The Truth About the Proverbial 10x in Startup Investing
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This article is an excerpt from the book Revenue Based Financing by Luni Libes. by Luni Libes. Luni is a 25+ year serial entrepreneur, (co)founder of seven companies. His latest startups are Fledge, Africa Eats and Realize Impact.
ODDLY, WHEN YOU talk to a startup venture capitalist or Angel investor and ask them how much they expect to earn on their last investment, the answer will inevitably be "10x or more."
Why? Where does this magic number come from and what does it really mean? This general response is even more odd once you realize the answer has nothing to do with what company they invested in. It doesn't matter if it was another software-as-a-service, a company using drones to replant forests, or a company with self-driving cars. The answer is always 10x. Isn't that strange?
Actually, it is not strange at all once you unpack all the unstated assumptions hiding within that very shorthand term, 10x.
Equity Investing
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Let’s step back to look at the details of how startup investors make their investments, which is by buying preferred shares a.k.a. buying equity. (The word “preferred” refers to the fact that the investor’s shares come with a set of terms that place “preferences” on their shares over the “common” shares owned by the founders.
The details of the preferences will be discussed later in the book.) For now, let’s focus on the money. The total amount of cash provided by the investor equals the number of shares multiplied by the share price.
Let's call the total amount of cash $D. In exchange for the cash, the company makes no promise to pay any of the money back to the investor. Instead, the expectation by both the investor and the startup founders is that the company will grow in value and that sometime, many years later, the company will have an exit (be acquired or go public).
In the case of an acquisition, within 30 days of the transaction, the investor receives a check or bank wire with a percentage of the acquisition price, based roughly on the number of shares owned at that time (Roughly, as the details can get complicated, and thus are described later).
In the case of an IPO, the investor’s shares can be sold on the public stock exchange 180 days after the IPO (the waiting period is called a “lock up” and is a regulatory requirement).
Either way, soon after an exit, the investor knows how much money he/she made on that investment. An exit is considered successful for the investor when the total cash returned to the investor is much more than the investor provided to the company.
It could be five times the initial investment. Or ten times. Or for the early Facebook and Google investors, fifty times. For a less successful exit, the investor might simply get their money back: their return from the exit is exactly the same amount of cash as their initial investment was, which, if you remember your grade school math, is the same as one times $D.
They call this “1x” (pronounced “one ex”). And for companies that run out of money and shut down, no money at all is returned, which, again from grade school math, is zero times $D. They call this “Zero ex” and most investors don’t like to talk about these.
Given these values have a large range, investors talk about them as multiples of $D rather than percentages. Thus "10x" simply means the investor received ten times more money back than was originally invested. “2x” means they doubled their investment. “1x” means they got their money back.
One in 10x
Earning ten times your money seems like a great plan. Who wouldn't want to turn $10,000 into $100,000, $500,000 into $5 million, or $7 million into $70 million?
That sure sounds better than earning 0.1% interest in a savings account or the historic 7% annual average from the stock market. What you have to understand is that most startup investments don't return anything close to 10x.
In fact, even for successful,full-time, professional venture capitalists and for the most experienced Angels, a good result is that only 1 in 10 investments returns 10x or more.
Below is what a successful startup portfolio looks like (with a big thanks to my friend and Seattle “Super Angel” Geoff Entress who explained this to my MBA students).
Let's break it down line by line. First, in the header, note this is "per ten investments." A venture capital fund typically invests into fifteen to twenty different startups and Angels are told to similarly make at least fifteen investments, ideally more.
To keep the math simple, the table looks at an arbitrary collection of ten of those investments. Next, note that the unspoken assumption is that each of those ten investments had an expectation of returning at least a 10x.
Investors who follow this traditional 10x investing model often talk about how every startup needs to "swing for the fences" or how the only option is to "go big or go home." You cannot earn an average of 2.3x as listed in the table if one of your investments is a loan to your sister-in-law for her business, or is some equity you received in exchange for being a startup advisor without other payment.
In this analysis, there is an unspoken assumption that the investments are about the same size. The results will differ if nine of the investments are $10,000 each and one is $100,000. Or if half are $25,000 in size and half $250,000.
With those assumptions exposed, let’s go back to the table. In this successful portfolio, just one out of the ten investments has a 10x return. In reality, an investor’s “home run” could be 12x or 20x or 100x, too, but 10x is the minimum for the following to be true: if 1 in 10 investments returns 10x, then that one investment has returned all the original capital from all ten investments.
In other words, the portfolio is "repaid" by one investment. The other nine investments then determine the amount of total gains. Looking at the second line of the table. Two of the investments have returned 5x. In reality, this could be anywhere between 2x and 7x.
Investors may call these “doubles” (in keeping with baseball parlance) or, for those investors who truly think every investment should by 10x, they’ll call these returns “base hits,”, as if doubling your money is a bad outcome. (What happened to 8x and 9x? Those are close enough to 10x to get rounded up).
Next we have three investments that return the original capital. A 1x return. It's not uncommon for these to be exactly 1x, not a penny more or less. The reason is that the preferred equity terms nearly always include a preference that repays investors before the founders, and thus when the startup isn't doing well, the investors often look for an acquirer at a price just sufficient to repay the investors.
The last row of the results are four investments that return nothing. Zero. Nada. Bubkis. Startup investing is risky. A lot of startups do not find enough customers, do not reach profitability, and run out of money, returning nothing to investors. The weighted average of this sample portfolio is 2.3x.
Change the 10x to a 17x and the average goes up to 3x. Lose one of the 5x's, and the average drops below 2x. In general, success is considered anywhere between 2x and 3x. So instead of the 10x we were dreaming of above when focused on a single homerun investment, the total return on a “successful” portfolio is closer to 2.5x. Upon success you turn $10,000 into $25,000, $500,000 into $1.25 million, or $7 million into $17.5 million.
7 Out of 10 Lose Money
Before we take it a step further, note that in this successful portfolio, seven out of ten investment were failures. Four were zeros and thus complete failures. Three were 1x, which look much better than zeros, but as they typically take 3-5 years to return 1x, the investor would have been better off leaving the money in a savings account earning 1%.
This result of seven out of ten failures is considered a successful result. 70% failures, 30% winners. Perhaps this is why baseball analogies are so common, because in baseball a .300 batting average is considered good, and that is a 30% success rate, too.
The flip side of seven of ten failures is three of ten successes. Yea, successes! But before you accept this 30% success rate as sufficient, compare this result to other asset classes. How do you feel if your mutual fund reports that seven of its stock picks went bankrupt, with four returning nothing and three just barely returning your capital?
Or imagine you are moving across country and get a call that the moving truck was in an accident. Seven of your favorite collectables were damaged, four a total loss and three recognizable but no longer of any value.
Having a bad day? Note, as well, that this is what a successful portfolio looks like for a professional venture capital fund or professional Angel investor. Emphasis on the word professional. Professional. As in, their full-time profession is to make these investments.
They turn down thousands of companies before picking any one investment. And after all their scrutiny, they invest only in companies that they think could return 10x. And yet they still only pick correctly 3 out of every 10 times.
What makes Sequoia, Kleiner Perkins, Andreessen Horowitz, Union Square, and my friend Geoff Entress so successful is that they review more opportunities than other investors and consistently choose one in ten investments that returns them 20x or 30x or 50x.
But at the same time, even they still fail more than half of the time.
2.5x NOT 10x
Let’s back to the portfolio analysis. What's most interesting is that startup investors repeat the term "10x" over and over again, but the actual goal is only 2.5x (plus or minus a few tenths).
Not so long ago I was at an investor education event. A dozen speakers across four hours. Across those hours, the term "10x" was spoken at least a hundred times. Not five minutes went by without someone referring to a "10x return." Not once did anyone explain why the 10x was needed.
The point of all this is that the true goal of startup investing is a 2x-3x "cash on cash" return on investment across a whole portfolio. The proverbial 10x is an interim step toward that goal, and the rarest of the expected outcomes across the whole portfolio.
Startups vs. S&P 500
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I’ll repeat once more, startup investing is not in fact about a 10x return. That 10x is the tool needed to reach the true goal. The true goal is to earn a return on an investment that makes the investment a risk worth taking.
Given that investing in startups is riskier than investing in public companies, the return on investment from investing in startups should be higher than investing in public companies. Substantially higher.
In the U.S., the most common benchmark for investing in public companies is the S&P 500. Thus, over any reasonably long period of time (e.g., ten years) a startup investment portfolio should have a higher ROI than the S&P 500. The historic average since the Great Depression for investing in the S&P 500 companies is around 7%.
A 7% return compounded over ten years is a 1.8x cash-on-cash return. A 2.5x across the same time period is an 11% return. This is why 2.5x is a reasonable rate of return for startup investing. 11% is a lot higher than 7%.
Whether it is sufficiently higher to offset the added risk is up to the investor to decide. What we do know, however, is that from 2003 to 2013, the average venture capital fund did not beat the S&P 500, returning an average of only 7.4% (2.04x). By early 2016 the average had finally risen above the S&P 500 and was just over 10x (2.6x).
Finally, do note these are average returns across the whole venture capital industry. In reality, nearly all that success was captured by the top 10% of the venture funds with about half of the funds never beating the S&P 500 because they failed to find any 10x winner.
