Valuing Early Stage Equity Investments - 04/13/2008

Once you have found a promising investment (done your sourcing), and concluded your initial due diligence (completed your evaluating), the next phase is to value the deal (valuing). Valuing is the 3rd early stage investing fundamental described in the book Winning Angels: The 7 Fundamentals of Early Stage Investing, by David Amis and Howard Stevenson.

The 7 Fundamentals of Early Stage Investing

The first thing that jumps out regarding valuing early stage companies is that the process is very subjective and often there is no baseline for comparison or objective valuation.

To help put some structure to the process, the authors cover five categories of valuing strategies they found were used by active angels. These can be described as the simple method, the academic method, the venture capitalist method, the advisory method, and what I call the avoidance method - which basically means you leave it to someone else to figure out later.

When we talk about valuing early stage companies, we are talking typically about determining the pre-money valuation. This is the value of the business (or potential business) before it takes in the funding you are considering putting in. So a business valued at $1 million dollars, prior to any investment, has a pre-money valuation of 1 million dollars. If $500,000 is then invested in the business, directly following the investment, the business is valued at $1,500,000 - the post-money valuation. The post-money valuation is simply the pre-money valuation plus the money invested. Your job as an investor is to determine if the pre-money valuation is fair.

Some angel investors keep it simple, sometimes extremely simple. Apparently some angels consider an investment that otherwise passes muster to be adequately valued if it is valued at less than 5 million on a pre-money basis. That is it, all in about 5 seconds of time invested. These angels are generally happy with the valuation if it is less than 5 million, and will not typically invest in deals over that threshold. Why would an angel use this rule? Well, the higher the initial valuation, the more valuable a company needs to become at the time of an exit or liquidity event for you to make a given level of return. For an investor making an early stage, risky investment, they will want to see a 5-10x return potential, which means a company valued at 5 million initially will need to be valued at 25-50 million later on to make the required rate of return, and even that is optimistic as it assumes there are no further investors later on. If there are, then the company may need to be valued at closer to 80-100 million, which is the typical exit valuation of a venture capital backed company these days. So any early stage investment with an initial valuation much over 5 million means you need to really be sure the business has a good chance of being extremely valuable down the road.

The academic approach to valuing companies focuses on a multiplier of revenue (or other relevant business metric) and/or discounted cash flow. There is a concern expressed that discounted cash flow can tend to over-value deals. These methods can however often be used to test deals for possible rejection.

The venture capital valuation method builds on the discounted cash flow and multiplier models to basically calculate out their needed investment return for the company, based on expected future company value, size of investment, and pre-money valuation. This provides somewhat of an upper limit on the valuation that would acceptable to drive the needed return. A note, this book was written in 2001, so I suspect many venture capitalists have since matured their valuation methods in the face of the Internet model, as I am sure a traditional valuation applied to a company like Facebook would not come up with 15 billion. I think the value of understanding these methods however is to also get the angel investor to do the math and figure out if their investment will deliver the required return, and if so, when.

A compensated advisor type of method is discussed, which is not really a valuation method as much as a way to get involved with a company, bring some value to the table as an individual, and get a piece of the action. Later, when you know the company better, you may decide to (or have the right to) put some money into the company and at the time I assume you would resort to one of the other methods based on your now deeper understanding of the business and opportunity.

My favorite valuation method - which has actually seen a lot of popularity in very early stage investing - is what I call the avoidance method. This approach assumes that you cannot adequately value the company at such as early stage, therefore put some money into the company now, treat it as a loan, and later on when a larger investor gets involved you have the right to convert your loan into equity at a specified discount to the price determined by the later investor. Charles River Ventures, which launched an early stage investment fund, has chosen to adopt this model for what it calls the QuickStart program which makes up to $250,000 available for early stage companies.

Overall, I found the valuing section my favorite so far in the book. It is direct and to the point, and helpful when thinking about different models to value potential investments. When I think about my strongest take-aways, it would boil down to seeking a pre-money valuation of about 2.5 million as a sweet-spot, for early but established businesses with a strong prototype or even product with a large potential payoff.

For my own quick first-pass evaluation of opportunities, I like and will use an adaptation of one of the simple approaches described in the book, a method used by David Berkus:

  • Sound, Promising Idea & Business Model: up to 500k
  • Product or Prototype that exists: up to 500k
  • Strength and experience of management team: up to 500k (maybe more?)
  • Team of Advisors and Board Members: up to 500k
  • Existing Customers, Sales, or Revenue: up to 500k and up

Wait a second… If you read the book and browse elsewhere on the web, you will find this table published with values of 1M per category. So what gives? The fact is, I updated this table based on comments from David Berkus posted here in August of 2008. David makes the case that the original book was published prior to the Internet bubble, and the valuation ranges of 1M per category just do not hold up anymore. This also lines up better with a 1-2M valuation range that I think is common and reasonable for most software companies coming to angel groups today.

So with that, I will share one final word of caution, and that is that valuing deals poorly can really put a lid on potential returns, or even taint the company to later investors. Entrepreneurs will always feel like their idea and their talents are worth a lot, so careful negotiation is required. I think the valuing techniques shared by David Amis can help to drive some sensible reference points into this highly subjective process.

Evaluating Early Stage Investment Opportunities - 04/05/2008

So you think you have a live one. Then what? When your hard work in building a sourcing strategy pays off with a promising opportunity, you need to evaluate it carefully. This is the second stage described in Winning Angels: The 7 Fundamentals of Early Stage Investing, by David Amis and Howard Stevenson.

The authors devote […]

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