Why 3x return is sometimes not enough for a startup investment.
Most angel investors are driven by passion, more than data. While this is perfectly fine and healthy for the ecosystem, startup investments are also an important investment class that can profit from data-driven decision making.
Assessing startups in their pre-seed phase is very difficult because there are very few data points available to base a decision on. What if there is a single determinant that quickly helps to sort out?
In this case, it’s helpful to look at other professionals in the startup space and learn from VCs. One of their infamous criteria is searching for “fund returners”.
Even though angels do not have a fund, the logic is extremely helpful to build a profitable startup portfolio.
As we incorporate more and more data in our own decision processes, we are now always trying to determine the right exit valuation benchmark for a startup investment which depends on several factors, including the size and composition of the angel investment portfolio, the investment round, and the dilution rate until exit.
The portfolio
The size and composition of an angel investor's portfolio play a significant role in determining the right exit valuation benchmark. While angels don't operate as a fund and don't have a clear target for portfolio size, there are some basic guidelines to follow. As everyone knows, the failure rate for startups is tremendous. At JVH Ventures, we face a 64% failure rate for our historic investments. Mostly, this rate lies between 60-80% for most early-stage investors.
Therefore, it’s extremely important to reach a portfolio size that is large enough to account for this risk of failure. In light of returns, the smaller the portfolio, the higher the expectations for each startup.
For example, suppose an angel investor builds a startup portfolio with a volume of €1 million. She invests initial ticket sizes of €50,000, with no follow-ons. In that case, she would end up with 20 companies in her portfolio. Assuming an 80% failure rate, she would need to recover her total investment of €1M from four companies (and ideally make a plus as well).
However, not all four companies would generate the same returns, with some potentially return 2x the investment, while others might even generate up to 100x. Even if all four companies generate a 3x multiple (which is not bad), the angel investor still loses a lot of money - with a return of €600,000 and a loss of €400,000 in total.
Without this logic, founders are often puzzled by VC decision making. Johannis learned this himself the hard way:
After successful talks with an investor for his company ProductsUp and their statement they could get a 5x on their investment, the fund turned them down because the return perspective was too small for them. Without the logic from above, this makes absolutely no sense for an entrepreneur.
So even if everything goes according to plan, the angel could end up losing money, if the multiple was not considered during decision making. Making up your mind about the expected multiple of a startup, is therefore extremely important before the angel even considers to invest. Let’s have a look at the example portfolio from above, we would like to find out what the benchmark valuation (or multiple should be, no matter what the business model of the startup might be).
Initial Shares
The initial shares acquired or the valuation of the startup also play an important role in determining the right exit valuation benchmark. Our average initial post-money valuation across all deals was €6.7 million. This includes some investments in later-stage companies, so therefore the number is a little skewed towards higher values.
Let’s go back to the example from above and assume a post-money valuation of €5.0M for the initial investment. With a €50,000 investment, this would result in an initial post-money share of 1.0% for the angel. Of course, this is a big lever already, as the multiple relies on the initial valuation (see also our story on valuations).
Dilution
While the failing companies will drop out over time, the successful companies will continue to thrive, which most likely means new fundraising rounds and hence - new dilution. The average dilution per round at JVH Ventures is around 17% per round. While this average also includes smaller bridge rounds, the true average dilution for a full-fledged round is around 20-22%.
For the example portfolio, let’s assume a 20% dilution per round for the sake of simplicity. Furthermore, we assume that successful startups are ready to exit after four more funding rounds (e.g., after Series C). With four rounds of further funding, the total dilution would be almost 60% for the angel.
Exit Benchmark
Finally, the angel investor is able to determine how the startup at hand can achieve €1 million in expected gross returns.
After five funding rounds, the investor would be left with ownership of 0.41%, which means that the startup would need to be worth roughly €244 million for their exit to return €1 million for the angel. This calculation does not include any waterfall logic that may reduce returns for early-stage investors (Read more on this here: https://capnamic.com/post/the-liquidation-preference-dilemma )
It is worth noting that most exits take place below unicorn status. But also €244 million is a high benchmark for a successful exit, in the age of sinking valuations and acquisition appetite.
The European Median for VC-backed startups’ exit valuations was €38 million in 2022 (PitchBook). Also by looking at the German exits in 2021, it’s clear that €244m is quite a significant benchmark: https://www.deutsche-startups.de/2022/01/06/startup-exits-2021/
Astonishingly, this implies a multiple of 20x on the angel’s investment and a valuation multiple of 49x on the €5.0 initial post-money. As these multiples rather sound like VC targets, the basic example illustrates that it should actually be quite a realistic expectation for everyone to consider angel investments.
Conclusion for angels
First things first, angels should build a large enough portfolio to account for the high risk of startup failure. In addition, it’s sometimes helpful to adapt the VC perspective and also introduce the metric of expected multiples before considering a startup investment. The expected multiple should always allow all startup investments to be recovered, given the risk preferences of the angel.
Multiples of course can only be influenced directly by setting the initial valuation and the acquired shares. However, it is still helpful to model the other influencing factors such as continuous dilution and the number of following fundraising rounds.
Dilution is an important factor that needs to be considered since successful companies will continue to thrive, which means new fundraising rounds and hence, new dilution.
Finally, angels should determine how the startup at hand can achieve the expected returns and set an exit benchmark. By following these guidelines, angels can build a profitable startup portfolio.
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Conclusion for founders
For founders, it’s definitely an advantage to manage angel expectations from the start! Be realistic about your business and benchmark what potential returns might be. It’s also helpful to understand your dilution over time and how this affects your own shares and returns. Normally, you are the one to set the first valuation and hence, you can influence to make the deal attractive to your angels.
Are you a founder and don’t know how to think about your valuation?
Hit us up, we are happy to give feedback: www.jvh-ventures.com/pitch