How Do Angel Investors Value Startups?April 20, 2020
Most of the tried and true methods for valuing companies simply cannot be applied to startups. Why? They rely on data that must be accumulated over time as a company operates. This means that the older a company is, the more data can be analyzed on its past performance, the more accurately we can predict its future performance, and the more precisely we can arrive at a present valuation. However, startups, by definition, are just getting off the ground, so data on their performance hardly exists. Yet, for investors to allocate capital to the startup, a concrete valuation must nevertheless be reached. Putting a number on the value of the startup, after all, is the only way to determine how much of a stake in the company each angel investor’s allocation is worth. So how do they do it?
The short answer: by comparison. “Comparables” are far and away the favored method of valuation for startups because, despite a lack of data on past performance of the startup in question, comparing can indicate what the market is willing to pay for a startup that is ‘most like’ the one an angel investor is considering. But how to compare the startup in question to the market at large?
An angel investor does so primarily by determining the following:
- The size a company in your space needs to get to before his investment can be liquid (the size at which the angel can “exit”)
- How long it will take to get to that stage
- The value of other companies in your space at that exit size
- The total investments needed for your startup to get to that stage.
Let’s break that down with an (over)simplified example:
Imagine the angel investor estimates that your company needs to get to a size of $20 million before he can exit his investment. Now let’s say your startup, after six months of bootstrapping, can convince the investor that a $1 million cash injection is all you need to get to that $20 million size within the next two years. If the investor is willing to give $1 million for a 50% stake in the company, that would value your startup at $2 million as of today (and, assuming you reached the $20 million in value in two years, it would mean a 10x ROI for the angel over the two years).
Of course, this simple valuation is made more complex as we consider the potential for additional investment rounds which will dilute the angel investor’s original allocation.
Read more: Startup Funding Rounds Explained
Other factors that affect valuation
In the above example, another factor that will affect the startup’s valuation is how confident the angel investor is that the startup can get the job done. The angel investor’s willingness to allocate capital and the percentage of the company he expects to get from it, will ultimately be determined by assessing the risk/reward profile of the investment.
Here’s where the progress made thus far by the startup comes into play. This will include metrics like number of users, number of paying customers, growth rate, and so on. The more detailed the data, the less risk, and the easier it is to arrive at a fair valuation. Of course, particularly for very early stage startups, the data may be very sparse indeed. In that case, the angel investor will be looking more at the team. If the team has the experience and credentials in place, an angel investor may be willing to value the startup highly even though there isn’t much data yet in place.
Read more: The Essential Guide to Angel Investor Due Diligence
The final factor to consider when assessing the valuation of startups is market forces. For the industry in which the startup operates, what is the balance (or imbalance) between supply and demand of money? What is the size of recent exits? How does this startup stack up against the competition? What is the level of desperation of the entrepreneur asking for money? (is the startup quickly running out of cash?). These factors will determine the willingness of an angel investor to pay a premium (or not) to get into a deal.
Valuing startups is far from an exact science. Angel investors who have a lot of experience in a given sector are likely to know what “similar” companies are worth and what it will take for the startup in question to reach viable exit stage. From an entrepreneur’s perspective, the best thing you can do increase the perceived value of your startup is show investors that people love your product and are willing to pay for it.