What’s a Successful Return on Investment?
Are you satisfied just to draw a salary or break even? Learn how to measure success and earn back double the investment you put into your business.
One of the top reasons why entrepreneurs start new businesses is to make money. It’s a good goal, too.
Entrepreneurs are very much like farmers in that they plant and sow seeds for a lucrative harvest. So what constitutes a successful harvest? Just how much money should business owners expect to make on their invested capital?
Here are some benchmarks to inspire your goal-setting:
- Compare to key stock indices. According to Morningstar, from 1926 through 2009, large company stocks returned an average of 9.8 percent to investors. During the same period, small company stocks that investors might find in the Russell 3000 index returned an average of 11.9 percent.
Of course, some years are better than others. Last year, the Russell 3000 returned a robust 14.8 percent to investors. In 2008, the Russell 3000 lost about 38 percent!
Because entrepreneurs typically pull their savings from the stock or bond market, comparing public market index returns is a helpful exercise. Most investors define success as beating the S&P 500, which returned about 15 percent in 2010. This should be your minimum expectation of investment success.
- Match private equity investment expectations. During the last 20 years, the Venture Capital Index returned 25.6 percent. This nifty return was achieved through a “portfolio” approach to venture investing.
Venture capital (“VC”) funds, as well as experienced angel investors, specialize in investing in startup and growth-oriented privately held companies. They understand the statistical risks of business failure within their investment portfolio. They know that on average, only four out of 10 investments in promising entrepreneurial companies will deliver any profit to VC fund investors.
This means that those four winners must cover the six losers to achieve a blended 20-percent-plus portfolio return. This is why VCs and angels aim extra high and turn down investment opportunities that don’t represent a “grand slam home run potential” to the overall fund.
- Understand the time value of money. Another insightful way to think about your investment returns is to consider the time value of money. Typically, angel and VC funds are tied up for a good five years before their portfolio companies are ready for harvest — typically through a sale to a larger company.
The same is true for entrepreneurs. If you triple the value of your investment in three years, you will earn a robust return of 44 percent. If you triple the value of your investment in five years, your return drops to 38 percent. The longer you expect to have your funds tied up in your company, the greater your return expectations should be.
- Diversify your portfolio. Investments that entrepreneurs make in their own businesses differ from those of angel and VC limited-partner investors in one important way. Investing in privately held companies typically represents a small portion of their total investment activity — usually less than 5 percent.
In contrast, entrepreneurs can go “all in” and invest everything they have in a new company. The upshot is the risks and opportunity costs of holding an underdiversified investment portfolio are substantially greater for entrepreneurs than independent investors. Again, greater risk demands greater potential rewards.
Make sure you’re compensated
My concern with too many business owners is they set very low standards for their investment dollar. They are content to break even or just draw a salary when the business can afford it. Even worse, they continue to invest in troubled companies in which they might not ever get their funds back.
My advice to entrepreneurs is to try to at least double total invested capital plus the value of any contingent liabilities associated with guaranteeing bank debt, real estate leases and equipment leases. Building a successful business is hard work. Earning a salary is not enough to compensate for all the risks and effort involved with business ownership.
Watch this Business on Main webinar for more information on what business attributes are most likely going to double, triple or quadruple invested capital.