Note: This article is the tenth in an ongoing series on valuation and capitalization. To learn more about the financial mechanics of early stage investing, download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.
As an active angel investor in the Boston tech sector, I witnessed many paths to a successful return on my invested capital. Sometimes the path is short and sweet. Other times the path is long and convoluted, but ultimately leads to a happy ending. I subscribe to the belief that as an angel investor I should be open to a variety of investment opportunities as I build a successful, early stage company portfolio.
Anyone who has been around the tech startup world is certainly familiar with some of the big successes in venture capital. Companies such as Google, Amazon and Facebook made billions for the investors at Kleiner Perkins, Sequoia and Accel. Such multi-billion dollar exits are the fuel that drives the venture capital industry. But, according to industry analysts such as CB Insights, these unicorn exits represent a tiny percentage of the successful exits in tech.
If you are like me, you make most, if not all of your angel investments in your local area. Here in Boston, we’ve had many billion dollar exits over the past fifty years, but they have still represented a tiny fraction of the total number of exits. Unless you live in Silicon Valley during a boom cycle, you are lucky if there are more than one or two of these unicorn exits over a ten year time frame.
So, is it possible for an angel to make venture capital returns (e.g. 25+% IRR sustained over many years) if you don’t have access to a steady stream of potential unicorn-sized exits? The answer is absolutely yes, as long as you understand how to properly finance a company from its earliest days all the way through to its exit. As many people have heard us say, “You can make money in any kind of exit as long as the staging of capital and the valuations at which it went in are appropriate for the exit type.”
To help show how this works, we are going to give some examples using numbers. To ensure the math in this article is illuminating, we are going to assume you are an early stage investor who is not investing from a large fund and does not have unlimited capital to put into every deal. Maybe you are an angel investing $500K, or perhaps, a professional angel willing to invest $20M in startups. With that in mind, let’s ask Ham how he builds his portfolio with a mixture of small, medium and large potential companies.
Ham, what are the primary pathways to an exit for a successful angel investment?
I like to break down the potential exits in my portfolio into four separate categories. The categories include:
Dividend, Royalty or Buy-back
Elsewhere we described each of these exit pathways in more detail, but it’s important to point out that your investment returns (and IRR) can vary significantly under each scenario. For example, in an early exit, you might be lucky to get twice your money back if the acquiring company is just interested in hiring the founders and their team. On the other hand, if the acquiring company needs the core technology for strategic reasons, you could be looking at a 10x or greater return.
No matter which path the company ultimately heads down, it cannot be left to random chance. Building a solid exit strategy in the early days of the company, and refining that strategy as time progresses, is crucial for driving the optimal investment outcome because capitalization decisions need to be calibrated to match likely exit scenarios.
What are some of the successful financing strategies you’ve seen companies employ to help optimize the investment outcome?
Raising the right amount of financing for a successful exit takes a lot of forethought. Having a solid understanding of your long-term capital requirements is crucial planning for all the company shareholders (e.g. management and investors.) Over-capitalize the business and your returns will be sub-optimal. Under-capitalize the business and you might never reach an exit because you fail to hit your escape velocity.
Let’s illustrate this by outlining four examples of how this works so I can discuss the strategies that should be employed to help drive a successful outcome.
Let’s begin with a relatively capital-efficient software business. And let’s make a few assumptions: 1) at the time of your initial investment the company bootstrapped its way to shipping product and a small amount of initial revenue, and 2) the product provides real value to an already existing market of decent size that is dominated by 3 or 4 large software companies, limiting likely market share to something less than half. Based on these assumptions, and historical norms, the most likely successful outcome for our company is an acquisition in a best-case 5 year timeframe with a target exit price in the $20M to $40M range.
Now, let’s overlay some investor math to see whether you can achieve your investment objectives as an angel investor. Given the risk, illiquidity, time and effort, you need to be able to model a possible 10X return for all your investments (if you cannot model that level of return at the honeymoon stage, you are exceedingly unlikely to see an acceptable multiple once the plan has collided with reality). We need to make one more assumption before we can complete this exercise. To make the math easier let’s generously assume that valuations have been reasonable and after all the rounds of financing the investors own 50% of the company. Based on our target acquisition price $20M to $40M, the investors end up with return capital somewhere between $10M and $20M. For the investors to achieve a 10X return, the total amount of equity capital raised needs to be in the $1M to $2M range. That’s not a lot, but in our very simple example that’s what it needs to be! And that is assuming investors hold 50% - they might end up with less.
It’s not too hard to put together a spreadsheet to model the financing and exit plan for a company. I encourage all investors to take the time to understand this math and make sure the CEO does as well!
My first example was pretty basic, but with good financial discipline and some significant customer revenue, great CEOs can achieve those results - we've seen it done. But what about a more complex example? Our second example is in a technology company that’s an early entrant in a brand new market. Let’s make the following assumptions: 1) at the time of your initial investment the company built a prototype using non-dilutive financing from government grants, and 2) they’ve built a product that addresses the needs of a potentially very large market.
Based on these assumptions, you’ll tend to see two different exit paths. The first path is a relatively capital efficient path that results in the company being acquired in a few years as big companies start to realize the potential size of the new market and choose to make strategic acquisitions to establish a market presence. These early exits can range all over the place, but are typically at the $20M to $100M scale. Performing similar math to our first example, the investors can expect a 10X or greater return if the company raises between $1M and $5M.
But what if the company decides to turn down those lucrative early offers and tries to go big? What happens then? Well, first off, the company will need to raise a significant amount of capital in order to build a much bigger company. In scenarios like this, it’s not unusual for companies to raise $10M to $50M, or more over 2, 3 even 4 rounds of financing. Now, in addition to the much-extended time scale associated with building a large company, the exit math also becomes much more complicated. That spreadsheet I described above has a few more rows and columns! A typical scenario results in the early investors having their ownership position reduced by subsequent rounds to around 10% for the $2M they invested in the early days. Once that level of dilution is factored in, for the angels to achieve their 10X return, the company must be acquired for more than $200M. Large exits at that size do happen, but the bigger the exit, the less frequently it occurs, so the odds of success for the investors are much, much lower. And, don’t forget the impact that this will have on your IRR. That 10X return is now extended out by 5 or more years on top of the typical 5 years. Your exit multiple might be the same in both cases, but your IRR has dropped significantly!
What happens if, as all too commonly occurs, the company and its investors pick the worst of both models? What if the company raises lots of money and tries to go big, but ends up lucky to get a $40M exit? Well, if the angel investors put in $2M but were diluted down to 10%, they would be looking at about a 2X return. Given the ten year time horizon, that is about a 7% IRR! That is a horrible outcome given the amount of risk and illiquidity undertaken, especially if you subtract from that return what the money would have done in a broad stock market index over the same period. How did that dismal return occur? The capitalization strategy did not match the exit realities. The company loaded up on tons of equity capital but was lucky to get a low single digit multiple of revenue for an average price.
As an early stage, angel investor, what happens to my ownership position in the company as each new round of venturing financing occurs?
It shouldn’t come as much of a surprise to investors that their original ownership percentage shrinks every time additional equity capital is raised by the company. That said, it’s helpful to apply some real numbers based on actual data to give investors a better sense for what is going on.
In 2016, CapShare analyzed over 5,000 cap tables from private companies who use their Cap Table Management software. Their research highlighted some key insights that are highly relevant to both management and investors. Starting with the Series Seed round and going through the Series A, B, C and D rounds, the average dilution for all stock holders was approximately twenty to twenty-five percent at each round. That means by the Series D round, the founder's ownership share was reduced from 100% to a range of 11 to 17%.
For the angels who participated in the Seed Round, they can expect their ownership percentage to decline at a similar rate. So if, as an individual angel, you start off personally owning 1% of the company after the Series Seed, you will be down to less than 0.4% at the Series D round. You can avoid this dilution by exercising your pro-rata rights and continuing to invest in the company, but that might require more capital than you plan on investing in just this one company.
One important side note on this topic. As Christopher likes to point out, there is a big difference between “arithmetic dilution” and “economic dilution.” Just because your percentage ownership is going down, does not mean the value of your holding is. Although your ownership percentage might decrease with each round of financing, the value of your position will move based on a more important variable -- the post-money valuation of the company. So as long as the company is making progress and the value of the business increases, you should expect your investment to increase in value over time even though your ownership percentage is shrinking. You are arithmetically diluted, but not economically diluted. Your slice of the pie is smaller, but the increase in the worth of the overall pie more than makes up for it.
Can you provide us with some data on the range of acquisition prices for a technology company?
There are many great sources of data from the technology investment world, including Investment Banks (e.g. Goldman Sachs, JP Morgan), Accounting Firms (e.g. PwC Moneytree) and Research Firms (e.g. CB Insights, Pitchbook, Crunchbase). If you are the type of investor who likes to dig into data, I encourage you to go online and access the reports from these organizations. Many of these firms have blogs and newsletters that you can subscribe to in order to stay on top of industry financial trends.
One of the more comprehensive research organizations for tracking technology company exits is CB Insights. As of this writing, the most recent report on exits was their 2016 Global Tech Exits Report. This report analyzes the results from 3,358 exits in 2016. Out of this cohort of companies, 97% exited through an acquisition and 3% made it all the way to an IPO.
The breakdown for exit size is as follows:
Under $50M 54%
Between $50M and $100M 13%
Between $100M and $200M 13%
Between $200M and $300M 7%
Between $300M and $400M 4%
Between $400M and $500M 1%
Between $500M and $1B 6%
Greater than $1B 4%
As you can see from this breakdown, 80% of exits they tracked are for less than $200M. For investors looking to achieve a 10x return, the company has to raise quite a bit less than $20M in equity over its financing history.
Please note that this report from CB Insights does not cover all exits that happened in 2016. In fact, it is probably overly rosy in its outlook. It’s impossible to track every deal that occurs throughout the year, largely due to the lack of publicity and small transaction size for many deals. Smaller deals are far more likely to go untracked. If you were to factor in these transactions, the percentage of exits that are less than $50M in size would likely be much larger than the 54% indicated by the CB Insights report.
Why aren’t VCs interested in investing in companies that will, in a best case scenario, end up selling for around $50M?
Ultimately, the answer to this question comes down to an issue related to the amount of capital that a typical VC fund needs to invest. The best way to answer this question is to do a little bit of math, so here we go again:
Let’s say that the VC Firm is small and has a $100M fund
For the fund to be considered a reasonable success by industry metrics, it must return at least $250M to the fund’s limited partners (2.5x capital invested)
The fund makes investments into 15 companies
On average, each company will receive $6M in equity capital from the fund
With this $6M investment, the fund will own 20% of each company
A top performing fund will end up with ⅓ failures, ⅓ returning invested capital and ⅓ large successes
That means the fund will return approximately zero from one third, $30M of capital from another third, which means ⅔ of its portfolio returns just 30% of the fund.
So the remaining 5 companies need to return $220M in total to make the fund successful
That means, on average, each of the 5 remaining companies has to return $44M to the fund
If the fund owns 20% of each company, to end up with a $44M return, the exit size for each company has to be over $200M
As we have just agreed, $200M exits are just not that common. So the VC needs to bank on the fact that one of its companies will be a $1B exit. And that is not going to happen if you are focusing on $50M opportunities. Although this may be a gross oversimplification of the equity investment approach by a VC fund, it does highlight the importance of exit size to the ultimate financial success of the fund. If a VC can only model a $50M exit as a best case scenario for a company, they are looking at a return of $10M to the fund. It’s hard to justify the time and effort of putting such a small investment into their fund.
Angels and very small funds (i.e. funds with less than $25M in capital) do have the ability to make profitable investments into smaller opportunities. As long as the total amount of equity capital raised by one of these small exit opportunity companies is less than $3M, the math can work out well for this type of investor. So, I am not surprised when I hear that VC firms make 3,000 to 4,000 investments in a typical year and angels make 50,000 to 70,000 investments per year. There are so many more small exits that occur each year that ultimately will end up making a great return for angel investors.
Want to learn more about the financial mechanics of early stage investing? Download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.