VALUING: 3rd Fundamental of Early-Stage Investing
Valuing and Evaluation are close in the concepts and parameters they look at. However, valuing is as essential as an evaluation because it helps the investor determine the value or worth of the potential investment. While Evaluation helps an angel investor determine the overall potential and viability of a startup as an investment opportunity via review methods that assists angel investors in making an informed decision regarding the startup’s overall merit and prospects.
Conversely, valuing determines the startup’s value and considers financial indicators, market comparable, growth estimates, industry dynamics, and other pertinent aspects. A monetary amount or a valuation range are the most common ways to communicate valuing. It aids angel investors in estimating the cost of a stake in the startup that they are willing to pay.
As highlighted in the text, the five main approaches to valuing early-stage startups include, the Market Approach, the Cost Approach, the Asset-Based Approach, the Income Approach, and the Venture Capital Approach.
The authors outlined twelve distinct valuation techniques within these five frameworks, including the Scorecard Method, the Comparable Transactions Method, the Risk Factor Summation Method, the Rule of Thumb Method, and the Discounted Cash Flow (DCF) Method.
The most common approach to valuing early-stage companies is the ‘Discounted cash flow (DCF)’ method, which involves estimating the company’s future cash flows and then discounting them back to the present to get a present value; many early-stage startups tend to go with this approach to valuation.
Another method is comparing the company to similar companies recently acquired or publicized. The company’s valuation is based on the ‘multiples of revenue’ or earnings these comparable companies have traded.
A third approach highlighted in the text is ‘precedent transactions,’ which involves looking at the prices paid for similar companies in previous transactions. This can be a helpful way to get a sense of the range of valuations possible for early-stage companies. Another approach is through ‘expert opinion’ wherein the startup’s value is determined by consulting an expert, such as a venture capitalist or investment banker. Though considered a good approach when seeking a second opinion on the start-up to be invested in. However, not all expert opinions are accurate.
A last but not the least method is to base one’s valuation on ‘gut feeling.’ This feels like a risky way to go about valuation, but it can sometimes be powerful when an investor has mastered what to look out for when being prodded by ‘the gut.’ Sean Peek states, “As a business owner, you develop your sixth sense or intuition, which can be a valuable tool for helping you make good decisions for your company. Depending on your gut instincts allows you to access innate knowledge that’s not always consciously available”. However, every gut instinct should be followed up with quantitative facts.
The authors also highlighted twelve ways in which valuation can be done, including:
- Book value: Refers to the value of a company’s assets less its liabilities is its book value.
- Liquidation value: This is the price at which the company’s assets could be quickly sold.
- Break-even value: This is the sales volume the business requires to pay its expenses.
- Sales multiple: The ratio of the company’s revenue to the price at which it is sold.
- Earnings multiple: This is how often the company’s earnings are valued when sold.
- Free cash flow multiple: This is the quantity at which the corporation sells its free cash flow.
- Pre-money valuation:refers to the company’s value before the new investment.
While valuing is not the only factor in determining an investment’s success, it can significantly influence several factors that help the startup develop and succeed. Angel investors must consider additional elements such as market dynamics, the competitive landscape, company execution, and industry trends because valuation alone cannot guarantee returns.
Valuing attracts other critical parameters, including funding, investor confidence, talent, partnerships, influencing customer opinion, and media attention. When combined with careful due diligence, valuation is essential for enabling angel investors to realize significant returns on their investments in early-stage firms.
For the entrepreneur, it is about building a sustainable startup; for the investor, it is about gaining outstanding investment returns. To ensure a win for both sides, the angel investor and the early-stage startups need to align the valuing process with actual performance, growth prospects, and market realities.
Resources
- Amis, D., & Stevenson, H. (2001). Winning Angels, “The Seven Fundamentals of Early-stage Investing. Pearson Education Limited. Print.
- Sean Peek, “Business Decision-Making: Gut Instinct or Hard Data?” https://www.business.com/articles/business-decision-making-gut-instinct-or-hard-data/,Updated Feb 21, 2023, Extracted June 11 at 21.25 pm.
Dolapo,
I like how you address the distinction between evaluating and valuation right at the top of your post. It is important for both aspiring investor and aspiring entrepreneur to understand that both are necessary and vital pieces of the investment process.
It was fascinating to read about all the methods potential investors may use to valuate a prospect. I appreciate that you’ve chosen to highlight those that consider ways in which cash-flow can be accounted for, even if not quite proven practice or scale yet, due to the early stage of the business. I imagine that “crunching the numbers” – even just potential numbers – can help an investor feel more secure in their decisions.
After all, it would seem even an experienced investor appreciates some statistical and mathematical work to help support any “gut-feeling” they may be having. At the end of the day, angel investing seems to be quite a lot of risk, but not without calculation.
-Amanda
Dolapo, great post. Taking a broader scope to see the value the market is essential for a more accurate picture of the deal at hand. An investor should be ready to look at many different sides and also not forget the main side they were pursuing the deal. I liked that the book provided many tools on how to value a deal, based on what criteria, and train a future investor to know what to look for and what to steer clear of. Without proper valuation, an investor signs themself up for future disappointment.
Dolapo,
I enjoyed your post. One part that jumps out at me is the method of basing one’s valuation on “gut feeling”. I agree in that this seems like a very risky approach to investing. That said, unbeknownst to me at the time, I have based my business on a gut feeling I have about the luxury shoe category. I am letting it all ride on this gut feeling that will not go away. It is a main factor in my drive to make my idea successful. Since reading Winning Angels, I now know that this feeling is not just something that happens. It is a legit feeling that some angel investors use to make a move on an idea/business venture. Your post brings that feeling to life. Valuing, putting a value on the business idea/venture, allows angel investors to come to a decision on whether or not they will make the leap and invest.