What does it mean for your early startup valuation if your investors are really clever?

Occasionally, founders of startups approach seed investors with expectations that are very unrealistic. For instance, I have seen them cases where they present a 10-year budget, calculate an exit value based on the planned scenario 10 years out and ask investors to accept that future valuation today.

That will in all likelihood not work (at all), since professional venture investors:

· Require compensation for high degrees of uncertainty

· Require compensation for illiquidity

The table below shows the names of the different investment rounds as the business grows, as well as indications of how many times investors will expect to return their capital if everything goes well (right column). The expected return is the so-called “multiple”, where “20x” for example means an expectation of getting the invested amount back 20 times.

The reason for the very high return requirements in early stages is mainly that investors factor in very high risk of failure. As the startup matures, this risk declines and so do return requirements.

However, there is also a time/illiquidity factor to consider. Venture funds typically have limited average holding period of perhaps six years or less, which means that startup that grows from pre-seed to exit may, for instance, have three generations of investors along the way — requiring, for instance, 20, 10 and 3 times their money back. The initial valuation must allow this to happen, which again means that the initial investors should believe in a long period of aggressive commercial scaling.

That is, if they are clever.