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A stylized but accurate reflection of the direct relationship between market
value and stage of development.
High
Market Value




Low
Start-up Development Revenue Profitable Public
Stage of Development
Figure 13.2 Valuing the Venture over Time


ital; and (4) the shorter the waiting period to liquidation, the lower the risk,
and thus the lower the share of equity required to purchase any given
amount of capital.
In addition, remember that investors will most likely seek opinions from
their network of co-investors in order to obtain the bids of other respected,
experienced investors. Estimates from others that reasonably approximate
an investor™s own appraisal can increase confidence in a valuation assess-
ment.


INVESTOR INVOLVEMENT
Especially relevant to the angel investor is the degree of involvement in the
company that the investor will take after he or she invests. It™s natural for
former entrepreneurs, now angels, to become active in a company in which
they invest; for example, as director or consultant, or even in an operational
management role. If the investor can have some degree of influence or con-
trol (control being the operative word here) over the direction of the com-
pany, most would be inclined to give that company a higher valuation,
because they are involved. Conversely, if the investor is a minority share-
holder, that is, a passive investor vulnerable to the whims of the entrepreneur
and especially other investors (who may come aboard in future financings
and gain control of the deal), he or she will most likely place a lower value
on the company.
284 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


The level of involvement by the investor will dictate the degree to which
that investor will perceive that such involvement lessens the risk in the deal.
No involvement other than reviewing periodic reports and attending meet-
ings (i.e., a passive involvement) will probably not be seen as lessening risk.
Providing advice or counsel as needed and requested will not have an impact
on risk. However, representation on the board of directors, working full- or
even part-time with the company and, in some cases, joining the founders™
team as a member will most likely be perceived as reducing risk, if the in-
vestor is experienced and knowledgeable in the industry and possesses the
necessary functional skills needed by the company.


CORRELATING RATE OF RETURN
WITH TIME TO LIQUIDITY

Once the investor has looked over the deal and feels comfortable with the
risk, he or she is in a position to develop an expected or desired range of re-
turns. Next, based on due diligence and deal structure negotiations, the in-
vestor can estimate the amount of time to liquidity. In the case of the
early-stage company without cash flow, earnings will likely come at some fu-
ture date.
Investors correlate time to liquidity and expected rate of return, so that
the longer the period of time until liquidity, the more the investor expects as
a return. The higher expectation helps justify to investors their increased in-
vestment risk and the loss of access to his capital. But seed, R&D, and
start-up companies rarely, if ever, have cash flow or earnings, so calcula-
tions are used to deduce valuation, which will necessarily involve projec-
tions and estimates, reasonable targets, and realistically attainable targets.
This is especially the case since technology companies derive their voracious
appetite for capital from the same growth rate that lets them offer high
potential investment returns. So early-stage technology companies are loath
to pay dividends or interest during the term of the investor™s hold. Instead,
these companies will reinvest any cash surplus into their own high growth.
Again, liquidity, return on capital, or investor profit is dependent on an un-
certain future.


MULTIPLES

Another consideration that enters into the investors™ valuation calculation is
the multiple that future buyers will be willing to pay. Investors will rely on
estimates of future net earnings and comparable cash flow multiples in cal-
285
Valuation of the Early-Stage Company


culating valuation. In addition, investors will attempt to be realistic in their
targeted level of returns.
The investor will try to get a feel for what the market will bear, regard-
less of the liquidity mechanism. For example, the investor might say, “If I in-
vest for X years, I™ll need to make Y times my investment.” What all markets
pay can be measured as a multiple of the original investment. Of course, we
are talking about the probable price here, not the highest price. Identifying
other companies in the same industry with comparable market value is not
an exact science.
To begin this comparative analysis, the investor will, we hope, use re-
ports that explain valuations in completed mergers and acquisitions. IPO
data are also readily available in the public domain to help calibrate market
value conditions. These reports indicate what multiple of earnings, cash
flow, or sales is typical in valuations of other private and comparable firms in
the industry. While this approach may seem to be based more on intuition
than on objectivity, it can provide the investor with benchmarks and guide-
lines on current market value. The key is using comparable companies!
In ICR™s own research, we see investors targeting multiples of five to ten
in seed-stage, three to six in start-up, and two to four in development-stage
companies. In contrast, institutional investors are targeting multiples of ten
for start-ups, four to eight in the development-stage, and three to five in prof-
itable-company investments. It is important to note here that the angel and
institutional investors are not evaluating the projected performance of an in-
vestment using ROI. Instead, they measure how many multiples they can
make on their money over what period.
One calculation used by investors is the premoney comparables method.
The investor observes other private equity or venture capital transactions to
find out what other premoney valuations are currently being given by in-
vestors to companies with similar characteristics to the venture investment
they are considering. In other words, how are these deals priced? The in-
vestor might use public stock multiples, price-earnings (P/E) ratios, and/or
merger and acquisition sales values. This helps the investor develop an as-
sortment of acceptable values for negotiation purposes. The investor can
then estimate the required current equity ownership percentage by dividing
the investment amount by the premoney valuation plus the investment
amount.
Rates of return on early-stage venture investments are time sensitive.
Sophisticated investors spend time and energy considering liquidity”that
is, how they are going to get out”before they invest. Exhibit 13.3 shows
what happens to ROI over different time periods for a given multiple on an
investment.
You can see from Exhibit 13.4 how important it is to the early-stage in-
286 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


10
9




100




35
30
28
90




26

24
50
45
80
70

60




40
8
22
7
20
6
19
Ratio of Final to Initial Value




18
5
17
16
4 15
14
13
3 12
11
10
9
2 8
7
6
5
4
3
1
0 1 2 3 4 5 6 7 8 9 10 11 12
Time to Liquidity (Years)

Figure 13.3 Correlating Rate of Return with Time to Liquidity


vestor to achieve liquidity as soon as possible and realize the gains. ROI as-
sociated with higher multiples typically requiring longer hold times clearly
do not justify the risk exposure of longer-term investments.


DISCOUNTING PROJECTIONS
As a group, entrepreneurs rarely achieve projected sales as soon as expected,
and they incur more costs than anticipated. Therefore, they usually need
more capital sooner than they anticipated. Start-up companies ordinarily re-
quire several rounds of funding before they become financially mature
enough to qualify for sale, merger, acquisition, or IPO. This entrepreneurial
planning failure boils down to dilution for the angel and a negative impact
on returns. One technique the investor uses to ensure his percentage owner-
ship when he analyzes projections for valuation is to give them a “haircut.”
In other words, successful angel investors are skeptical and always dis-
count projections and develop their own cash flow models when they con-
sider an investment proposal, paying particular attention to the possibility of
unforeseen additional financing needs. The principals of early-stage enter-
prises rarely forecast cash requirements accurately, not because they are bad
managers, but because the situation is fraught with circumstances beyond
their control. When entrepreneurs say $1 million absolutely will do the job,
287
Valuation of the Early-Stage Company



Internal Rate of Return on a Multiple of Original
Investment Realized Over an Assumed Time Period

Multiple
Years 2 3 4 5 6

2 41 73 100 124 145
3 26 44 59 71 82
4 19 32 41 50 57
5 15 25 32 38 43
6 12 20 26 31 35


Figure 13.4 Correlation of Multiple over Hold Time



sophisticated investors are thinking otherwise”and with good reason. The
sophisticated investor™s mental cash register is clicking away as it adds num-
bers to the entrepreneur™s modest valuation appraisal.
Angels discount the optimistic entrepreneur™s projections by 25 percent
to 33 percent or more when they calculate venture valuation, and the entre-
preneurs have been willing to give away more equity to get the investor™s cap-
ital. Present-value formulae, which we will present shortly, for calculating
value incorporate a discount rate, using interest rates combined with a risk
allowance to discount cash flows. Entrepreneurs need to remember that in-
vestors will not forget that they have substantial leverage in valuation nego-
tiations, especially for smaller deals in today™s market that do not meet the
criteria of institutional venture capitalists. Whereas a venture capitalist or
angel might use a risk premium of 39 percent for an early-stage equity deal,
an institutional investor scheming a traditional debt private placement might
limit the discount to 18 percent.


VALUATION METHODOLOGY USED IN EARLY-STAGE,
PRIVATE EQUITY TRANSACTIONS
While a number of different financial calculation methods are available, not
all are applicable to early-stage ventures, and their applicability varies.
Asset-based valuation rarely applies since most early-stage companies
have few tangible assets. Some analysts suggest replacement value may be
substituted; however, you just end up with the sum of replacement costs of
what assets are tangible. This is more a reflection of the cost of buying assets,
not a fair market value estimate.

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