In a recent post Fred Wilson wrote about seed investing:
“When you lose on 60–80% of your investments, you really need the ability to make 10–20x on your winners.”
Does that make sense?
Money multiple fund
Assume that a seed investor invests out of a fund.
And that he wants to make a 12–15% IRR per year on this fund.
And that he exits a startup after 7–10 years.
With 13.5% IRR per year and 8.5 years till exit, the seed investor needs to make (1 + 13.5%) ^ 8.5 = 2.9x on his fund.
Loss
Assume, like Fred, that the seed investor loses on 60–80% of his investments.
With a 2.9x money multiple on his fund and a 70% loss, the seed investor needs to price each startup that he invests in at a 2.9 / (1 - 70%) = 9.7x expected money multiple.
The seed investor needs to make 9.7x on each startup that he invests in. Not just on his winners.
Dilution
Assume that each startup raises 1–3 follow-up rounds.
And that each round buys 15–25% of the company.
With 2 follow-up rounds and 20% new shares per round, the seed investor will dilute 1 - (1 - 20%) ^ 2 = 36%.
With a 9.7x expected money multiple and 36% dilution, the seed investor needs to price each startup that he invests in at a 9.7 / (1 - 36%) = 15.2x money multiple.
So
If you believe these 3 assumptions then Fred’s “when you lose on 60–80% of your investments, you really need the ability to make 10–20x on your winners” makes sense.
“When you want to make 2.9x on your fund, lose on 70% of your investments and dilute 36%, you really need to price each startup that you invest in at 15.2x” makes even more sense.
Joachim Blazer is the author of The #1 Guide to Startup Valuation.