Angel Investing: Valuation I

Continuing on our Angel Investing journey comes this reader's questions: How do you value a pre-revenue company?

Aaaaahhhhh...the age old question - what exactly is something worth? If you've ever taken any economics, then you know that something only has "value" if there is demand for it. So what is the value of a fledgling startup with few if any customers?

There is an old joke that goes something like this: How do you value a startup company? Add 100k for every engineer on the team, subtract 150k for every MBA on the team.

There is no set formula to valuation because valuation is usually done by shooting from the hip. It's kind of like when bankers take a company public and say they are selling shares within a range of $20 to $25 dollars. Then the night before trading commences, you hear that they actually priced shares at $30. How can the "value" of a company change by 25% overnight?!?! So now you get the picture that outside of the public markets, the valuation process is inefficient. If you are an investor, that is why you are investing in private equity, because you want to take advantage of the inefficiencies in a huge marketplace.

Now when I speak of valuation for angel investing, I am not talking about the valuation process in a buyout or M & A transaction. You could write a whole book on valuation analysis using various techniques. I doubt anybody wants to hear about that dry stuff (if you do let me know and I will post more about it).

At any rate, every person has to have an internal gauge of something's intrinsic value. The best way to get an idea of value is to get into the market and see as many deals as possible. Investing in a startup is a process not altogether different from shopping for any major purchase. If you take the example of shopping for a 3 bedroom/2 bath house, every person should be able to throw out a value of what a 3/2 home in their suburbia costs. I can tell you that I believe the intrinsic value of such as home is $250k in California. This means that if I drive through the Silicon Valley and see a $800k home, I know that it is expensive. If I can get a $250k home in any good suburban area of California, then I know that is a pretty safe investment.

Now you are probably thinking that is a pretty dumb analogy because homes are pretty static items and do not contain all of those variables in a startup that are difficult to value. What I will say is that every startup entrepreneur should have a valuation table they put together in Microsoft Excel. If you don't have any idea of what to value a company, at the very least you should ask the founder to show you how he values the company. If he doesn't have a valuation table in place, then tread with caution because you know this person doesn't have a clue about valuation.

A proper startup valuation table should work backwards from a future point in time at an anticipated liquidity event. That future valuation should be based on either trade valuation by the public market, M & A valuation by recent activity, or valuation by its cash flow patterns. You should also see how the entrepreneur has worked from his initial valuation to that liquidity valuation, taking into account revenue growth, changes in the cost of the revenue, expenses, future funding events, etc,. Basically, this valuation is somewhat like a financial projection, except that it will include the financial projections of the value of every type of share based on the financial projections. In this table, you should be able to see what the planned capital structure of the company will be. This will be very useful for example if you are worried that they may take in an institutional round that will wash out your investment.

Once again, I guarantee you that most startups will NOT have a good valuation table that maps out their trajectory. If you can get the startup to make one, then they will likely immediately see the value of having you on their team.

I will post more on this topic later in Valuation II.

Comments

[joseph calderone]

While I found your post very interesting I was wondering if perhaps you could shed more light on the more quantitative techniques & models you think you might use to value a new Internet technology, i.e., something like Delicious, Juice, or Newsgator.

After reading a book on Valuation (published by FT - Prentice Hall) by 2 McKinsey Graduates the general rule of thumb was that the only way to value a company at start-up is by looking at the Multiples (EBITDA, EBIT, ROIC, et cetera) of like companies in the industry. This occurred in the red part of the J-curve. Other valuation methods like Stern Stewart's EVA or McKinsey DCF were not used until the company had matured after about 5 years (presumably, future cash flows are discounted from this point onwards) after passing into the "black" area of the J-Curve.

In other words: Why would anyone ever value a subscription-based start-up with the DCF method? (I don't think they should, or should they?) Is there a whole different set of criteria used for Internet Technology products? How did Union Square Ventures develop their valuation fro Delicious before it was priced in the market? Does these variables look familiar for the kind of valuation I am talking about:

cost per acquisition, monthly average revenue per user (ARPU), free
cash flow (EBITDA), and churn (cancellations/average users per
period). Subscription models require a clear focus on acquisition
costs, strategies to drive ever higher ARPU, and customer retention
strategies. I meet with many companies who are well-versed in
subscription economics, however, their business plans often do not
sufficiently factor in the power of broadcast/ad models to challenge
their revenue models.