IT ALL BEGINS WITH VALUATION
What is evident from everything discussed so far is that the primary decision to exit entirely depends on a scenario analysis of what the increase in the value of the company would be, relative to the value at which the investor had invested the money; and also the future value of the company if the investor stays invested.
However, the increase in the value of the company is not a good enough indicator.
Assume the that Mr. X, the investor, invested in company ABC in year 0 by pumping in $100 in exchange for equity. ABC was valued at $1000 at the time. It’s number of shares issued were only 10 at this point. ie. $1000/$100. So Mr. X owned only 1 share in the company.
In year 3, company ABC had grown to $2000. Mr. X had still only invested the $100 that he had entered in with in year 0. Technically, it looks like the company has grown by a 2x multiple in these 3 years. However, what we need to see is the price per share. It so happens that Company ABC had issued another 10 shares in these 3 years, and so the number of shares outstanding were now 20. So the price per share is still at $100. This means that over the 3 years, there has been no growth in the value of Mr. X’s shares or in his MOIC (Multiple on Invested Capital).
So were he given a choice to exit in year 3, he would not have made any returns on the investment. Dilution, led to a fall in his share price and in turn in his multiple. This is why it is very important for investors to have strong antidilution clauses in their term sheets.
What’s worse in the above scenario is that the actual IRR (Internal Rate of Return) is 0% although his absolute multiple is 1x. The reason for this is the time value of money. He had invested the $100 in year 0 and even in year 3 he is leaving with $100 in case he chooses to exit. So he has not made any money.
If for instance he had managed to double his investment and had a 2x on his exit, then the actual IRR would be significantly higher. Technically around 25%. One might ask why it is not 100%? Well, it would be if he got the exit in year 1 itself. However, due to the compound effect, when adjusted for interest, the actual IRR comes down to around 25% if he stays invested till year 3 and manages to double his investment.
Hence, IRR is another parameter that investors look at in addition to their investment multiple, as they would determine how good or bad the return to them would actually be if they decided to exit.