In response to the blog post on “Venture Capital 101″ we got a question, “What is a typical rate on preferred returns? I had an investor ask for a 130% preferred return plus equity. Is this normal?”.

Returns and the related concept of valuation seem to be a good topic for a blog note so I’m responding here rather than in the comments. I’ll provide some background before answering the specific question.

Early stage investors will be looking for returns that are higher than any other category of investor. Venture funds, for instance, will tell their investors that they are targeting somewhere between 20% and 40% per year on a fund investment. The “earlier” the fund the higher the expected return. This makes sense because venture investing is among the “riskiest” categories of investment so it needs to reward investors with a higher than average return. Note, however, that what a venture capitalist promises its investors is NOT directly tied to how it values companies. Given that at least a third of the investments made by an early stage fund will probably fail, and another third will probably just return capital, investors have to price every deal so that it could potentially “pay off the losers”. As a rule of thumb, it is generally safe to assume that an investor will be looking for at least 10X in an early stage investment (see “Venture Capital 101″ note).

So, the investor will most likely back into the valuation he’ll offer based on what he thinks he can someday sell his position for. For instance, if the investor has come far enough in the process to believe he wants to invest $5mm, that must mean that he believes he has a good chance of making $50mm or more on the investment. If his expectation is that the company will most likely exit at $100mm that means that he’ll need to own 50% of the company. So, the “pre-money” valuation on the company would be $5mm (post money = pre-money of $5mm plus $5mm invested = $10mm).

The final component of the discussion is the structure and terms of the investment. In almost all cases the investor will ask for at least a “preferred” equity. Preferred could mean a lot of things, but at a minimum it generally means that it will accrue some type of dividend and if something goes wrong in the company, the preferred investors will get paid back all the proceeds from liquidation prior to any common shareholders (called a liquidation preference). There are many things an investor might want as part of a preferred stock beyond these items and it is very important for an entrepreneur to understand all of the preferences very well as they might be more important than the valuation itself. The list is long enough that it would be tough to address in this note.

Now back to the original question, “What is a typical rate on preferred returns? I had an investor ask for a 130% preferred return plus equity. Is this normal?”. My answer is that the question is phrased in such a way that I’m confused about the structure. Groups that invest in debt generally refer to specific rate of return on their money (e.g. they’ll loan you money for a certain annual percentage rate, like a mortgage). Groups that invest in equity don’t usually speak in these terms. They cannot “fix” a rate of return - they can only make assumptions about what their equity might someday be worth. They might calculate an expected return given their own assumptions but this usually doesn’t enter a negotiation. If this is a debt investment of some sort then I would say it is very unusual, and in some cases illegal, to ask for a 130% annual return. If it is an equity investment, please drop another note to clarify and I’ll get back to you via direct email.

I hope this is helpful and, as always, welcome questions.

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