose some of their investment if things go wrong, they can go even further up the risk/reward scale to…venture capital.

VC funds in general target a 20% or so annual return to their investors, which can certainly bring up the overall average return on Mr. Investor’s diversified portfolio. That sounds great, but with that high return comes equally high risk. Last year, a majority of US venture funds actually lost money and had negative returns, let alone not making their 20% IRR target!

Indeed, venture capital is only one part (the riskiest part) of an asset class called “alternative investments” that include things like private equity buyout funds, commodities, hedge funds, etc. And most institutional investors (the university endowments, pension funds and insurance companies who provide the majority of money to VC funds) nevertheless put only 2-3% of their capital into alternative investments as a whole…because they’re so risky.

Let’s look, therefore, at what it takes a VC fund to get that elusive 20% IRR. Well, it turns out (in case we didn’t already know) that investing in entrepreneurs is indeed a Risky Business. VC’s fund fewer than one in 400 deals they look at, but even with that discriminating judgment they are resigned to the fact that between 30% and 50% of their prized investments will crash and burn. Completely. And another 30% or so will end up being “walking dead”, that is, making just enough money to keep themselves alive, but not enough to provide any return on the investment. Indeed, statistics over many years have shown than virtually ALL of a VC fund’s returns will come from fewer than 10% of their investments. It’s the one home run with Google that makes up for all the WebVans, Pets.com and eToys.

Thus, continuing with our math lesson, and taking into account the facts that: one in ten companies in a VC portfolio need to come up with all the return for the portfolio; the average holding time for a VC investment is 5-7 years; and the return for the whole VC portfolio needs to be 20% or so, we can calculate at the end of the equation that ONE company needs to deliver an ROI after six years of something north of 20X! And therefore, since the VC doesn’t know WHICH of his investments is going to be The One (otherwise, of course, he wouldn’t invest in the other nine!), EVERY one of his investments must have the potential to hit a 20X return.

It’s because of all the forgoing realties, concepts and math that there is typically an enormous disconnect between entrepreneurs and investors. The former figure that ‘risk adjusted return’ means that an investor should be delighted if his/her/its investment brings back a 20 PERCENT profit (which is five to ten times the return from less risky asset clases), while the latter realize that if they don’t aim on each deal for a 20 TIMES profit (which is required on a deal basis to deliver the 20% return on a portfolio basis), they will be out of business.

The result? A two-order of magnitude misunderstanding.