Before investing in a startup, the first question many angels ask is: what is the company worth? Determining the valuation of a company before it has revenues is actually pretty difficult. Unlike valuing companies with revenues, assets and longer track records there is no agreed upon standards for startups.
Valuation of a pre-revenue company is often one of the first points of contention that must be negotiated between angels and entrepreneurs. Entrepreneurs want the value to be as high as possible and angels want a value low enough so that they own a reasonable portion of the company for the amount they invest.
“How To” Tips From Experts
As I brush up on my startup valuation skills, I tap experts like Bill Payne. He is a founding member of four angel groups, an investor in more than 50 companies and a long-time instructor of angel investing courses. While there are dozens of valuation methodologies, he suggests these four that work for angels and startups. These offer an excellent starting point:
- Venture Capital Method calculates valuation based on expected rates of return at exit.
- Berkus Method attributes a range of dollar values to the progress startup entrepreneurs have made in their commercialization activities.
- Scorecard Valuation Method adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company.
- Risk Factor Summation Method compares 12 characteristics of the target companyto what might be expected in a fundable seed/startup company.
Don’t stop with one approach. Sophisticated angels and entrepreneurs will want to use several methods to value a startup because no single method is useful every time. Multiple methods also help in the negotiation process because an average can be determined from among them.
Since most startups have little-to-no history, revenue and earnings, there isn’t much information to analyze or plug into a spreadsheet. To close this gap, angels can look for clues from similar startup deals in the same region and industry. Like real estate, valuations will go up and down depending on market forces. Expect lower valuations during a recession and higher in boom times when there is more competition for investment. Startup valuations may also be adjusted up or down based on the strength of the management team, location of the business, industry or market.
Like Payne says, “It really is an art. Entrepreneurs and professors would love for it to be something that we just throw an Excel spreadsheet at. But there is no perfect methodology to establish the pre-money valuation of pre-revenue ventures, making it even more important for investors and entrepreneurs to know how the number is derived.”
Valuation Trends for Angel-Backed Companies
While many media stories hype wild valuations for startups these days, studies and national datasets show a different story for companies receiving angel investment. The real story is that these valuations have been relatively steady for more than three years and that the pre-money valuations are in the $2.5 to $3 million range rather than $10 million plus.
National reports such as the Halo Report, analysis by the Center for Venture Research, member surveys by the Angel Capital Association, and Payne’s informal surveys over the past few years pegged the national median pre-money value of companies funded by angel groups at $2.5 million in 2012 and 2013, jumping to $3 million in mid-2014. Behind the medians are differences by geography and industry. The valuations are higher in Silicon Valley, for instance, and life science startups generally have higher valuations than tech startups.
The 2014 increase to $3 million in the Halo Report is important and time will tell if it is a harbinger of bigger changes. A worrisome trend is the increase in the upper range of valuations, which ticked up from $6.7 million in 2012 to $10 million in 2014. It appears the 2014 increases are from Silicon Valley, which may be headed toward a tech bubble. The question is whether that trend might trickle to other parts of the country as more entrepreneurs access data on these deals and ask for similar prices in their home towns. Many angels across the country are standing pat with lower valuations, but I’ve heard from several angels that there is pressure to pay more.
One last trend in startup deals is having no valuation at all – through convertible debt deals. In these cases, angels provide loans to startups that are then converted into equity in the next investment round, often at an agreed upon maximum valuation and/or a discount on that valuation for the angels who support the convertible note. This is a topic for a future article, but it is worth pointing out that these deals are increasingly common for tech company deals in Silicon Valley.
Valuation is an important topic for angel investors. It helps to get as much information as possible to make good early-stage investments. There are a variety of resources to start. The Angel Capital Association offers best practices and Investor tools on its website and the Angel Resource Institute conducts several courses on the subject, including one called Valuation of Early-Stage Companies.
To read the original article: https://www.forbes.com/sites/mariannehudson/2015/03/06/the-art-of-valuing-a-startup/#1c4576141d73