Risk, Return and VC IRR Benchmarks
JANUARY 8TH, 2019
I get asked some variation of this question a lot, “When you invest, what is a good expected return?”
Generally speaking, I frequently hear early stage tech/life-science investors state that they're targeting a 10x return. While this is a quick/easy benchmark, we at Brightstone believe that returns are not simply a function of high multiples. Return profiles vary depending on risk profile. For direct investments, loss rates and holding periods play a significant role. Exit strategies – whether through IPO or M&A – and follow-on capital-deployment timing also matter a great deal. Beginning with the summary below, let's explore the various alternatives and how we think about risk and target returns.
At Brightstone, we employ a strict 50% internal rate of return (IRR) benchmark for any given portfolio investment. There are two key factors driving our IRR assumptions- ultimate return multiple on invested capital and the holding period of the investment. Our experience suggests that most venture investors seek a 30% IRR on their successful investments; according to the National Venture Capital Association, the average holding period of a VC investment is eight years. This means an early-stage investor would need to garner 10x plus multiples on the winners to meet his or her IRR target. I suspect this is why many early stage tech/life-science investors focus on the 10x benchmark. Brightstone differs in a few meaningful ways- first, our IRR threshold is 20% higher than a typical venture investors. We're use this benchmark because 1.) it forces us to be patient- our dealflow is strong and if an investment doesn't trip our IRR threshhold, there will be another opportunity around the corner that will, and 2.) we're located in an area of the country in which valuations on early stage tech/life-science startups are priced at an approximate 50% discount to valuations in Silicon Valley.
We also take risk and necessity of follow-on capital into account. Later-stage opportunities typically involve less risk. Among other things, more mature entities are typically generating significant revenue (though they may still be unprofitable) and have moved beyond the market and product development stages. They are also seen as less risky because the odds of a successful exit are higher. In theory, these investments should have lower loss rates and shorter holding periods. This impacts our IRR equation, and allows us to look at later stage investment opportunities as long as we can be reasonably certain that a sucessful near-term exit is likely. Such opportunities are rare, and our high IRR threshold obviates out the vast majority of later stage opportunities, but they do exist.
So, what’s the moral of the story? When it comes to venture investing, there can be much more to expected returns than multiples alone. This is why we employ a strict IRR benchmark, and we're lucky to be in a position to employ a premium IRR benchmark as compared to most other VC funds.
