Valuing Your Software Start-up for Angel Funding - 09/11/2008

I see many start-up business proposals as part of our angel group deal flow, and one of the most difficult things for founders seems to be deciding how much money to ask for, and what to specify regarding the pre-money valuation for the company. Angelsoft, the tool we use to manage deal submissions, requires that both fields be entered on the funding application.

I have commented in prior posts regarding some of the methods angel investors may use to value an opportunity, and many of these can be helpful. But even the simplest which is probably the “Berkus Method” can result in a valuation anywhere from less than 500K to up to 2.5M - covering all stages of the start-up life cycle. What is “normal” for a true start-up company that is pre-revenue, has a team of 2-4 people and a good looking product prototype?

I have seen many extremes. I remember one entrepreneur I spoke with who was adamant that his 1 person “idea” with no team, product, revenue, or customers had a value north of 3M. The same person argued it really wasn’t a “start-up” either because he had run a business once before. Well, any company without a team, product, revenue, or customers is a start-up, and a very early one.

On the other extreme I saw one founder seeking to raise 1.5M dollars on a pre-money valuation of 100k. Unfortunately, if he succeeded, the founder would end up being a 6% minority owner of the company and the investors would be in charge. Ownership following an investment is typically computed by taking the pre-money valuation, adding the amount of the new investment, this gives you the post-money valuation. Then, to figure ownership, the amount of the new investment divided by the post-money valuation is the amount of the company owned by the new investors. The remainder is held by the previous investors/founders.

Now with all due respect these entrepreneurs, they really did not know what to ask for or what the process was. And congratulations to them for taking the time to get their business started, to put thought into the business plan, build a product or prototype, prepare the appropriate documents, navigate the local ecosystem to find the right angel groups, and get their idea submitted. They went a lot farther than many others who just dream their ideas until someone else brings them to market. And as investors we try to see the good opportunities even if the “deal terms” don’t seem right. There is nothing wrong with being a first-time entrepreneur, everyone starts there, and if these individuals learn through the process and adjust along the way, they should be fine.

To take some of the mystery out, however, we really want to understand what is “normal” and typical. So how should the entrepreneur determine what pre-money valuation is appropriate and how much funding to ask for? In this case I am still talking about a new team that has not done it before and is therefore not able to bring an “experience premium” into the equation.

For an early software or web start-up, that is pre-revenue and at the product prototype stage, one stick in the ground might be 200k per founder as a pre-money valuation. If the product is further along or even “shipping” and some real customers have expressed interest or committed, maybe this could rise to 300k per founder or even a bit more. If there is only one founder, then the entrepreneur really needs to get another one quick - starting a technology business is just too hard for 1 person. And a founder is not a part-time bookkeeper, but a committed member of the team that has relevant skills and who will be 100% dedicated to the venture either already or upon funding. This would give many companies at the pre-revenue and pre-product stage a low end valuation in the range of 500-900k, which seems about right to me. Revenue, product readiness, customers, track record, submitted patent applications or an exceptional market opportunity can all start to bump up the range from there. Any valuation above 1M certainly should have one or more of these things.

Comparing this to YCombinator as a point of reference, which typically bets on an idea, and takes a 6% stake for $15,000 of investment, that means YCombinator is investing at a valuation of around $250,000. However, given that the value of the YCombinator program is probably 50% money, and 50% education and network, maybe the upper range of that comparable valuation is closer to 500k. YCombinator does require a team of usually 2-3 people, so this is at least compatible with the low end of my guidelines above - which makes sense given YCombinator usually invests at the idea stage.

So once the company can be valued appropriately, we have a basis to answer the question “how much money to ask for?” There are two factors to consider here. The first is how much one angel group will be willing to provide to a company at this stage, and the second is how much ownership the founders are willing to give up.

An individual angel in the groups I am familiar with will invest 25k-50k in a typical deal they like. This can go as low as 10k and certainly can go higher - but usually won’t be higher for the profile of investment we are talking about here. If an angel group has 12 or so active members, sometimes more, that means one angel group can provide 300-500k in funding - if most angels were interested in the deal, which is certainly possible. A more realistic expectation may be in the 200-400k range. I am sure there are exceptions, and that angel groups (or individual angels) in the hubs of Boston or San Jose can do a lot better than this, but in my experience, this is a common profile. I have even seen 50k investments made that included several angels. Beyond this range, you need to expect multiple angel groups to get involved, or the angels may bring in other investors from their personal network.

Based on this, my recommendation for the profile of company we are discussing would be to seek 200-400k from an angel group as a first angel investment. This would put out 20-30% of the equity for these first investors. A little high maybe, but in this case we are looking at a company that is seeking investors pretty early in its life cycle. This investment should cover the company and team for 6-12 months.

The last point I will make for the entrepreneur is that if you can bootstrap your company a little longer, you should. Many companies take small investments (<100k) from family or other people who believe in the idea (”family, friends, and fools”) before approaching an angel group. As founder, you also need to be personally very financially committed to the deal - this is very important to investors. If this type of smaller investment can get the company further - to shipping a first product, getting a first customer committed, or getting a patent application done, the positive impact in justifying a higher angel valuation will be well worth it. And the angels may even feel better too because they will see less risk in the deal.

For more reading, especially of your business is a little further along than the example here, a good resource is the Angel Capital Assocation which has a lengthy document on this topic.

4 Responses to “Valuing Your Software Start-up for Angel Funding”

  1. Andrew Hemingway Says:

    Jim,

    Thank you for this particular article. You answered for me many questions, and gave me loads of valuable insight.

  2. Ravi Joshi Says:

    Jim, thanks for this informative article on valuing a start up. It validated some of my assumptions, corrected some and pointed me to additional information as well.

    Regards,
    Ravi

  3. Trevor Smith Says:

    Very helpful article - thanks.

    I’m in a situation where I’ve boot strapped the start of my business and am now in talks with an angel that can provide working capital, direct contacts and industry expertise. I wonder how to value my business.

    The website application that is the foundation of my concept is complete and functional - 2.5 years of bootstrapping. The replacement cost for my website is $400K-500K.

    I own 100% of the business. I have a trusted partner that would invest some and jump in full-time once I get funded.

    I have no revenue because I need working capital for marketing and stronger industry connections. What is good range of valuation for my start-up from your experience?

  4. jstjean Says:

    Trevor,

    It is very hard to say and the answer depends on your business, the market, the team, and even the angel. As a stake in the ground, the replacement cost could be considered a baseline, and ideally your idea and market opportunity justify more than that. Unfortunately, things are not always worth what it cost to build, and some things are worth much more than it cost to build, and it all depends on the circumstances.

    With all that said, I would be surprised if a serious angel investor would consider the value of a *really good* idea at this stage less than the replacement cost of what was accomplished during the bootstrapping phase. But in this market, it happens, and without a team you are at a disadvantage. I would also be surprised if a 1+ person start-up would get valued anywhere close to 1M by an angel investor. In the end, the value of your business is what an investor will accept.

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