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.
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
[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)
Featured Image Source: Pexel.com
David Harkins is a business strategist, speaker, and teacher.
He is the founder and executive consultant at David Harkins Company. In his spare time, he writes hikes, explores, and creates art. Although, not necessarily in that order.
Connect with him on social media below: