Part 2: Early stage investment math – the rule of 3x
Monday’s post, the math of early stage venture capital sparked off interesting debates on various forums. Generally, there is a belief that 268x return in 7 years is unrealistic, many conjectured that early stage VCs expected lower returns, some made the argument that 20% irr was the return expected from a VC (answer to that later).
It occurred to me that maybe (just maybe) the naysayers haven’t looked at the math behind the multiplier effect of early stage investments. So herein below is the math of how a 1 crore investment in seed turns into 243 crores in 6 raises over 75 months. I have refrained from naming the rounds to avoid a tangential debate otherwise here are my assumptions:
- A startup raises money for 18 months and starts scouting for a new round in 12 months therefore I have taken a median time of 15 months for a startup to raise the round.
- The valuation increases by 3x for a startup between the last round and the next (ideal scenario). The numbers move up or down by a factor of 1x due to many factors that may or may not be under the control of the founder (or funder) but in an ideal scenario the valuation should multiple 3x.
- This model may not apply for startups that require long development cycles like startups in the medical space, manufacturing, etc.
|Round 1||Round 2||Round 3||Round 4||Round 5||Round 6|
|Timeline (months)||15||15||15||15||15||75||#of months|
|Pre-money valuation (in crs)||4||15||56||211||791||2966|
|Raise (in crs)||1||4||14||53||198||742|
|Post money valuation (in crs)||5||19||70||264||989||3708|
|Seed Investment Value (in crs)||1||3||9||27||81||243|
|Founder’s Holding (Post Money)||80.00%||64.00%||51.20%||40.96%||32.77%||26.21%|
|Founder Valuation (in crs)||4||12||36||108||324||972|
The message is clear, money invested in early stage venture capital demands that the investor provides more than just risk capital and that they stay invested for 6-7 years to see a surge in their valuation. When the startup starts scaling new heights, the investor’s early risk is rewarded handsomely. Granted that most startups will not pan out the way the investor and entrepreneur expected and that is the risk the investor must live with and get rewarded for.
Lastly I am a firm believer in risk adjusted returns for my money which means that money should flow to those areas where it achieves the highest reward to risk ratio (and not the other way around!).
So, I compare the returns of my team’s work at Artha India Ventures to the work my team at Artha Energy Resources is doing wherein they have placed over $5 million capital from a clutch of investors (including us) into operational wind power projects on long term PPAs at 15% irr in the last 6 months. If my money can earn that return, why should it be deployed at 20% irr in highly risky early stage investments?
The clearer the investor and the entrepreneur are about what they expect from their investment… the easier it is to keep each other happy!
Thank you Vijay Anand of The Startup Centre for sharing the previous edition of this discussion.