Estimating equity investment return

The Excel in Tekedia Daily podcast in Blucera or Tekedia Startup Masterclass portal or Tekedia Capital board

From Tekedia AI Companion, here is the summary of the presentation (pdf).

Modeling Startup Investment Return: A Guide

Section 1: Introduction to Investment Return Modeling

This presentation provides an in-depth look at modeling investment returns for an equity investment in a startup. The core concept revolves around understanding how an initial investment, coupled with the company’s growth and subsequent funding rounds, affects a shareholder’s return. The lecture uses a practical example of investing $10,000 in a startup initially valued at $50 million.

Section 2: Understanding Dilution

Dilution is a crucial concept in startup investing. It occurs when a company issues new shares, decreasing the ownership percentage of existing shareholders.

• Cap Table: The lecture introduces the concept of a cap table (capitalization table), which is a record of all shareholders and their ownership percentages.
• The 100% Rule: The total ownership of a company must always equal 100%. When a new investor buys a stake, they must be accommodated, which means the percentages of existing shareholders are reduced.
• A simple example: If 10 people each own 10% of a company, and a new investor buys 20%, the original 10 people now collectively own only 80% (100% – 20%). Their individual percentage ownership is diluted.

Section 3: The Dilution Paradox: How Dilution Can Be a Good Thing

While dilution reduces your ownership percentage, it is often a sign of a healthy, growing company. The lecture explains a key paradox: a smaller percentage of a much larger, more valuable company can be worth significantly more than a larger percentage of a smaller, less valuable company. When a company brings in a new investor with a large amount of capital (e.g., $100 million), it increases the overall value of the company, and thus the value of your stake, even if your percentage ownership is lower.

Section 4: Calculating Investment Returns

The presentation provides a step-by-step approach to calculating potential returns, using the concept of multiples.

• Initial Investment: $10,000
• Initial Valuation: $50 million
• Initial Ownership: The initial ownership is calculated as $(\$10,000/\$50,000,000)=0.0002$, or 0.02%.
• Multiple (X): The return is often expressed as a multiple (e.g., 10x, 27x, 50x), which represents how many times your initial investment you received back.
• Impact of Lower Valuation: The lecture emphasizes that investing in a company with a lower valuation (e.g., $10 million instead of $50 million) at the beginning of the investment journey can lead to a much higher multiple, such as 50x.

Section 5: Case Study: Y Combinator

The lecture references Y Combinator as a real-world example of these principles.

• Average Dilution: The average dilution for Y Combinator startups that reach unicorn status is between 40% and 55%.
• Example Calculation: An investment of $10,000 at a company valuation of $30 million that reaches unicorn status with a 40% dilution rate would yield approximately a 20x return.

Section 6: Summary and Conclusion

Extensive Summary

The video lecture provides a clear and concise explanation of how to model returns on a startup investment. It highlights the importance of understanding dilution, which is the reduction of an investor’s ownership percentage as a company raises additional capital. While dilution may sound negative, the lecture argues that it is often a positive sign, as it indicates the company is growing and increasing in value. The core of the model is that a smaller percentage of a higher-valued company can be worth much more than a larger percentage of a lower-valued one.

The calculation of returns is based on multiples, or “x,” which signifies the profit as a ratio of the initial investment. The lecture uses a practical example of a $10,000 investment in a startup to illustrate these principles and even uses Y Combinator as a case study to provide real-world data on average dilution rates and corresponding returns. Ultimately, the key takeaway is that the initial valuation of the company and the subsequent rate of dilution are the two most critical factors in determining the final investment return.

Conclusion

In conclusion, this presentation has covered the essential components of modeling startup investment returns as described in the provided transcript. The lecture effectively explains the mechanics of dilution and its surprising role in creating value for investors. By providing a clear framework and a real-world case study, it helps investors understand that the key to significant returns isn’t just a high ownership percentage but rather a company’s ability to grow rapidly, thereby increasing the value of their diluted stake. It is a valuable tool for anyone considering an early-stage startup investment.

Connect via my LinkedIn | Facebook | X | TikTok | Instagram | YouTube