A note on valuation

One of the hardest things to do in understanding investment in startups is valuation for investment purposes. One common methodology (there are many) starts with the commony believed and historically justifiable statistic that 80% of companies fail in the first 2 years of operation. Add to that the recent studies showing that 70% of angel funded startups return less than the invested capital, and you get a multiplier that seems very unfriendly to most startups.

Different investors invest for different reasons and with different views. Game changers in enormous markets are sometimes viewed as very valuable, recent M&A results may affect valuations, while cash on hand and other assets are certainly helpful to the process.

Some relatively simple ways of backing out valuations come from statistics on investments. For example, the average angel investment in 2015 was ~$600K-$800K for ~20-25% ownership. Thus the value after investment was from $2.4M to $4M, making the pre-money valuation $1.8M to $3.2M. We can then multiply the valuation by the success likelihood for estimated net present value of percentages of the company to an investor.

Here is an example from the Angel Capital Association: "The valuation methodology most frequently used is backing into it from the exit value. For example, if the company is expected to be worth $50 million in five years, the company needs to raise a single $1 million round to reach that valuation, and the investors will require a 10X cash-on-cash return upon exit, the investors' share must be worth $10 million in five years. Thus, the investors would need to own 20 percent of the company, which implies a $4 million pre-money valuation and $5 million post-money valuation. (Note: this presumes no further dilutive capital is needed.)"

The best way to "back out" a valuation is to show comperable recent sales of similar companies to similar buyers. For example, if 3 similar startups (e.g., ice cream startups) in closely related fields (e.g., selling organics into Greenland and Finland) were bought by similar companies (Breyers and Ghirardelli) for 25 and 35 times revenues, and the revenues expected at sale are $10M, the sale price may be valued at $250M-$350M, assuming these are comperable in size to the other examples.

Another approach is to calculate cash value as (assets - liabilities) and multiply by likelihood of failure based on stage of operation. Intellectual property assets are generally valued as $0 on this basis because thay are rarely saleable to anyone else. This is reasonble to use for early angel/advisors who, for example, become advisory board members in exchange for equity only.

At $2.4M of total valuation when ready for angel investment, a company in its first 2 years would be expected to fail 80% of the time, and if it got angel investment, 70% of the time if it survived the first 2 years. The current value of 1% ownership could be reasonably guestimated at 0.01*$2.4M * 0.2 * 0.3, or $1,440.

On the other hand, once funding arrives, 1% of the same company might reasonably be assessed as having a fair market value of $32K for 1% (after all, the recent buyers just purchased at that price). However, the likelihood of failure remains at 70%, so a discount to 0.3*$32K, or $9600 is a reasonable present value.

Statistics also show that 10x-30x exits are about 3% likely and 30x or higher exits are 3% likely. Assuming at angel funding the real potential for these exits and history of simlar multiples for similar exits is justified, these have to also be taken into account for future value. Future expected value is normally identified as capital gains. For those putting in cash, the calculation is simple. Money out after repaying cash in yields capital gains. For those putting in labor, intellectual property, good will, time and effort, etc. and doing so without cash payment, things are far more complex.

By the assets - liabilities method, if assets are $1M, liabilities are $250K, 1% ownership in the first 2 years would be reasonably estimable as $750K * 0.01 * 0.2 * 0.3 or $450.

Finally, the value of time is critical. A sale in one year at 10x is equivalent to a sale at 100x in 2 years. Angel returns are in the range of 22%/y taking into account the 70% non-success rate in 10 years. If you sell a company in one year, in order to get 22% average return with 30% chance of success, you need to invest for a 4x return (4*0.3=1.2), 16x in 2 years, 64x in three years, and so forth.

Angel To Exit provides these without endoresement. So beware!