Valuation for Angel Investor

Valuation is the procedure by which a startup’s potential worth is determined, alongside the ownership stake an investor will have within the business.

Why valuation matters for angel investors?

It is often tricky for angel investors to allot a meaningful value to early-stage startups, particularly without existing revenue. Hence it becomes imperative to make a dedicated attempt at the valuation process, as it directly correlates to the profits you will earn at the time of successful exit. It will facilitate you to decide whether — and to what extent– an investment is worthwhile. Furthermore, it provides insight into similar companies and the market on the whole.

A valuation is often done by the investor, by an angel group, or both. Generally, the first valuation happens before any investment is finalised; however, it is then repeated at a later stage during future rounds of funding.

An angel investor may be ready to take the baton forward only when full analysis has been performed. At this stage, they will have an option to choose the amount they are willing to invest, and in return, the possession stake they will get. These details are explicitly laid out in the term sheet and must be agreeable to both parties.

Since investors want to strike a good deal and startups want to project their worth in the market, valuations are often a sensitive issue. Angel investors must plan thoughtfully while also ensuring that each one of the facets of the company is comprehensively covered.

Pre-money valuation methodologies used for startups

There are different methods of valuing a business, and no one method, in particular, is ideal for any given investor. Many angel investors make use of more than one method to be precise, while some adhere to a specific methodology which they find dependable.

Scorecard

It is one of the commonly used valuation methods and derived from Bill Payne. The Scorecard method weighs different criteria before estimating how the startup fares concerning similar businesses. It then takes the adjusted weight and multiplies it by the average pre-money valuation of comparable startups to reach the target company’s valuation.

This method offers a worksheet which facilitates angels better to grasp the impact of varied issues on different criteria. This method is both quantitative and qualitative and can end in a subjective valuation. It will nearly always be the case for early-stage startups.

The Berkus Method

Derived by Dave Berkus, the Berkus Method focuses on four risk factors, namely technology, execution, market, and production.

By sinking these risk factors, a business can receive a better valuation. Fundamentally, the Berkus Method associates a specific value amount with the lessening of a particular risk, usually $500,000. If a startup effectively mitigates the risks on all four fronts and instead provides a sound idea (also valued at $500,000), it might then be valued at $2,500,000.

The Risk Factor Summation Method

It is similar in methodology to the Berkus method. But while Berkus method takes under consideration only four important risk factors to assist review valuation, this method considers a higher number of risk factors.

It makes use of small sums, therefore, weaving in a more inclusive valuation. This method apprises the investors with numerous risks and helps to assess whether each is being adequately mitigated.

The twelve risks are: (1) Management, (2) Stage Of The Business, (3) Manufacturing Risk, (4) Political Risk, (5) Competition Risk, (6) Sales And Marketing Risk, (7) Capital Raising Risk, (8) Technology Risk, (9) Litigation Risk, (10) Reputation Risk, (11) Potential Lucrative Exit, and (12) International Risk.

Each risk is measured, and therefore the investor must weigh up whether the business is positively, adequately, or negatively controlling and mitigating the risk.

Each assessment is related to a number, which then translates to value. +2 is taken into account as very positive for growing the business and accomplishing a successful exit. +1 is positive, and 0 is neutral. -1 is taken into account as negative for developing the company and completing a successful exit, and -2 is exceptionally negative.

For every one-point added, $250,000 is added to the average valuation. For each one-point subtracted, $250,000 is subtracted from the average.

The Risk Capital Method

Professor Bill Sahlman introduced the risk capital Method in 1987. It focuses on how much an investor wants to profit on their investment. Unlike the previous two methods, this doesn’t take under consideration risk factors.

It merely considers the company’s anticipated sales price, and therefore, the profit an investor desires on his investment. It should, therefore, be clubbed with other methods to supply a more appropriate valuation picture.

Most angel investors hope for a return on investment (ROI) of roughly 30x. In simple words, once the corporation has been sold, or on successful exit, the angel investor aims to net thirty times their initial investment. For this, the post-money valuation (the value of the business after an investment has been made) is going to be an equivalent terminal value (the sale price of the company) divided by the predictable ROI (30).

To conclude, there’s no particular ideal valuation method. The valuation process overall may be a very challenging one for an investor, especially when faced with an entrepreneur who believes that you undervalue his company.

It’s necessary to devise effective communication strategies to present your findings and for negotiating with entrepreneurs ensure that appropriate investment terms are achieved. Once a valuation is frozen, you will then decide your level of an ownership stake and whether you ought to move ahead with the deal.

Nurseli Kultufan

Angel Effect Team