Angel Investor Basics
Valuing Startup 101
First, we should set a couple ground rules, when valuing a startup we are dealing with private market actors, startup founders, angels and venture capitalist, who some like to call smart money. The operative word here is market — not your neighborhood supermarket, but something closer to an open-air market in India or Nigeria. Most times, a startup founder enters this market their view of what their company is worth is either based on the money and time they’ve personally invested and their dreams of how the company will grow. That’s until they’ve met an investor, especially a seasoned angel, accelerator or venture capital firm — that’s when expectations meet reality, it’s not called a market for nothing.
At its core, startup valuation is similar to the valuation of any company listed on a stock market. So let’s walk through how analytical stock market investors perform valuation. First, estimate the amount of money the company will make for its shareholders (typically through an acquisition or IPO, while dividends are usually not considered). Second, you estimate from that sale or IPO how much of the company would the investor/founder own. Third, decide what the required return or how much you need to make for it to be worthwhile. Fourth and finally, you compare what the company future value to your alternatives by estimating its future value when it sales.
It would be great if that’s the end of valuation — it’s not in the stock market and it’s not the case for startups either. In reality — even when analytical stock market investors calculate what the company is worth they compare it to the current stock market price determined by other investors and overall market sentiments. Which is why valuation, in general is called an art not a science — the valuation just form a basis for conversation. The intangibles of startups makes the value even harder to determine given the absence of a public scoreboard of a trading stock price. So startup founders and investors, find themselves in a market where the laws of supply and demand rule the day. Once you have the basics down to enter the market — what matters most is how many people with capital and how many people have companies that, for whatever reason, have caught the attention, of those investors. The “for whatever reason” part typically combines an investors existing relationships, knowledge, experience, analysis, and intuition to estimate the likelihood that a company will succeed. Again, succeeding is the ability to navigate the dark waters of entrepreneurship to have an acquisition or IPO. Below we provide our own start-up valuation framework based on traditional valuation methodologies with adjustments for the startup market “for whatever reason”.
Reading some of the headlines of news on tech startups, there seems to be a mysterious logic behind certain start-up valuations — however as noted, the price investors ultimately pay is a function of supply and demand. When a proven team (read that as having sold or IPO’d another company) has a product with impressive traction is in the market fundraising, oversupply of capital will skew the valuation higher. Whereas a first-time entrepreneur team with little to no traction trying to fundraise will face the opposite, in most cases. There is also the impressive team with great traction — that for whatever reason just never seems to build a head of steam in the fundraising market. Typically, this is when no investors has “priced” the opportunity, made an offer to invest. As, start- up investors, we are presented with these opportunities, in which case our job is to develop and evaluate against our own price range. In most cases, since our principals led an accelerator, startups founders ask us to introduce investors who can make an offer or “lead” a round which requires a process of negotiation with the entrepreneurs against their own price range. Either way, the analytical process around our valuation is the same.
Start by developing a model of the future expectations of the company and its market for possible sale. Obviously, this means one has to understand both the company and the market it operates to forecast the range of outcomes. Internally, we come up with 4 potential scenarios and assign a likelihood. This likelihood is purely subjective but grounded in our assumptions about industry growth, business milestones, expected capital raises, traction, legal and regulatory issues, buyer universe/exit opportunities, business and product development, the competitive landscape and execution of the team. The goal of this exercise is to form a rigorous thesis on what the investment upside from each opportunity. For example, below is a fictitious Internet of Things company named BeaconCo.
Best Case: BeaconCo leverages its crowdfunding campaign to transition from early adopters to mass consumers and reaches $100m in annual revenue, Apple and Alphabet become strategic partners, and the company IPOs for $1bn.
Probability: 10%. Exit Timeline: 10 years.
Base Case: BeaconCo builds a cool brand that speaks to millennials, generates $50m in annual revenue, frustrates Apple or Alphabet products targeting millennials enough that one of them acquires the company for $200m. Probability: 20%. Exit Timeline: 8 years.
Bailout Case: The company creates a niche product that doesn’t cross over to mainstream and misses customer and revenue targets, sells its technology and/or team to a strategic buyer for $20m. Probability: 30%. Time Horizon: 6 years.
Bust Case: The company fails to execute and ultimately closes, resulting in a write-off. Probability: 40%. Exit Timeline: 4 years.
We can now calculate our investment’s expected future value, depicted in the table below.
Once a startup gets into the fundraising market, they soon realize no investor wants to give the company all the money it will ever need. If the company, is not able to bootstrap on revenue or obtain bank financing — most tech startups don’t — then they must re-enter the fundraising market. Effectively, the company will reduce the ownership of the existing shareholders by raising new capital, this dilution occurs more and more as the company grows. Since, the stake owned by an investor is key to calculating their returns, gaging how much dilution should be expected is also necessary to the projections. This is one key point where angel investors and venture capital investors diverge — whereas most angels seek a significant enough stake, that the dilution of the angel’s investment will still allow them to make a sizeable return. However, venture capital firms, seek to ensure they’ve sized their initial investment to maintain a significant stake in the company and have a seat at the table, in terms of board voting decisions, even in the event of future dilution.
Venture Capital Brings More Complexity
Beyond dilution, new investors request new shares to be issued in different classes with preferences over existing shareholders. Essentially, venture capital firms consider their investments a payment for preference in the capital structure of a company. This preference affects angels and founders, by resulting in, angel investors receiving their investment returns after a venture capital firms receives their investment from an IPO or sale of the company — a “last in first out” model, called liquidation preferences/ capital waterfall. .
Reducing share ownership but increasing value of the stake from $1m to $2m. The key aspect for angels and founders is to ensure the initial valuation is reasonable.
Angel investors — at least the ones that are successful at it — typically think about required return at the portfolio level, whether they are investing a total
of $100,000 or $10 Million. The odds only get better through exposure to the total amount of companies they invest in, rather than the total amount invested. To construct an optimal start-up investment portfolio, we recommend investing in at least 20 companies over time and reserving approximately 50% of total allocated amount to follow on rounds.
What does this mean in practice? Well let’s say an investor wants to triple their $100,000 total investment, reserving $50,000 for follow on — to achieve this 3x portfolio return over 10 years, or 20% Internal Rate of Return (IRR/ percentage earned on each dollar invested for each year invested) assuming an average investment duration of 6 years. Angel investors must account for the high failure rate of startups — so the future value of the angel’s stake in 1 startup investment should be able to return their total investment portfolio.
Going back to our example, let’s assume our required rate of return for BeaconCo is 50%. This means an investor making a $10,000 investments expects to make roughly $114,000 in a best case IPO or acquisition.
Calculation: $10,000 X (1.50)⁶ = ~$114,000 investor return
After we have compiled all the variables in the analysis above, we can calculate a
maximum price for the investment opportunity.
Step 1= $146m and 6-year time horizon Step 2= $65m after accounting for dilution Step 3= 50% required rate of return
Calculation: $65m/(1.50)⁶ = $5.7m post-money valuation.
While this exercise is based on many assumptions, it provides us with a framework to evaluate the opportunity in BeaconCo’s.
Startup intangibles are the reason why despite fairly-priced valuations investors select one startup over another. Diverse founders often cross this threshold of having a fairly-priced valuation but for whatever reason after meeting with angel investor groups or venture capital firms aren’t selected. The storyline is common, a diverse founder that ticks all the traditional boxes, will still succeeds in raising capital or bootstrapping until they do but is in the market for 6–8 months while their non-diverse peers take 2 months. With Affiniti VC emerging from an angel network and pre-accelerator program, we’ve seen 500+ investment opportunities a year led by diverse founders since 2014. We recognize these startup intangibles of diverse founders that will succeed in raising funding and go on to raise follow on capital. The startup intangibles are often measured by startup investors using the scorecard approach to benchmark a potential opportunity based on a list of success factors — at Affiniti VC our philosophy is “all investing is tribal”. Tribal in the sense, all investors have a lens according to the investor’s preferences, investment philosophy and intuition of what is the make-up of a successful founding team. This tribal lens enables an investor to decide for whatever reason, one startup over another. The traits we’ve seen of diverse founders that have found success in the fundraising market is the ability to navigate their tribe and build bridges in others. See an example below as a reference point.
The valuation method above forces both founders and investors to think through critical issues and to try to reach the right balance for future fundraising. Inherently, startup valuation relies on the lens that one has of the future — so it will always remain an art form, rather than a science. Even the most seasoned investors don’t necessarily work through the entire exercise for every investment opportunity. For whatever reason, all investing will remain tribal.