Early stage investors versus venture capital: The importance of exit timing and price
The “successful exit” ultimately determines the performance of any investment in early stage ventures. The exit price and timing will be critical to overall investment profitability. Because of the realities and incentives they face, participation by venture capital (VC) firms in later stage rounds may often negatively impact the investment returns of early stage investors.
Investments in Seed or Series A rounds of financing can give investors valuable access to companies at the earliest and riskiest part of the capital structure lifecycle: the beginning. If successful, these discrete, early ownership stakes can provide a return far in excess of those in the public markets. The risk from early stage investing, however, is quite high. The Bureau of Labor Statistics (BLS), for example, estimates that only 20 percent of businesses survive after their first year of operation. The probability of “home runs” for a business is much lower.
While price and timing are the ultimate determinates of investment profitability, there are two measures of investment return: return on investment (ROI) and internal rate of return (IRR). ROI, which is defined as net exit price divided by initial investment, does not take into account the time an investor waits to receive his or her return. IRR, on the other hand, which is the single rate that discounts the sum of all cash flows back to the present value of the initial investment, is very sensitive to time. Typically, early stage investors target ROIs of five to ten times their initial investments within five to seven years to achieve IRRs of over 30 percent. As an example, say an initial investment of $500,000 returned $4 million, the ROI for an investor would be eight times his or her initial investment or a 700 percent return. If that $4 million were returned in five years, then the IRR would be 50 percent. If that $4 million were returned in seven years, the IRR would fall to 35 percent.