Venture capital investors has a 10x return requirement on invested capital over a five year period, on average. That is a very high returen requirement but reflects the risks with early stage startups. Early stage investors return requirement is high because early-stage ventures often fail.
- Seed investments in new-born startups are difficult to measure due to lack of revenue. Market potential, problem solving and the team’s energy, focus and endurance to build and grow a business during the next 10 – 15 years are most important to potential investors.
- Early stage investments beyond the seed phase are typically made by venture capital funds. Investors in venture capital funds require 25 – 40% annual return on their investment. These investors know that early-stage investments statistically have a high risk of failure and that all funds don’t become successful.
The requirements on individual startup investments made by a venture capital fund are extremely high because those investments that succeed, will have to make up also for those that fail. Success is measured in milestone targets such as Minimal Viable Product, Go To Market and Sales Expansion, but also in revenue and the number of customers.
- Private equity investors have a 20 – 30% annual financial return requirement. It’s somewhat lower than venture capital investors because the risk of failure is lower. Private equity targets larger, mature businesses. Since each investment is large, private equity can also make fewer investments per fund and therefore afford to support and operationally risk mitigate their investments with industrial advisors.
- Infrastructure investors have a 15 – 20% annual financial return requirement, lower than most other investors. Assets that these investors focus on has infrastructure characteristics, meaning that revenues are stable and long term. The risk is therefore lower than for other investments.
Why do early stage ventures fail?
Statistically most startups fail to earn any revenues. The ones that do make sales have a high risk to stop growing already at $0.5 – $2 million in revenue. The most common challenge is the entrepreneur himself, who could have misjudged the market potential, lack sales skill, or simply lack energy or endurance.
Failure means different things to different people. For the average mom and pop business around the corner, or solo-consultants, failure can be not to be able to put food on the table or go bankrupt because margins are too thin.
For venture capital that invest in startups, failure occur when the startup does not reach the next milestones for funding. Consequences are often dramatic with no more funding being available for the startup. New investors will also be reluctant to add new funding when current investors decide not to make further investments.
To private equity owned businesses, failure means not growing EBITDA or net cash flow enough to be able to make a 20-30% return annual return after exiting the business.
Investors financial return requirement are highest for young, immature businesses with little or no proven track-record. There are plenty of really great idea’s but execution skills, endurance and growth make a great idea a great investment.
Failure from the perspective of investors are most often measured in financial terms. Financial investor manage money and need to make money returns.
Why investors look for unicorns?
Neither investors nor entrepreneurs can know for sure which one of all the investments that will become successful. At least by investor standard that mean reaching all milestones and delivering on the financial return requirements. Those few ones within the portfolio that will become that successful, will be the once worth continue to investment.
Those one or two successful startups will have to be so successful that they can also compensate for all the other non-successful investments within the investor’s portfolio. Otherwise the investor will not deliver on the financial return requirement on his total portfolio.
These few successful investments has to be really fast-growing businesses to be able to earn hundreds if not billions of dollars within a distant future. Those are the unicorns.
For that reason, all potential investments need to have future unicorn potential.