There seems to be a lack of long-term investment in startups. Why is the 3-5 year exit strategy more desirable than a 10-20+ year timeframe?
Precisely because seed stage investments in private startup companies are NOT Warren Buffet’s types of investments. Early venture and angel investments are much, much riskier than Buffett’s, with more than half of them typically failing completely and losing the entire investment. As such, the returns on an early stage portfolio typically come from only one or two investments out of every ten.
If an early stage fund therefore targets, say, a 20% annualized gross return (to compensate for the risk and for the GP’s carried interest), that means every individual company in the portfolio needs to be at least theoretically able to return that entire amount for the whole portfolio.
Play out the math, that means each investment needs to be able to generate 200% of the initial investment each year (of course, nine out of the ten won’t get there, but the fund hopes like hell that one will.)
Because that 200% is an annualized return, that means if the investor is going to hold for four years before an exit (taking the midpoint between your 3-5), the company needs to be able to generate 2x2x2x2 at exit, or a 16x return.
If, on the other hand, the money must patiently wait for its payoff for fifteen years (taking the midpoint between your 10-20), the math goes:
2x2x2x2x2x2x2x2x2x2x2x2x2x2x2 at exit, or 32,768x. Which means that a $1 million investment today in a “long-term play” has to pay off with a future value of over $32 billion…and that’s just the VC’s share, and assuming no other investment into the company during those 15 years. If the VC fund took the typical 20% interest, that sets the IPO value of the company around $160 billion, or roughly eight times the value at which Google went public.
NB: The math is very rough, and is estimated off the top of my head, but is intended primarily to illustrate to underlying challenge of very long term, risky investments.
*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.