Valuing (3rd Fundamental of Early-Stage Investing)

After discussing Sourcing and Evaluating, it is time to look at the process of Valuing early-stage investment deals. An important lesson learned from those prior discussions is that there is more than one way to accomplish each of those two functions. Valuing early-stage business opportunities follows the same pattern. There is more than one way to value early-stage investment deals and there are numerous considerations influencing this decision-making process.

The Basics

According to Amis and Stevenson, valuation is defined as “placing a price on a stake in a company, based on a future, potential capital return” (p. 145. 2001). These future return expectations coupled with the uncertainty associated with early-stage investment deals poses significant challenges in the valuation process. Some of those challenges include lacking historical performance data, revenue flows, or other key determining factors. Amis and Stevenson’s book Winning Angels: The 7 Fundamentals of Early Stage Investing, explains 12 different approaches and methods to valuing business deals and those factors each takes into account. These approaches and methods range from instinctual to more quantitative approaches. As Seedcamp’s Managing Partner, Carlos Eduardo Espinal explains, “The instinctual [methods] are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used” (Seedcamp, n. d.).  Amis and Stevenson labeled these “instinctual” methods as “Quick and Easy” and include the following:

• $5m limit
• Berkus Method
• Rule of Thirds
• $2m-$5m Angel Standard
• $2m-$10m Internet Standard

One of the challenges with valuing an investment deal is that a given set of facts can yield drastically different valuations depending on the methods employed. These discrepancies can create serious impasses as investors and entrepreneurs determine and negotiate the terms of a deal. Perhaps Marianne Hudson, Forbes contributor, offers the best approach by suggesting not to settle with one method. She writes, “Don’t stop with one approach.  Sophisticated angels and entrepreneurs will want to use several methods to value a startup because no single method is useful every time” (Forbes, 2015). Using several valuation methods for a single investment deal can provide an acceptable range of possibilities when negotiating the terms of a deal. Amateur angle investors and entrepreneurs would greatly benefit from using this approach until gaining more experience in the process.

Greed

The discussions on valuing can be complex and lengthy, but it would be remiss not to acknowledge the implications of greed in the valuation process. While everyone arrives at the negotiating table looking get the most favorable terms, it is important to remember that it is a coordinated effort; a two-way street. Amis and Stevenson highlight the importance of the investor-entrepreneur relationship when they write, “Most of the winning angels recognize that their relationship with the entrepreneur is essential, that the entrepreneur must be highly motivated not only to succeed but also to get a win for the investor” (p. 176, 2001). Additionally, the successful execution of a given deal might pave the way for other bigger and more lucrative opportunities. It would be naïve to opt for immediate rewards without considering potential gains of a longer-term strategy.

Each investment deal valuation is unique and deserves careful consideration. The highlights above offer a starting point to a much larger knowledge quest regarding valuing early-stage investment deals. Hopefully, these notes spark the right questions and lead readers to find their own place within the greater valuing picture.

References

Amis, D. & Stevenson, H. (2001). Winning angels: the 7 fundamentals of early stage investing. London: Pearson Education Limited 2001.

Espinal, C. (n. d.). How does an early-stage investor value a startup? Seedcamp. Retrieved from  https://seedcamp.com/resources/how-does-an-early-stage-investor-value-a-startup/

Hudson, M. (2015, March 6). The art of valuing a startup. Forbes. Retrieved from https://www.forbes.com/sites/mariannehudson/2015/03/06/the-art-of-valuing-a-startup/#3daa27551d73