In simple words, return on investment (also called as ROI) is just a measure of how much you gain from your investment into a venture.
The simple formula to calculate ROI:
ROI = [(gross profit – investment) / investment] x 100
For example, if you have invested USD1mil in a business and made USD1.25mil from the investment, then:
Your ROI will be [(USD1.25mil – USD1mil) / USD1mil] x 100 = 25%
In other words, your ROI of the USD1mil investment is 25%.
What happens if you have a multi year return?
Say that you invested USD 1mil in a business that will return USD0.1m every year?
In this case, you will have an annual ROI of 10%.
In the real world, no business will survive forever. So, lets assume that the business will close down after 15 years.
So, your total return will be 15 x USD0.1m = USD1.5m; So, your ROI will be 50%.
Now, lets look at a more complicated case.
The scenario: You have invested USD1mil at the inception of the business for 20% ownership of the company. Say that the business thrives for the first 5 years and they paid you an annual return of USD0.2m. The business started declining after that. So, they paid a return on USD0.15m in year 6, USD0.1m in year 7 and USD0.05m in year 8.
They completely closed the business in year 9 and sold their assets for USD2.0mil to a competitor. Let’s assume you are the only investor and no dilution happened.
How do we calculate the ROI of this investment?
Your initial investment is USD1mil.
Lets look the return for every year:
* Year 1: USD0.2m
* Year 2: USD0.2m
* Year 3: USD0.2m
* Year 4: USD0.2m
* Year 5: USD0.2m
* Year 6: USD0.15m
* Year 7: USD0.1m
* Year 8: USD0.05m
* Year 9: USD0.4m (you get 20% of the proceeds since you own 20% of the company)
So, your total return is USD1.7m. So, your ROI for the whole investment is 70%.
You can also use multiples to indicate ROI: For example, for the above example, you have a 1.7x multiple (1.7/1.0)
How is ROI used in real life?
- The explanation of ROI above is simplified to give you a basic understanding of the concept. In real life, the calculatations can get really complicated (we will cover this is later posts).
- Most early stage investor (outside of tech startups) consider your as a high risk investment. As a result, they are typically looking at a 30 – 40% annual ROI. If an investor asks you anything less, you might have gotten lucky. Be careful is an investor asks you way more than 40% as it indicates low investor confidence in your business model. In this type of company, profit maximization is favored over growth for its own sake. The investor here is looking to get high annual return. Hence, they are more concerned that dividends will be distributed to the founder and managers in the form of perks and salaries. It’s also not unusual to ask for royalties till the investment with some return is recouped.
- In the case of tech startups, early stage investors/VC or incubators are typically expecting at least 10x of ROI in 3 – 5 year horizon. This does not mean that they are greedy. It’s just math. This is because tech startups are way riskier compared to regular businesses as less than 1 in 100 tech startups survive. Most early stage investors will invest in many startups to make sure as a portfolio they can make back their money.
- Beyond seed stage – if you are dealing with organized VCs, you need to understand how they think about ROI. VCs normally don’t collect dividends, instead they must for capital gain. Preferred shares are a natural vehicle to support these governance and investment return goals, because they are a different class of shares and the terms of the security can stipulate conversion rights and the priority of distributions. VC funds will have a fund life period i.e. If it’s a USD25m fund with 7 year fund life, they have to figure out a way to exit at the end of the 7 years and return money to the investors. Most funds will promise 3x return to their investors. Thats equivalent of USD94m return on a USD25m investment including 20% of standard carry factored in. So, if they invest in 30 startups and expect 1/3th will make a positive ROI. So, within the 10 startups, they need to make sure their total value of collectively equity owned across the 10 companies, need to around USD100m. In other words, the combined valuations of these 10 companies needs to be around USD1.5B to USD2.0B (as diluted equity % at exit will be around sub 5%). So, if you consider that, the VCs are looking for more than 10x return (Don’t be surprised if they are looking for 100x).
- At late stage, investors are investing big amounts (can easily be in billions) and they are looking at 2x to 5x within a short time. This is because although it’s just 2x, it’s a billion on top what was invested.