That’s a lot of talk about “probability of success of a startup”.
Sounds all very interesting, but how does that work, really?
You are an investor.
You decide to invest in 10 startups.
You want to make a 15.0% internal rate of return (IRR) on your portfolio.
You have a 5-year investment horizon.
So you want to make a 2.0x money multiple (MM) on your portfolio.
That means the portfolio must have a $2,011 exit value on a $1,000 post-money valuation.
For each startup
Based on the number of milestones till their exit and the probability of success for each milestone, you invest in 10 startups, each with a 30% probability of success.
That’s the same as saying that 3 out of 10 startups in your portfolio will succeed. The other 7 will fail.
Failure means an exit value of $0.
Because the portfolio must have a $2,011 exit value and only 3 startups succeed, each startup you invest in must have a $670 exit value.
A $670 exit value on a $100 post-money valuation means you must invest in a startup at a 6.7x money multiple or 46.3% internal rate of return.
Some investor remarks
Given this logic I have a hard time understanding the following investor remarks.
“There is still so much uncertainty in your startup.”
It is an early-stage startup, so it does have a low probability of success. But that is discounted in the money multiple at which you discount our exit value.
“We would rather invest in the next round.”
That means at a higher probability of success than the current round, so at a lower money multiple. It will not make a difference to the internal rate of return of your portfolio.
Hesitant: “Your startup is very risky so we need a very high internal rate of return?”
True. We are early stage, so we have a low probability of success.
What does Warren say?
Am I pulling this logic about risk/return and startup valuation out of thin air?
Let’s hear it from my personal hero, Warren Buffett:
“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. [..] Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”
Thanks to Hans Westerhof and Chretien Herben.
Joachim Blazer is a corporate finance advisor. He helps founders raise money. Contact him at email@example.com.