I’m working on my financial projections and want to make sure I show enough revenue and profit growth to attract investors. What rate of return do investors expect?
I love working with numbers and I hope you do too. After all, business does come down to numbers—increasing the number of customers served each year, reducing costs, improving gross profit margins and then counting up your profits.
Trust me, though. What you show as your projected revenue and earnings growth will not be the only numbers that investors consider about your business.
Since most investors get their money back from the sale of a company to another business, investors think a lot about how big a company’s valuation can grow to over time. The bigger the better.
In general, angel investors expect to get their money back within 5 to 7 years with an annualized internal rate of return (“IRR”) of 20% to 40%. Venture capital funds strive for the higher end of this range or more.
So how big does a company have to grow to in order to achieve a venture-friendly rate of return?
As the table demonstrates, the greater ownership percentage an investor has in a company, the less the company’s value has to grow to in order to achieve a venture-friendly return.
|Build Value on Purpose|
|% Ownership of a Company Required to Deliver 30% IRR|
If, for example, a group of angels invest $2 million in a company, and own just 10% of the company at the time of exit, then the company would have to grow to be worth $100 million to deliver a 30% return over a six year period. That’s a big valuation gain in a short period of time!
Caveat: If the company was sold successfully in less than six years, then the IRR returns noted above would be higher than 30% because of the time value of money.
Investors know that building a company up to be worth $100 million is exceptional (and unusual) performance. It’s why most savvy investors ask for a larger percentage equity stake at the time of investment. The extra percentage ownership helps compensate them for risk plus gives them a better chance of reaching a 20% to 40% IRR.
Now that you know more about the relationship between a company’s valuation at the time of business sale and percentage ownership, you can evaluate your business strategies in a more purposeful way.
Consider, what is it about your business that other companies will want to buy in the future that will boost your company’s value. If you want some ideas on the factors that tend to boost a company’s value at the time of sale, read chapters 3, 7, 10 and 11 of Start on Purpose.