After nearly eight years of cutting interest rates, the Fed finally hit us with a rate hike yesterday.
Many investors are wary of higher interest rates, and understandably so:
When money becomes more expensive, businesses (and stock prices) tend to suffer.
In fact, historically, whenever the Fed has raised rates, the markets have stagnated or declined. This is true of both stocks and bonds.
But there’s one investment that will benefit from a rate hike:
How to Make Money in Start-up Investing
When you invest in a start-up, there are two main ways you can make money:
Either the start-up goes public, or it gets taken over by a larger company.
But just because one of those events happens, that doesn’t necessarily mean you’ll make money.
That’s because, just like stocks, your profit depends on the price you paid.
When it comes to public stocks, you determine what you’re paying by looking at a company’s stock price and market cap.
But when it comes to start-up investments, you look at something called “valuation.”
Essentially, valuation is the same thing as a company’s market cap—it’s the value of the entire enterprise.
But regardless of what it’s called, basic investment rules still apply: if you pay too high of a price to begin with—too high of a valuation—even if the company goes IPO or gets acquired, you might not make money.
Case in point: look at the recent Square (NYSE: SQ) IPO. Just last year, in its last private financing, the company was valued at $6 billion.
But in last month’s IPO, the company was valued at just $3 billion.
So even though investors got in while the company was still private—a full year before the IPO—they still didn’t make money on the IPO.
The moral of the story is simple:
When investing in start-ups, you need to pay attention to valuation.
Valuations and Interest Rates
So now that you know about valuation, let’s look at why yesterday’s rate hike will be good news for start-up investors.
First of all, as rates go up, money will be more difficult to come by.
Meaning, early-stage companies will be chasing fewer dollars. The market will thus become more competitive.
And when that happens, the balance of power will shift from start-ups to investors. Investors will be able to negotiate better deal terms—in particular, lower valuations.
And with lower valuations, your chances to make big gains go up dramatically.
I think you’d agree that would be a good thing.
So what sort of valuations should you be looking for?
By The Numbers
When you’re making a start-up investment, first you need to set a profit target.
In general, most professional venture capitalists and angel investors target a 10x—or 1,000%—return on their early-stage investments.
Meaning, before they make an investment, they ask themselves if it has a chance of returning 10x their money.
The way they answer that question is by looking at a company’s valuation...
First of all, they assume that if a company is successful, it’ll get acquired (as opposed to going IPO, which is far less common).
And according to PricewaterhouseCoopers and Thomson Reuters, most technology M&A (Mergers & Acquisitions) takes place below $100 million. And the majority of those acquisitions take place under $50 million.
So, if you want to give yourself the highest probability of making 10x your money, you should invest at valuations that are one-tenth (or less) of the expected takeover value.
In the case of a $50 million M&A transaction, that would be a valuation of $5 million.
Rome Wasn’t Built in a Day
Now that the Fed has raised rates, you might be itching to go out there and look for “cheap” early-stage companies.
But valuations won’t come down right away: the private markets tend to move more slowly than the public markets.
But that’s ok...
You see, unless you’re an accredited investor (at least $1 million in net worth or annual income of at least $200,000), you can’t invest in start-ups today anyway.
But this will change on May 16th—that’s when ALL investors, regardless of income or net worth, will be able to invest in private start-ups.
So take your time now to learn about start-up investing...
Because once this market opens up to you, there’s going to be some great deals—with great valuations—waiting for you.