Angel Network Valuations

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, and different investors weigh those factors differently, leading to wildly different results.

You might be wondering why early valuations matter. The answer is that valuations drive returns. They determine the percentage of a company you own based on your initial investment, and they determine your return if you back a startup that has an exit. Here, we’ll discuss the various factors that drive valuations at the early stage, and then three valuation methods that can be used to effectively triangulate a value.

Before we start, a distinction. As an angel, you’ll either be a price-taker or a price-setter. A price-setter leads an investment and negotiates the specific terms in the term sheet with the founders. While some angels lead rounds, most 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 your own 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, there are only a few terms to agree on. The most important is the valuation, typically a cap set on the highest valuation at which the SAFE note will convert to equity. When you lead a round, you want that cap to align with your valuation of the startup. When you’re evaluating a deal, you want the cap, effectively the price you’re paying, to be less than what you value the company at.

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.

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 a proven ability to execute. A skilled team is likely to navigate the many challenges of a startup, increasing the probability of success.

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 one. Scalability, the ability to grow rapidly and generate high revenues with minimal incremental cost, plays a significant role, as does the uniqueness of the product, the startup’s competitive positioning, and the business model.

Traction. Traction (in terms of users, customers, partnerships, or revenue) can be a strong signal of a startup’s potential, helping to de-risk the investment and enhance valuation.

Three Valuation Methods

Opinions differ on which method to use. Realistically, the best option is to find the value using each method, then triangulate a true value. 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 Method is a future-based valuation approach. It 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. 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. This method relies heavily on assumptions about exit values and return multiples.

The Berkus Method, proposed by angel investor Dave Berkus, is more straightforward. 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. Its simplicity is a strength, but its lack of precision and 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 by setting an average industry pre-money valuation for pre-revenue startups, then evaluates the startup on criteria like management, size of opportunity, product and technology, competitive environment, marketing and sales 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 for navigating a tricky process. Angel investors typically combine these approaches, complemented by their own experience and judgment, to arrive at a valuation that balances risk and potential reward. It’s important to note that the negotiation between investor and entrepreneur ultimately determines the final terms, valuation is as much an art as it is a science.