What kind of returns do investors look for in a start-up?
Wednesday, February 15, 2012/
What kind of returns do investors look for in a start-up? Will I have to squeeze every last cent out of my business for them to be happy?
The only reason for a rational investor to back a start-up is the promise of very strong returns compared with other, less risky options.
They can make modest returns by leaving their money in the traditional places – equities, real estate, term deposits, managed funds, etc.
And smart ones will of course know that the chances of any one start-up succeeding are statistically very small, despite the fact that you know that yours is the exception to the rule.
So it is certainly true that investors will expect high reward for the high risk.
Each will have their own specific criteria but it’s not unusual for them to think in terms of a five to 10 times return on their initial investment, depending on the stage at which they invest; the initial seed investment being obviously the riskiest.
For you as an entrepreneur this shouldn’t be a problem – you’ll be expecting a similar return yourself, and should be happy to share it with someone who’s taking essentially the same risk as you.
The only exception to this is a sentimental investor, whose rationale is to “back” you and your team.
Friends and family are the likeliest in this category, and are often early investors in start-ups. They put in a small amount of money they’re prepared to lose so that you can get going.
It’s easy to think of this as easy money, in that it comes without the demands of rational investment, and so gives you a bit of breathing space while you do the hard early yards in setting up.
Be very careful here. Experience strongly suggests that rational investors are much more likely to ask you the hard questions, and hold you accountable to your plans, than the sentimental ones.
And that’s what you need as you shape and define your proposition and business model.
A good rational investor, however, will not ask you to squeeze every last cent out of the business until the model is proven, scale is achieved and your position is stable and growing.
In order to get a great return they’ll know that the company needs to be very valuable, because the return comes when either it makes big profits or when someone buys it.
And in order to be very valuable the company needs to do the hard yards in establishing itself, getting customers and showing that the business model works and scales. This takes time, patience and determination.
So what you want is a rational investor who expects to get five to 10 times their initial investment, knows the inherent risks, and understands that building the company to do this takes time.
Their reward is mid- to long-term, not short. It’s great to get a strong mutual understanding of these things at the point of investment, so that your thinking is aligned.