Three different angel investors are likely to give three different values on a startup if you ask them to calculate the fair market value. Valuations are an art and a science, driven by a number of factors. Different investors weigh factors differently, leading to wildly different valuations. You might be wondering why early valuations matter and the answer is because valuations drive returns. Valuations determine the percentage of a company you own, based on your initial investment. They also determine your return if you back a startup that has an exit. It’s important to consider the valuation when you’re looking at potential investments. Here, we’re going to discuss the various factors that drive valuations at the early stage, and then we’ll discuss three valuation methods that can be used to effectively triangulate a valuation.
Before I get started, I want to make a distinction. As an angel, you’ll either be a price-taker or a price-setter. When I say price setter, I mean that you’re leading an investment and you’re negotiating with the founders on specific terms found in the term sheet. While some angels lead rounds, most angel investors are price-takers. They come into a deal that already has terms and their job is to evaluate the investment-worthiness of the opportunity. One way to do this is by comparing the investors’ estimation of fair market value with the value placed on the company in the term sheet.
Since most early-stage investments are written using SAFE notes (we’ll talk more about this in the coming months) there are only a few terms to agree on. The most important term is the valuation, which is typically a cap set on the highest valuation at which the SAFE note will convert to equity. When you lead a round and you’re negotiating, you want to make sure that cap aligns with your valuation of the startup. If you’re evaluating a deal, you want to make sure the cap, which is effectively the price you’re paying, is less than what you value the company.
So, what drives valuations?
To be completely honest, valuations are incredibly difficult and subjective. With many startups, we’re placing a value on not much more than a team, an idea, and possibly a minimum viable product. The valuation of early-stage startups is driven by a mix of quantitative and qualitative factors, often more reliant on the latter since there often isn’t revenue or other traditional metrics.1. Team
Among the most important qualitative factors is the quality and experience of the management team. Investors generally look for teams with a strong entrepreneurial mindset, industry experience, and proven ability to execute. If the team has successfully started or managed businesses before, or if they possess deep industry expertise, this can positively influence valuation. A skilled team is likely to navigate the many challenges of a startup, thereby increasing the probability of success.2. Scalability
Another crucial driver is the size and growth potential of the market the startup targets. A startup addressing a large, growing market is typically valued higher than one serving a small or stagnant market. The potential for scalability also plays a significant role. Scalability implies the ability to grow rapidly and generate high revenues with minimal incremental costs. Furthermore, the uniqueness of the product or service, the startup's competitive positioning, and the business model are essential. A unique solution with a strong competitive advantage and a robust, sustainable business model can command a higher valuation.3. Traction
Now let’s talk about how we can put those factors together to come up with an actual valuation. There are three major methods and opinions differ on which to use. Realistically, the best option is to find the value using each method, then use those values to triangulate a true value. You can then use this number when you’re looking at the valuation the company put on itself through the cap in the term sheet. One other thing to note is that one method will often provide a substantially different value than the other two. I recommend excluding outliers, as they can be evidence of faulty inputs.
The Venture Capital (VC) Method is a future-based valuation approach. This method works backward by estimating the potential exit value of the startup, typically via an IPO or acquisition, then determining what the company's current value must be to provide a specific return on investment. For instance, if the expected return is 10x in five years and the estimated future value is $100 million, the current post-money valuation would be $10 million. However, this method heavily relies on assumptions about exit values and expected return multiples.
The Berkus Method, proposed by angel investor Dave Berkus, is a more straightforward approach. It assigns a range of values to five critical aspects of the business: sound idea, prototype, quality management team, strategic relationships, and product rollout or sales. Each aspect can be valued up to $500,000, creating a maximum valuation of $2.5 million for a pre-revenue startup. The simplicity of the Berkus method is its strength, but its lack of precision and heavy reliance on subjective judgment are potential weaknesses.
The Scorecard Method builds on the Berkus approach by comparing the target startup with other funded startups. It begins with setting an average industry pre-money valuation for pre-revenue startups. Then the startup is evaluated on multiple criteria like management, size of opportunity, product/technology, competitive environment, marketing/sales partnerships/channels, and need for additional investment. Each criterion is weighted, and the resulting score adjusts the average valuation up or down.
These methods all share the goal of quantifying the intangible aspects of early-stage startups. While none can provide a definitive valuation, they offer guidelines to navigate the tricky process. Angel investors typically combine these approaches, complemented by their experience and judgment, to arrive at a valuation that balances risk and potential reward. It's important to note that the negotiation between the investor and entrepreneur ultimately determines the final investment terms, indicating that valuation is as much an art as it is a science.
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