How valuation is done at the time of angel investment

Why focus on valuation? 

For investors, valuation is the most important driver of return at the moment of investing. In other words, an investor's return is determined by the growth in the value of the shares they get in exchange for their money. Successful investment necessitates a thorough understanding of valuation. Unfortunately, valuation is the most misunderstood aspect of the investment process, which frequently leads to tense talks and a rocky start for the entrepreneur-investor relationship.

What is the problem?

Most entrepreneurs and investors have oblique points of view, which mean their perspectives do not cross. In reality, the two sides don't even communicate in the same investing jargon. Fundamentally, none of them comprehends what I refer to as "valuation divergence." Understanding divergence may help to prevent squabbles and guarantee that investors and entrepreneurs have a productive working relationship.

Is Valuation a Key Issue in Funding Startups?

"I will not talk to an entrepreneur about valuations for more than five minutes," Ron Conway, a well-known Silicon Valley angel investor, was recently reported as stating. I'm probably not going to invest if they want to chat for more than five minutes."

It's tough to argue with Conway's argument since it's so clear and plain, and it's based on so much common sense. Pre-seed startup valuations are as flat and stable as a Tiger Woods game of golf, independent of the ups and downs of the venture market. Of course, there are exceptions, but as a logical entrepreneur or investor, you wouldn't bet on seeing one before investing. Small, high-growth prospects should be evaluated more on the basis of the quality of the opportunity.

Small, high-growth chances should be evaluated based on the quality of management rather than the size of the values.

Payne, William H. (Bill) "An angel's valuation of a firm is influenced by a variety of things. The strength of the management team and the magnitude of the opportunity, or a company's capacity to scale, are the most important factors. A valuation worksheet is included with this article for entrepreneurs to utilise in order to better understand what investors are looking for and to find characteristics that might justify higher pre-money valuations. Investors would benefit from being able to evaluate firms and determining if their valuations should be increased or decreased."

Valuation has Many Aspects

Investors frequently discuss a company's pre-money or post-money value at the time of investment. This computation might be simple if you just acquire a certain percentage of common shares in return for your investment. Angel investors, on the other hand, have learnt from venture capitalists to bargain for preferred stock rather than common stock as the form of security for their investments, as well as additional financing terms such as board seats, controls, warrants, and dividends. In these circumstances, value at the moment of investing becomes complicated and difficult to quantify. Although explicit and implicit value may be calculated by accounting for some financing conditions (for example, warrants or dividends), other financing terms, such as board seats or voting controls, are difficult, if not impossible, to determine.

Experienced angel investors have utilised the following rules of thumb for investing in seed and fledgling firms for decades:

• The whole return on investment is provided by home runs. In a typical angel investor's seed/startup company portfolio of 10 investments, half of the firms fail with no return on investment, while the remaining three or four enterprises return some cash or give a minor return on investment. Investors are hoping that these three or four firms would at the very least repay the full portfolio's capital—all 10 investments. Only one or two out of every 10 investments will pan out and provide the majority of the portfolio's return on investment.

Angel investors must only invest in high-growth businesses. Because of the low chances of success, angel investors search for firms that can scale—that is, organizations that have the potential to expand ten, twenty, or even one hundred times in value over the course of a typical five-to-eight-year investment. Companies lacking the capacity to demonstrate such scalability are not eligible to apply.

4 Startup Valuation Methods Used by VCs and Angels

Scorecard Valuation Methodology

To arrive at a pre-money valuation for the target, this startup valuation approach compares the target firm to typical Angel-financed startup ventures and modifies the average valuation of previously funded companies in the industry. Only firms at the same stage of development may be compared in this way.

The first step is to figure out what the typical pre-money value of pre-revenue firms in the target company's industry is. The economy and the competitive climate for new businesses within an industry influence pre-money valuation. In most sectors, the pre-money value of pre-revenue companies does not change dramatically from one business field to the next.

Venture Capital Valuation Method

Professor Bill Sahlman of Harvard Business School initially proposed the VC valuation approach in 1987. It calculates pre-money value by first calculating post-money value using industry criteria. The following equations form the basis of the venture capital valuation methodology: Post-money valuation = terminal value / projected ROI; ROI = terminal value / anticipated ROI

Dave Berkus Valuation Method

Dave Berkus is a well-known professor who has invested in over 80 start-up businesses. Dave's strategy was initially published in a book by Harvard's Howard Stevenson in the mid-1990s and has subsequently been adopted by Angel investors.

The Risk-Factor Summation Method

In assessing the pre-money value of pre-revenue enterprises, this technique takes into account a considerably larger range of characteristics. "Reflecting the notion that the bigger the number of risk components, the higher the total risk, our strategy pushes investors to think about the many sorts of risks that a given enterprise must handle in order to reach a prosperous exit," said the Ohio Tech Angels, who invented the method. Of course, the most significant is always 'management risk,' which requires the most thought and is seen as the most significant risk in any business by investors. While this technique takes management risk into account, it also asks the user to consider other risk kinds, such as management, business stage, legislative/political risk, and manufacturing risk.

Consider all of the risks you'll have to evaluate, with management, stage of business, legislation/political risk, manufacturing risk, sales and marketing risk, funding/capital raising risk, competition risk, technology risk, litigation risk, international risk, reputation risk, and a potentially lucrative exit being the most important.

Conclusion

To determine the right pre-money value, it's a good idea to use at least three startup valuation tools. If they all come up with the same figure, take the average of the three. If one is an anomaly, average the other two, or use a fourth approach to try to bring the other three into near agreement.