How Angels Value Entrepreneurial Investment

June 4, 2017 ENT640 - Entrepreneurial Feasibility Analysis, Entrepreneurship, M.E. Program Coursework Comments (10) 406

ENT640 - WEEK 4

This post is the third of seven posts about angel investment in entrepreneurial ventures.


When an angel investor has completed his or her evaluation of the entrepreneurial venture, the next step is to determine the potential value. Valuation is how an investor estimates the future value of the venture and places a price on his or her possible stake in the company (Amis & Stevenson, 2001). Some argue the valuation stage is the only time in the investment process that angels indeed consider hard numbers; until this point, and perhaps afterward, many angels lean heavily on emotional and altruistic factors when making investment choices (Amis & Stevenson). If you have made it this far in the process, it is important to understand the various approaches an angel might take to valuing an investment in your company.

An angel’s approach to entrepreneurial investment will likely depend in part on their background and motivation. Many are liable to use their hard-earned experience to create a unique methodology that enables them to determine interest in the venture quickly. Some may use finance-based methods which include multipliers or discounted cash flow, others may trade the value of their time investment for a percentage of the firm, while still others may choose to invest now and do a valuation in the future (Amis & Stevenson, 2001). Let’s take a closer look at each of these approaches.

1.  Quick and Easy Approach

This method uses the investor’s background and experiences with entrepreneurial investment to gauge the value of the opportunity. Some investors may have ranges or limits, meaning they will not invest in businesses with a valuation over $5 million, or they only invest in businesses that have valuations between $2-and-$10 million (Amis & Stevenson, 2001). Others may use a methodology based on assigning a value to tangible factors of the business such as a sound idea, a prototype, or a quality management team, and then invest based on the total valuation of these factors.

Some investors may just use the “Rule of thirds” method, arguing that whatever the valuation at the exit, one-third will go to each the founders, the capital providers, and the company management (arguably not the company founders) (Amis & Stevenson). For seed or startup[i] investment, and potentially for early-stage[ii] investment, the quick and easy approach may be the best for both the entrepreneur and the investor, but it requires a bit of due diligence to find the best match for both parties.

Entrepreneurs should keep in mind that each investor will have their personal and possibly unique methods when using this approach. This applies in particular to seed or startup investment where investors may be working one-on-one with the entrepreneur. Seek and negotiate with an investor whose valuation methods align best with you and your opportunity.

2.  Academic Approach

The academic or investment banker approach incorporates finance-based calculations to assess a venture’s valuation. The multiplier method looks at similar companies in an industry sector, assigns a “standard” multiplier for a normalized measure (e.g., annual revenue, revenue per “X” sold) when applied to the target company (Amis & Stevenson, 2001). The discounted cash flow method estimates the future value of the business and then reduces or “discounts” that value by a percentage for every year from the investment date and the established date of that future value (Amis & Stevenson). Both methods are somewhat complicated and may undervalue the investor’s risk or potentially overvalue the venture.

With a few exceptions, the academic approach is not as likely to be applied to seed or startup investments. Entrepreneurs are more apt to see such strategies in first-, second-, and third-round early-stage investments. As the business grows and more investment is needed, the entrepreneur should have a good understanding of this approach and expect to see investor valuations using such methods.

3.  Venture Capital Approach

This approach begins with the methods applied in the Academic Approach and then determines the percentage of ownership stake necessary to achieve the investor’s desired return (Amis & Stevenson, 2001). When using this approach, the investor is likely to be most concerned about the terminal value of the venture. Terminal value is defined as the estimated valuation of the venture at the time of exit (Payne, 2007). The Anticipated Return on Investment (ROI) method is the most used method for this approach. The ROI Method looks for a return of between 10x and 50x the invested capital at exit (Payne, Fundability and Valuation of Startups: An Angel’s Perspective, 2007). If the projections are accurate, this method is reliable. The challenge to this valuation is the viability and accuracy of those projections.

It would not seem reasonable for an entrepreneur to encounter this approach in the seed or startup phases. Nonetheless, entrepreneurs should take care to have accurate data that can be used to build ROI projections when valuations call for such an approach.

4.  Compensated Advisor Approach

The compensated advisor approach can take multiple forms. One form might be a “Virtual CEO” where the investor becomes part of the team and helps the entrepreneur finish a plan, arrange introductions to investors, hire new talent, as well as other things to help the business grow (Amis & Stevenson, 2001). The investor becomes an active member of the management team in exchange for a small percentage of the company and often a monthly fee.

Another method is sometimes called the start-up advisor method. Using this method, the investor provides some support to the entrepreneur in exchange for a small equity stake and sometimes a monthly fee (Amis & Stevenson, 2001). The primary difference between this method and the Virtual CEO method is that the expectations of investor involvement are typically less and so is the compensation and equity.

The compensated advisor method can be a great way for an entrepreneur to get an idea off the ground, or take a business to the next level. Entrepreneurs evaluating this option need to consider the track record of the investor and the company’s ability to provide the requested equity and compensation. Also, consider that the equity stake is often lower, but you, as the entrepreneur, must be prepared and open to being coached in this kind of an arrangement. The goal here to get the venture to a level of success where the investor can exit, and you can continue running the business, hire a replacement CEO, or perhaps exit yourself.

On a personal note, I have been on both sides of this method. In my early entrepreneurial ventures, I found compensated advisors to be invaluable to my personal and business growth. I have also served in various “virtual” and advisor capacities for startups and early-stage ventures throughout my lifetime. I remain open to such opportunities today on a limited basis because this approach allows me to pay forward what I have learned from those who have supported me and my past businesses while being compensated for my knowledge, experience, and time.

5. Value Later Approach

The value later approach might incorporate many methods. One such method could allow an angel to invest in the startup without initial equity or set price for future transactions provided the angel receives the same terms as those investors in the next venture capital round (Amis & Stevenson, 2001). Another method, for example, guarantees the entrepreneur a 15% stake in the company after the final round of capital (Amis & Stevenson). In both cases, the entrepreneur typically gets an investment with minimal negotiation time.

Entrepreneurs considering these methods need to understand the premium price paid for such an investment. In the former, the entrepreneur loses input into valuation process, and in the latter, he or she may well lose long-term control of the company (Amis & Stevenson, 2001). Depending on the investment need and time constraints, such methods may be a valuable option.

As an entrepreneur seeking investment, you might use one or more of the above approaches and develop a valuation scenario of your business before talking with any angel investors. Your valuation will provide some idea of how an angel might value your business and help you better prepare for negotiations with any prospective investor. However, keep in mind that your valuation of your venture must be objective, plausible, and very well-supported if you are to improve an angel’s investment confidence in you and your venture.

 

References

Amis, D., & Stevenson, H. (2001). Winning Angels: The Seven Fundamentals of Early-Stage Investing. London: Pearson Education Limited.

Payne, W. H. (2007, July). Fundability and Valuation of Startups: An Angel’s Perspective. Valuing Pre-revenue Companies. Ewing Marion Kauffman Foundation. Retrieved June 3, 2017, from angelcapitalassociation.org: http://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_-_Valuing_Pre-revenue_Companies.pdf

Payne, W. H. (2007, July 1). Valuation of Pre-revenue Companies: The Venture Capital Method. Retrieved June 03, 2017, from entreprenuership.org: https://www.entrepreneurship.org/articles/2007/07/valuation-of-prerevenue-companies–the-venture-capital-method

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[i] Seed or Startup funding is typically for ventures that are in development and not often operational. Usually these companies and/or their products are less than 12-18 months into development (Payne, Fundability and Valuation of Startups: An Angel’s Perspective, 2007).

[ii] Early-stage funding is typically for companies that have products or services available in the marketplace, may or may not have revenue, and are often 3-years-old or less (Payne, Fundability and Valuation of Startups: An Angel’s Perspective)

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David Harkins is a serial entrepreneur, which is a more professional way of saying he is still trying to figure out what he wants to be when he grows up.
When not working for himself, he has had a fulfilling career in marketing, advising both large and small companies including several in the Fortune 500 and many of America’s largest nonprofit organizations. In his spare time, he consults, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order. Connect with him on social media below:

10 Responses to :
How Angels Value Entrepreneurial Investment

  1. Since this book is pretty old I would be interested to find out what the trends were in terms of angels participating in terms of either a virtual CEO or are compensated adviser. Given the large numbers of startups and the challenge of technology it seemed like this would be a very useful technique to obtain the input not the company needs at a price they can afford.

    — Brad http://blog.medstudentlearning.com/2017/06/valuing-your-life-science-startup.html

    1. Although the book was published a few years ago, I think many of the ideas for investing are still sound. If you listen to some of the podcasts in the tech field (Tim Ferris, Kevin Rose, etc.) you will hear their guests talk about similar approaches. So, I think the book is still pretty relevant.

      I agree the compensated investor route is a good way to go and like you I wonder how many are actively working this method. From an investor standpoint, I would think it would be pretty time intensive and the opportunity would need to have a great upside for the investor to take the time.

  2. John says:

    David,

    I think it is great that you have had first-hand experience on both sides when it comes to the role of a compensated advisor. Since I am starting my entrepreneurial journey I have considered the option of having a compensated advisor to offer their advice and knowledge in times where I may need it. While there are many methods for valuing, I agree that as an entrepreneur you need to seek and negotiate with investors that align best with you and your company.
    John

    1. Hi John,

      If you can find a compensated investor, that’s the way to go. Even if he or she is just on call for questions and to help you navigate challenges.

  3. David!

    Great Post! Thanks for sharing and adding your feedback to the different methods. Again, this is a great post to read/share with entrepreneurs. Who knew there was so much involved with your own business, especially if you are seeking funding from investors.

    I like how you stated that we may use more than one approach, and that’s ok. We just need to know that we have a lot of work before we present our business to venture capitalists and angel investors!

    Great work!

    Christina

    1. Thanks, Christina!

      I think it’s good for entrepreneurs to evaluate different options themselves and figure out which approach might be best. Doing so will make them better prepared for their pitches and help them consider valuation approaches that might best meet a potential investor’s desired method.

  4. mnjimison says:

    David,

    I have also heard that compensated advisors are the most valuable approach with investors because they have the best advice to help you and also the best connections of the right people to get you in touch with to help you succeed. Business has a lot to do with who you know, and if you have a good advisor that can connect you with people that know how to boost your business and take it to the next level, that is, as you said invaluable. Experience and advice can be worth more than money. Great article!

    Thanks,

    Mackensie

    1. Thanks, Mackensie.

      You are absolutely correct when you suggest that a lot of business has to do with who one knows. Networking is paramount and often leads to success. I think the thing entrepreneurs need to remember is they ae not expected to know everything and that the greatest asset they have is a network they can call on for insights, direction, and often time outright help.

  5. David,
    I’m glad you shared your personal experience about this fundamental. It must be rewarding for you to be able now advise a startup and watch their progression. There are so many ways to value and I am curious if start ups do all the research and are prepared enough when they meet investors? Excellent explanations of all the methods.
    Cece

    1. Hi Cece,

      My pleasure. I think sharing the personal experiences is part of the “giving back” aspect. It can be rewarding; however, there are some hard-headed entrepreneurs out there. I do not have all the answers or the only answers, so often I ask questions to encourage entrepreneurs I work with to think through the topic or challenge. Some take the questions personally, and that’s never a good thing. When I do this kind of thing, I am all in, so tend to get frustrated when my time is wasted. Which is I am quite selective on what I get involved in these days.

      My experience is that most entrepreneurs don’t do enough homework prior to meeting with investors. If I get involved early enough, I ask questions geared toward helping entrepreneurs become better prepared.

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How Angels Value Entrepreneurial Investment

by David Harkins time to read: 6 min
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