What Return Multiple Does Lateral Target?
When we meet a new investment candidate, we lead with enthusiasm! We are a “yes” from minute one. Then, we start asking questions in an orderly process which yields a decision, ideally at the end of 4 weeks.
The first questions we think about are whether the product or service is something people will actually want to buy. This sounds obvious, but remember that the leading cause of failure for Early Stage companies is “no identifiable market!” Then we take a quick measure of the people: Do they have a clear view of “Why” they are investing so much of their time, money and passion into the business? Are they likely to fit to our target entrepreneur profile of “paranoid optimists of impeccable character”? Only if we can tick these boxes do we start thinking about the return potential. In a nutshell, we ask whether the company in question has the potential to return 5.0X our money in five years. Here’s the logic for this approach:
- A 5.0X is about twice the 2.6X average gross return we look to deliver for Lateral Capital Funds. This is basically the “industry average” return from a study of 450 Early Stage companies in 2007 and 245 additional companies in 2016.
- With research showing that about 50% of our investments will fail, a 5.0X return on half the companies would theoretically produce about a 2.6X average gross return.
- If Lateral Capital can produce a consistent average gross return of 2.6X for our Limited Partners, we should be able to attract a portion of the investable assets from an increasing number of investors over time. In turn, this will allow us to make more investments in Early Stage companies.
- If we can continue to increase the number of Lateral Capital funds we can launch, and deliver steady 2.6X returns, we can achieve our own “Why.”
Our mission is to become
the vehicle of choice for investors
who want to add Early Stage companies
to their investment portfolios.
And while Internal Rates of Return (IRR) are not the primary way we measure Lateral Capital success, this “5.0X for 2.6X” approach gives entrepreneurs a simple way to think about the competitive nature of capital markets. As shown below, there is a clear relationship between time and the return multiples necessary to deliver specific IRRs. For example, if an Early Stage company delivers 5.0X the investor’s money in 5 years, they will deliver a 38% IRR:
Said another way, this chart shows how much our invested companies have to “give back” in order to deliver a specific multiple. For example, if Lateral Capital targets to earn a 5.0X return on a $100,000 investment at the end of 5 years, we would need to receive $500,000 back. Pretty simple. Unfortunately, we know that only about half our invested companies can be expected to return much of anything! So the average return from half the companies is what we depend on to reward our Limited Partners. Hence, the “5.0X for 2.6X” model.
One other point. If we can’t decide whether or not to invest, we pass. For practical purposes, there are an infinite number of investment opportunities out there. Early Stage investing is, after all, an asset class. So if we don’t feel better and better with everything we learn about a potential investment, we pass. This doesn’t mean we won’t regret it. We have lived through dozens of coulda, woulda, shoulda situations. But the next investment is just around the corner and we try not to look back.