How Does An Angel Do Valuation?

(With thanks to Mark Witt for the question!)

Well, in truth, it is often a guess.  Along the way both of us gain an understanding of the way this potential relationship might evolve. 

Most often the discussion begins with two simple ideas - how much money the business needs right now to achieve planned growth to the next step, and what percentage of the equity the entrepreneur is willing to "sell" for that cash.

(In general this is not a discussion about technicalities, but this one bears mentioning.  The cash goes into the company and the stock "sold" is created by the company for the event.  It is not cash that goes to the entrepreneur, of course.)

There are then two sets of discussions here.  The entrepreneur is trying to value the current enterprise and the angel is trying to determine if the business can successfully meet his expectation of return. 

On the entrepreneur's side, especially if this is a first valuation, there are sometimes issues of the value of the startup cost and the "sweat equity" in the company.  If the entrepreneur is proposing $500,000 for 15% of the company, the implication is that the company is worth $3.3MM.  How either party really figures out what the value is today is a difficult question.

The more important question is one of total value. 

Let me start with a method to "ballpark" the outcome and see where it takes us.

Suppose in the above example that the entrepreneur feels that in three years he will generate EBIT (Earnings before Interest and Tax) of $1MM, and that companies in his industry seem to be selling for 12 times EBIT.

That would make the company worth $12MM in three years.

Fifteen percent of that is $1.8MM, which, under the investment terms above, would be the investor's share if the company were sold as described. 

Now let's consider the investor.  She feels that a 50% internal rate of return is a good benchmark.  At the end of year one following the investment, that would be 1.5 times her investment; 2.25 times at end of year two, and 3.38 times at end of year three.

So the ballpark return the investor expects is 3.38 x $500,000 or about $1.68MM.  If the investor agrees the projections make sense and are achievable (and especially if she can add value and help make them come true,) we have a deal.

Let's also suppose that the entrepreneur invested $200,000 in starting this company in cash, and feels emotionally that the idea and the early execution is worth a lot.  He has foregone a job and taken a lower salary, perhaps even guaranteed some debt.  How did he do on his $200,000?  Well, it returned him a bit better than $10MM on his $200,000.  (This assumes when the company is sold there is no debt owed to anyone that would come out of the proceeds.)

That works out to $3MM per year.

Were life only so easy, of course.  There's a lot of execution required between here and there and a thousand variables. 

Also, in negotiating this agreement, both parties are going to have to talk about the kind of investment instrument to use (common, preferred, debt with warrants) etc.

However, those are probably subjects for another time.  Thanks for the question, Mark!

 

Comments

[Paul Galland]

Great subject Tim. I hope you will touch on the angel's harvesting / cash-out aspect in another article. Especially as cash out means less money for the company itself.