Wednesday, 20 October 2010

Low Valuations on Dragon's Den

Every once in a while the TV show Dragon's Den comes up in discussion among startup founders, most recently on a thread on Hacker News, and typically someone brings up how low the valuations are and how much equity the Dragon's take arguing that the Dragons are exploitative and taking advantage of entrepreneurs.

(For those not familiar with the show it involves entrepreneurs, typically with an early stage business either with a new physical product or service, pitching a panel of five angels for investment)

The average investment is typically in the region of 100k for between 30-40% of the company.

While this may seem high our view of valuations get skewed because our background in startups for which exponential growth is feasible.

A Worked Example: Sheldor Industries

Let's look at an example with a fictional company:

Sheldor Industries have come up with a funky new gadget and have some initial sales. They have a pre-money valuation of 250k and are seeking an investment of 100k for tooling.

Say an angel took a 10% stake in Sheldor Industries, then the angel would need Sheldor to grow to a 10 million pound company in order to achieve 10x returns. That is the company would need to grow 40-fold.

Now if the angel took a 40% stake in Sheldor Industries, Sheldor would only need to grow to a 2.5 million pound company to achieve the same returns. Note that still requires 10-fold growth

Now while for tech startups which by-and-large are designed to scale and suffer less physical restrictions than traditional companies 40-fold growth can be perfectly feasible, for traditional product and service companies that sort of growth is completely unrealistic. Even 10-fold growth may be optimistic.

So to realistically achieve the 10x return on investment angels are looking for they have to take significant equity stakes in companies.

Hang on 10x...

While going for 10x return on investment may seem on the greedy side, it's actually the angels only option.

The average angel gets a return on their portfolio of between 2.4-2.6x after 3.5 years, but they need to invest with the objective of getting 10x return in order to achieve these numbers. Most angel investments don't pay-off, therefore the returns on the ones that make money have to cover not only their own cost but also that of the failed investments.

Typically 9% of angel investments produce 80% of the returns (this 9% generally being companies that do provide a 10x+ return on investment). Therefore it only makes sense for an angel to invest in a company if they can aim for a 10x return. If a company has no chance of being in that top 9% then the statistics say it's simply not worth investing in.

(Image Credit: Babbletrish)