Valuation World Cup: Group A – (Angel)

Up first is Group A: the Angel investing methods. This group features valuation techniques that can be used on companies with few, if any, metrics. Very early stage companies may be little more than an idea and two partners with big dreams. To get these startups off the ground, angels apply their own methods not found in traditional banks or private equity shops. Let’s run through the participants!

*Editor’s Note: Confused? Lost?  Head over to the Valuation World Cup Homepage for more information!

1. Adjusting the Average

Explanation and Use Case
This method relies on the angels having a pulse on the current market and doing a fair bit of due diligence. First, take the median (or mode, perhaps) of recent valuations of similar companies in the region and sector. Next, consider qualitative factors of the company (such as the competitiveness of market, the strength of the team, the quality of customers, etc.) relative to other investment opportunities. Finally, apply monetary value to these factors; relative strengths should increase the valuation, while weaknesses will decrease the valuation.

This method is particularly valuable for companies that are pre-revenue and just beyond a concept, but have all the makings of a strong company. It can certainly serve as a concrete answer to a number of intuitions.

Pros and Cons
The real advantage of this method is the flexibility. Taking a holistic approach to all areas of an early-stage company rather than a single metric is like being able to seamlessly transition from the counterattacking 4-4-1-1 formation to the possession-based 4-2-3-1. What’s more, the base value is rooted in the reality of the times.

However, this method relies pretty heavily on the subjective impressions and experiences of the angel. How much is a strong partnership worth compared to a team of seven? Does a large market potential cancel out a lack of product roadmap in terms of dollars?

Example
A particular iteration of this method championed by Bill Payne – and is sometimes referred to as the Bill Payne Method, though he has called it the Scorecard Method – provides specifics for values of qualitative measures and has been adopted by angel groups across the country.

2. Build Up

Explanation and Use Case
Like the Average with Adjustments, the Build Up method relies on qualitative estimates of future success. Unlike the above, the Build Up method starts at $0 and values a company’s ability to mitigate market, execution and technology risks. For example, strong industry partnerships with end-users would prove demand, thus reducing the market risk. By assigning a dollar value to aspect of risk, the company can “build up” its value.

This method is simple enough to be used with any pre-revenue company. It’s especially helpful for explaining to entrepreneurs where they can increase their value.

The Pros and Cons
The strength of the Build Up method is that it gets at the heart of investing: risk vs. return. An early stage company that has addressed the big risks of business has a much higher chance of big returns.

Once again, the drawback here is simplifying complex business questions into a set dollar amount. This is one that must be groomed over time to more accurately reflect the value of mitigating risks.

Example
The most famous user of this method is Dave Berkus, founder of Tech Coast Angels. His “Dave Berkus Method” is simple enough for any founder to follow and robust enough to capture the essence of a startup.

3. Cost-to-Duplicate

Explanation and Use Case
This method looks to the past for an estimate of present value. By adding the historical costs – hours of design and programming, research expenses, even the founders’ time – this method tries to ground the valuation in something real. The Cost-to-Duplicate method tries to address that very question: what would it take to duplicate this company?

This method is effective in cases where a company presents an exciting opportunity in high-tech, especially bio-technology, where the real value is in their research and development performed and the prospects and timing of revenue in the future are highly uncertain.

The Pros and Cons
One clear advantage of the Cost-to-Duplicate method is that, rather putting arbitrary values on a “strong team” or other qualities, the value is rooted in real dollars spent (or required) to get to this point in a company’s life.

However, this method places no value on the future of the company, where the investor will actually require returns. Spending $2M of the DoD’s money on developing and patenting the latest and greatest combat space pen does not equal a solid company. Put in futbol terms, would you look at David Beckham’s lifetime earnings to determine a salary to pay the 39-year-old next year? The opposite can also be true: fast growing consumer technologies may have huge market potential with very little developmental capital spent.

Example
Biotechr (fictional) is raising money to continue their pursuit of a revolutionary pharmaceutical treatment for turf toe. So far, they’ve had two Ph.D.’s working for the last 9 months at a cost of $10,000 each per month. Their equipment and analytics were funded through a grant of $1.5M. Their founder was so excited by the discovery that he rushed a patent through at a cost of $70,000. Total Value:  $1.75M

4. Recent Transactions

Explanation and Use Case
The simplest method in all Group A: look to the market for the value of the startup. This can come from several sources: recent investments in the space by accredited investors, recent investments from your own angel group or region, or even past investments in the founder’s previous ventures. No nonsensical values on product roadmap quality or number of JDs on the founding team.

This valuation method is especially useful when an investor has previously invested with the founding team or is especially active in the space. Again, it does not rely on company metrics that may not yet exist.

The Pros and Cons
The strength of the recent transactions method is in its simplicity, letting others do the hard valuation work on comparable opportunities. This leads both sides of the table to feel they are getting a reasonable deal.

The flip side is that no two companies are the same. With no adjustments for all that due diligence performed, this method can significantly undervalue a strong opportunity or overvalue a clear flub.

Example

“NeedFoodNow” A (fictional) on-demand food delivery service is looking to continue the disruption in space by raising a Series A.  They will look at prior funding rounds (SpoonRocket and Blue Apron’s), any M&A in the space, and even GrubHub’s IPO to find a comparable market value for their offering at their given stage in the company life-cycle. If the analysis of these deals provides that each company was worth $2M for their Series A, then NeedFoodNow will have their value.  Total Value: $2M

Bonus: Match to Watch

The intriguing matchup here is Recent Transaction versus Adjusting the Average. While similar in principal – what’s the current investment landscape? – Adjusting the Average takes it a step further into the unknown. Perhaps these fickle adjustments will overextend their line and leave them vulnerable to the counterattack of good ol’ transparency.

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4 thoughts on “Valuation World Cup: Group A – (Angel)

  1. Pingback: Monday Morning Memo | Capital: Ventured.

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  4. Pingback: Valuation World Cup: Semifinal 2 – Attach Rate advances! | Capital: Ventured.

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