Angel Valuation & Return

How can an angel value a company that has no revenue or customers?  There are a couple ways that have been devised but none is very good.  Still, angel investors want to make investments so they have to work with what they’ve got.

In truth an angel doesn’t have to do a valuation calculation.  Most angel rounds these days are notes that convert into preferred shares when a VC comes along and provides a “professional” valuation.  This works because the angel gets some interest (which is nominal but better than nothing) and then gets to convert into preferred at typically a higher valuation at a time not too far into the future. Also, the preferred might be at some discount (say 20%) to the price the next investors are paying.

However, angels should want to do a couple high level valuation calculations so that they can get a ballpark estimation of expected return.

First things first… the practical determinant of valuation is always the market.  If the market is hot the valuation will certainly be a little higher.  But beware, markets are cyclical.

Median – the median pre-money valuation of venture capital seed-stage enterprises has varied annually over a narrow range between $1.7 million and $2.5 million since 2002.  Experienced investors will compare the calculation of other methods to the median as a check for reasonableness.

Berkus Method – this method starts with a valuation of $0 and adds $500,000 for each of the following items:

  • Good idea
  • Prototype built
  • Good management team
  • Strategic relationships in place
  • Product at rollout or early revenue stage

That means the top valuation should be $2.5 million.  Sound familiar?

Scorecard Method – choose factors (team,  TAM, technology, etc) and assign a weight so the factors add up to 100%.  Then rate the startup on each factor with 100% being the norm (ex. a strong team might get 125% of the norm).  Multiply each weight by the factor value and add them up.  This sum is a multiple that gets applied to market rate for pre-money.  For the NYC area the recent median has been $2.0 million. As the example below shows, the pre-money valuation is $2.25 million.

Discounted Cash Flow (DCF) – DCF utilizes cash flow projections plus a terminal value for the business in future years, discounting them to the present as Net Present Value – the higher the risk, the higher the discount rate.  If you really want to use this method go here.  But I wouldn’t for two reasons: first projecting 5 years of cash flows of a startup is ridiculous and second, I recently did this for a company that has been in business for several years (going for a series C) that had great projections and the partner I was doing this for said,”we don’t really use that in venture. the P/E guys do and the public equities guys do, but we don’t.”  That’s good enough for me.

So that is a good place to start on valuation.  What about angel return?  Here’s a couple things to keep in mind.  The basic rule of thumb is angel investors are targeting 5 to 10 times return on their money in 4 to 8 years.  See the table below.


So what does this mean?  It means angels are seeking investments that can grow revenues to at least $50 million within four to eight years on a median valuation.  It means they are expecting a market value of the company in excess of $100 million.  And that building companies with revenues sufficient to create $100 million in market value in four to eight years typically requires much more capital than is normally invested in seed/startup rounds, or in other words, the angel investor is going to get diluted. Dilution sucks, but it is a necessary evil.  That is why angels need to be disciplined and frank when dealing with entrepreneurs they are going to back.

It gets harder… angel investing follows the 80/20 rule.  80% of the return of an angels investment portfolio are going to come from 20% of the investments (sometimes even less).  So the really do have to be home runs to make up for the ones that didn’t work out.

Plus, there is an early negative return bias.  The other day one of RTPs partners mentioned the old adage “lemons sour quickly”.  That means early on (about 2 years) in an angel investment portfolio, the angel investor will probably know what investments won’t work out, but it might take 8 years for the really great companies to develop. So an angel is losing money for a long time until all of a sudden there is a nice return.  Or not.

Here’s some more resources to help you think through valuation:

Angel Capital Association
Angel Resource Institute
Bill Payne Angel Valuation Analysis
Dave Berkus Method
Common IRR’s and their multiples
The VC Method