Navigation Pointe, a Los Angeles, California based venture capital firm advancing startup companies in the Technology, Media and Entertainment converged ecosystem has established its presence in the marketplace and is now working with investors and entrepreneurs.
At Navigation Pointe, we look to invest in those “perfect storm” companies. Those with, a great team, a great product and a great deal. We’ll leave the discussion of what comprises a great product and a great team for another post, but here’s rational behind what constitutes our version of a great deal.
It all centers around Return on Investment, or ROI. The higher the ROI the better the investment – brilliant, eh?
Now for some details. Lets start with the definition of ROI as presented at Investopedia.com (one of my favorite resource sites).
For this conversation, lets focus on gains exclusively from a sale and forgo a discussion on ROI from cash flow. Not that it’s irrelevant or infeasible, just that early stage investments are generally more exit strategy centric.
So for an example, assume a $500k investment in a company with a $600k pre money that professes to have an exit plan that will garner a $5m sale in 5 years. The investor ROI on this is 355%.
[Gain = $5m *$500k/$1.1m] – [Cost = $500k] / [Cost = $500k]
The gain divided by the cost of the investment is often referred to as the multiple. In this case 4.55.
Typically, the “multiple” is referenced more than ROI in Investor presentations. Since they are derived from the same parameters, they are synonymous.
Two other statistics that also come up are Net Present Value (NPV) and Internal Rate of Return (IRR).
Excel quants will be able to calculate these fairly simply, and in this example come to $828k (at 10%) and 35% respectively. However, from our point of view, really only the multiple is necessary. We assume an average five-year time horizon, but realize that three to seven years are plausible extremes. As well, all these numbers are all based on a rather large set of assumptions. That’s where we’ll turn our attention next.
Assumptions: everyone knows how the game is played. All Entrepreneurs say their projections (from revenue, to expenses to exit values) are conservative. All investors feel they are, at best, an educated guess. Investors know that endeavors take longer and cost more. Generally, it all nets out.
We are looking for the Entrepreneur to lay out three of different scenarios – best case, worst case and expected case – with the parameters and assumptions clearly articulated. If we can buy into a plausible scenario where the exit is approximately a 10x multiple in 5 years then you’ve got our attention. We’ll continue the conversation!
In the above example, you’d have to lay out your case as to why your company will be bought for $10m – not $5m – in 5 years. As Investors, we understand that 5 years out is an eternity for an early stage company, and the scenario has a better chance of being wrong than right, but we need to know the Entrepreneur has thought through the process and that the scenario is realistic. Sure there’ll be adjustments, course corrections and outright changes (aka “pivots”) to the business model, but the end goal is still a high ROI and we need to know the company understands that perspective.
In the financial part of a pitch, we’re also looking at the company’s validation points. From inkling to viability, the list of validation points includes:
· idea – is this all the company has at the moment
· beta – is there a proof of concept to show customers – is someone using the product
· sales – have the customers agreed the product has value
· gross margin – can the company make the product for less than its sold for
· operating profit – can sales cover the cost of doing business
· positive cash flow – a going concern
If the company can present a timeline showing each of these milestones, or at least the ones that get it to the exit point, the story becomes much more plausible.
Since an investor is focused on multiples, the implication to valuation now becomes clear. All else being equal, the lower the valuation the higher the (potential) multiple. Using the example above, if the pre money were $1m instead of $600k, the multiple drops to 1. At a $10m exit, the multiple equals 9
Again, for us transparency, plausibility and clear assumptions are most critical to persuading.
Navigation Pointe has established a supportive relationship with Startup UCLA, the University of California, Los Angeles incubator designed to bring together engineering and business students for the purpose of collaborating on new business ventures.