David Cummings on Startups

Looking at the 3-5x Return in 3-5 Years

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David Cummings

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A month ago I wrote a post titled Growth Stage VC with 3-5x Money in 3-5 Years about the idea that once startups are in the millions of dollars of revenue stage, the venture investment criteria changes. Instead of VCs talking about getting 8-10x their money back in 5-7 years for the early stage, the growth stage investors still have aggressive return goals, but are more modest compared to riskier scenarios.

A 3-5x return in 3-5 years seems simple and memorable enough but often it’s hard to visualize what that actually means in practice. Here are a couple scenarios:

  • Business has $5MM in trailing twelve months revenue
    Valued at 3x revenue for a pre-money valuation of $15MM
    Investor puts in $5MM for a post-money valuation of $20MM and owns 25% of the business
    Assume no other dilution or capital raised
    To get a 3x return, the business needs to sell for $60MM and be at $20MM in revenue (going from $5MM to $20MM of revenue is very difficult)
  • Business has $20MM in trailing twelve months revenue
    Valued at 3x revenue for a pre-money valuation of $60MM
    Investors puts in $15MM for a post-money valuation of $75MM and owns 20% of the business
    Assume no other dilution or capital raised
    To get a 3x return, the business needs to sell for $225MM (very few exits at $100MM+) and be at $75MM in revenue

From these two slightly different scenarios, and a number of simple assumptions, you can see that one takeaway is that if taking the outside money helps get you to a revenue size equal or larger than the post-money valuation in 3-5 years, you’ll be in the money. The next time an entrepreneur with a growth stage business mentions raising money, ask them what pre-money valuation they are expecting and ask them how quickly they can get their revenue to the size of the contemplated post-money valuation.

What else? What are your thoughts on the numbers for 3-5x return in 3-5 years?

Comments

2 responses to “Looking at the 3-5x Return in 3-5 Years”

  1. Jamie Bardin Avatar
    Jamie Bardin

    David —

    While in general your assumptions and math are correct, I think you are comparing apples to oranges. The 3-5X rreturn in 3-5 years is merely cash on cash, and is not tied to revenue per se. More simply put, if someone invest $10M in your business, in 3-5 years, dividends and other factors notwithstanding, they expect to get $30-50M out of it…the valuation and the revenue in your example cloud the issue and place additional constraints that are not always relevant…respectfully submitted…of course!

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  2. Sanford Avatar
    Sanford

    I don’t know why angels don’t focus more on net income rather than gross revenues.

    Many companies look great on gross revenue growth but the economic model is seriously flawed, i.e. the margins are not there. Many of these companies are “buying” business and customers at extremely high cost, only to lose them if they raise their prices. And a lot of hype and promotion goes on regarding the revenue growth but you turn the page on the financials and you see that they are heavily in debt and / or heavily funded.

    I believe that, on the most part, that growing revenues from $1M to $10M to $50M is often very difficult and not that realistic. Just look at gross revenues of the Inc 500 Fastest Growing Private Companies in America. Getting to $25M to $50M just doesn’t happen as often as many of us think.

    So, let me mention a lower threshold, say $1M to $5M in gross revenues in 2 to 7 years. And then look at these companies that have great net operating margins. Again, IMO, the key is net operating margin. A three year old company, with $3MM in revenues and a 40% net operating company will result in $1.2M in cash flow. IMO, that’s more realistic and the value is very promising. It speaks to a streamlined business where the founders are probably very hands on and know what they are doing. Another company, in their space, can buy them out at a nice multiple on earnings.

    Reply

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