In the VC method, required ROIs represent the minimum returns investors look for when funding a startup. They depend on the average returns of their portfolios.
Investors expect the majority of their portfolio companies to return less than the invested amount, so their final result will come from just a small, high-yield fraction of the companies. In a typical situation, out of 10 companies, 5 will fail, 2 to 3 will return around the invested amount, 1 to 2 will generate about 2X, and only 1 will yield a 10X return that will compensate for the negative results of the other companies.
If investors were to accept a deal with an expected return below the average, the few successful startups might just not pay off enough to cover the losses.
How Equidam determines the required ROIs
Investors’ return expectations are driven by 3 factors:
- The cash-on-cash multiplier – that is the ratio between the money they expect to earn when exiting a startup and the amount they are investing
- The dilution of their initial share in the company because of larger investments in subsequent funding rounds
- The years they plan to hold the equity in their portfolios for before exiting.
The following table reports the average values of these factors for investors working with startups in each stage of development:
These average values have been rearranged in the compound yearly rates representing the required ROIs through the following formulae:
Investors focused on Development stage startups expect to earn – on average – 5 times what they invested. However, they also expect their participation to be 75% smaller by the time they want to sell their shares, in 4 years.
Thus, the value of a startup they invested in must grow by 5 / (100% – 75%) = 20X to yield the same return with a smaller ownership. If a company grows by 20X in 4 years, it means its ROI is 20^¼ – 1 = 114.74%.