When it comes to valuing a startup, some people say it is more art than science or that you are really taking a shot in the dark. Many angels will start with where the company is today and try to determine a valuation based on the current condition of the startup. They may start with a low valuation and add to it depending on where the company is in its process – i.e. Do they have early revenue? Do they have stable customers? Are they profitable? etc.
Experienced angel investors, on the other hand, start with the end in sight and work backwards. They start with an expected return – usually between 5x and 10x their original investment in a three to five year timeframe – and then look ahead at what the future value of the company must be to get that return. They will use today’s condition to determine whether or not they believe a company can reach a future condition that will provide them with their desired return.
How do experienced angels use that method to come up with a valuation for the company? Here is an example.
Let’s say you have an investment opportunity, and the company in question is trying to raise $200,000 for 10% of their company. That means they think their company is worth $2,000,000 ($200,000/.10).
If you invest $200,000 in exchange for 10% and you expect to get $2,000,000, or 10 times your original investment back, then the company must be worth $20,000,000 in the future for you to get your 10x return, as you own 10% of the company ($20,000,000 x .10 = $2,000,000).
You may take a look at their projections and determine that there is no way that you think their company will be worth $20 million in three to five years. But maybe you think that it is more realistic to believe that it will be worth $10 million in three to five years (how to make that determination will have to come in a later blog post).
If that is the case, then in order to get your 10x return on your original $200,000, your investment would still have to be worth $2,000,000, but that is now 20% of the future expected value of $10,000,000, as opposed to 10% of the original expected exit of $20,000,000, which you found unreasonable.
So you will ask for 20% in exchange for your $200,000. That way, if the company has a $10 million exit as you expected, you will get your 20%, or $2,000,000, which would be a 10x return on your original investment. Nice job!
That is an example of how experienced investors will value a company. It is an overly simplified example in that we did not look at any financials, we did not talk about how to estimate the future value of a company based on those financials, or the types of deal terms that will ensure your stake is not overly diluted, but it will give you a basic understanding of the first step in negotiating your investment.