288 UNDERSTANDING THE ANGEL INVESTMENT PROCESS

discussed briefly in the previous section. This calculation entails obtaining

the observed market value of a comparable company relative to earnings.

Herein lies the rub: What constitutes “comparable”? Some analysts use sim-

ilar industry, products, customers, ownership structure, or other factors.

Investors are also aware that entrepreneurs have many ways available to in-

fluence pro forma earnings forecasts (e.g., EBITDA) and still be within the

guidelines of generally accepted accounting principles (GAAP). EBITDA is

often used in earnings-based valuation calculations.

The discounted cash flow method of valuation is a derivation of the free

cash flows valuation method. Free cash flow valuation defines the value of

the company as the present value of the expected future cash flows in excess

of those needed to operate the company. The company™s value is a function

of the present value of its free cash flow discounted with the company™s cost

of capital, plus the value of the company™s nonoperating assets (e.g., any in-

vestments insecurities). The discount rate is a measure of the company™s cost

of capital.

The venture capital method of discounted cash flow is a concept based

on estimates and assumptions. Also, the calculations of net present value can

be effected in the venture capital method by qualitative, nonnumerical fac-

tors. The venture capital method is just another version of the discounted

cash flows valuation calculation, basically adapting the method to make it

more appropriate for start-up and early-stage ventures.

Central to the venture capital method is determining the future potential

of the venture. This is called the terminal value, the projected net earnings in

the terminal year or year of projected exit, multiplied by an appropriate mul-

tiple of earnings. For instance, the multiple might be the P/E ratio of a com-

parable company, appropriate for a company that has successfully achieved

the projected forecasts. The P/E ratio becomes the current market price of a

public company™s publicly traded stock divided by current annual earnings

per share amount.

Terminal value can be expressed as:

TV = PNI at TY — PER

where TV = terminal value

PNI = projected net income from projections for year of exit

PER = price-earnings ratio of comparable company

TY = terminal year”future year when investor™s shares are sold

As the reader can see, terminal value is measured as a ratio of financial

performance for a comparable company. The P/E ratio is applied to net earn-

ings to estimate a future value at the terminal year, usually estimated at three

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Valuation of the Early-Stage Company

to five years out. Also, it is apparent that forecasts and assumptions will

drive the accuracy of the calculation.

For investors attempting to determine how much of the company they

need to receive for their capital to attain their targeted return, the investors

need to now calculate the present value of the company. Whereas terminal

value reflects potential, present value equals the terminal value of the future

company minus the capital to get the company to that stage. Calculating

present value becomes a way to quantify risk to the investor, the time the in-

vestor puts into the company, the loss of the use of capital during the term of

the hold, and to some extent to compensate the investor for losses in other

deals. To capture this, the investor uses a discount rate obtaining present

value of future income streams. We have witnessed discount rates ranging

from 20 percent to 70 percent.

To calculate present value, the investor discounts the terminal value cal-

culated above. The discount terminal value is a function of the investor™s re-

quired rate of return. Converting terminal value to present value necessarily

involves the investor in determining his or her target ROI, for example, a five

times return in three years yields a 70 percent ROI, whereas a ten times re-

turn in five years yields a 58 percent ROI.

As we mentioned earlier, investors give projections a haircut. High-risk,

illiquid companies, requiring involvement for an average of up to eight years,

plus time, energy, and entrepreneurial optimism”all are reasons why in-

vestors indulge in this precaution.

Present value (PV) can be expressed as:

TV

PV =

(1 + ROI)Y

where TV = terminal value or annual net earnings projected for the

terminal year multiplied by the P/E ratio of a comparable

company

ROI = required or targeted rate of return

Y = number of years to exit

Once terminal value and discounted or present value has been com-

puted, a calculation can be made to determine the required ownership per-

centage of equity the investors will need to reach their investment return

objective. The minimum equity stake that investors will request can be ex-

pressed as:

A

=E

PV

290 UNDERSTANDING THE ANGEL INVESTMENT PROCESS

where A = investment amount

E = minimum percentage share of company equity required

PV = present value

We point out “minimum” equity stake required because most investors

will further correct this third calculation to compensate for potential dilu-

tion from future financing rounds, both expected and unforeseen. We will

discuss dilution factors in the next section. As you can see from these for-

mulae, the higher the ROI that the investor expects and demands, the lower

the company valuation will be. However, the high discount rate becomes the

primary means to compensate the investor for the loss of the use of his or her

capital, risk, or entrepreneurial errors, and still allow him or her a reason-

able return.

DILUTION

The next element that the prospective angel investor will consider during

valuation”in addition to desired returns and time to liquidity, discounting

of projections, and clarifying multiples”is an assessment of how much ad-

ditional capital a company will need to get to the point that the envisioned

liquidity event can or will occur. More often than not investors are skeptical

about an entrepreneur™s claims of what it will take to get to break even and

to the point that operations and growth can be funded from internal cash

flows and traditional credit lines. So the prudent investor will create a dilu-

tion factor to compute into the valuation process.

While dilution may not be at the forefront of every valuation calcula-

tion, many angel investors have learned from painful experience that entre-

preneurs rarely, if ever, perceive that the company will need a lot more

capital than anyone had estimated. Just a little calculation will help investors

understand that for their investment to obtain their targeted and justified

rate of return, they need X percent of the company. If the entrepreneur has

miscalculated, and significantly more money is needed than has been pro-

jected, investors will suffer significant dilution and fail to make their targeted

rate of return. That is why dilution is rarely separated from negotiation of

deal structure by investors to protect the individual investor™s share, should

more money be needed later.

Less experienced angel investors commit a relatively common oversight

in their failure to recognize the difference between premoney and postmoney

valuations. Valuation of the company is called “premoney” because the

value was established before taking into account new investment. In other

words, the value is based on a view of the current climate for the company in

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Valuation of the Early-Stage Company

a specific industry or based on current revenue and some multiple of pro-

jected revenue for the year. For instance, if a company has a premoney valu-

ation of $10 million, the angel investing $1 million would purchase 10

percent of the shares of the company outstanding before it issues shares

to the investor. When the $1 million investment is added to the $10 million

premoney valuation, on a postmoney basis, the investor will hold approxi-

mately 9 percent of the outstanding shares of the company, with a post-

money valuation of $11 million.

Though no statistically valid research is currently available, our anec-

dotal research gleaned in speaking with almost 4,000 entrepreneurial com-

panies suggests that 90 percent of the deals worked out will need more

money than originally projected. The result is dilution, best explained this

way: If a deal calls for $1 million, 12 months later it will need more money.

An investor with a 40 percent ownership for the first million dollars is faced

with three options, if, say, another $500,000 is necessary. The investor can

put in $500,000, or he can put in a portion of it, or he can choose not to put

in any more money at all, in which case, to survive, the company has to raise

the $500,000 from somewhere else.

With all three options, the investor suffers dilution. He has to put more

money in to maintain his 40 percent ownership, or his stake will shrink.

Come liquidity, how much of the company will the investor own? The an-

swer is that the investor will own less than when he started out. This illus-

trates the dilemma a company creates when it needs additional money. This

scenario dramatizes dilution”something else that investors seriously ponder

during the valuation process.

How can the investor arrive at a dilution factor? As an example, let™s

say that the investor and entrepreneur agree that the company can achieve

$2 million in earnings in three years. They also agree that in three years buy-

ers can be found who will pay 20 times earnings for the company. Therefore,

based on these assumptions, in three years the company would be worth $40

million (that is, 20 — $2 million = $40 million). Let™s also assume that the in-

vestor has offered to invest $1 million, and he has decided to seek a 30 per-

cent return compounded annually over the time period. What percentage of

equity in the company does the investor require in order to obtain the tar-

geted ROI? Using his handy calculator, he determines that the present value

of the company is $18,206,645”$40 million/(1 + 0.30)3”and that the $1

million investment requires a 5.5% equity stake in the company ($1 mil-

lion/$18,206,645).

However, the investor not only needs 5.5 percent equity in the company

today, he needs 5.5 percent in equity three years from now as well to ensure

the return. Here the dilution factor comes into play. If the investor is uncom-

fortable with management™s forecasts and determines that more capital may

292 UNDERSTANDING THE ANGEL INVESTMENT PROCESS

be needed than is projected, he can incorporate a dilution factor into the eq-

uity share calculation.

Let™s assume that the investor estimates 20 percent more capital will be

required than management projects. To protect himself, the investor must in-

crease his equity ownership percentage to ensure that in three years he will

attain the targeted return. The investor must therefore correct the 5.5 percent

equity percentage figure to account for the increased capital that will be re-

quired. This is accomplished as follows: 5.5 percent = 80 percent X (where

X = equity share, corrected for dilution). The 80 percent figure is derived by

subtracting the 20 percent additional capital required from the original 100

percent of value. Therefore, the investor will seek a 6.9 percent equity share

(5.5 percent/0.8 = 6.875) to ensure his 30 percent return in three years. The

dilution factor accounts for unanticipated needed capital.

TRUISMS IN THE VALUATION PROCESS

Entrepreneurs must grasp some truisms regarding their position with in-

vestors. Be convinced of the merits of the opportunity before discussing val-

uation. Also recognize that demand for capital greatly exceeds supply;

embrace this leverage in favor of investors during valuation negotiations.

Furthermore, understand that investors always discount projections, so run

your own cash flow forecasts, paying particular attention to unforeseen

follow-up financing requirements. And remember, in the past five years,

fewer than two percent of venture-backed exit transactions have been

through IPOs.

It is worth taking a closer look at some of these truisms.

First, prospective investors will not necessarily share the entrepreneurs™

level of enthusiasm for the project. Investors must be thoroughly convinced

of the merits of the opportunity before any discussion of valuation or terms.

Entrepreneurs have to understand that sophisticated investors are besieged

with projects. Investors could look at business plans seven days a week. A

project may soak up 100 percent of an entrepreneur™s life, but it constitutes

only one more business plan on an already prodigious stack of business plans

as far as the investor is concerned. So entrepreneurs have to adjust their

mind-sets; they have to concentrate on selling the investor on why this ven-

ture is a great deal. Also, entrepreneurs sometimes become upset because an

investor fails to jump at a project; they fail to realize that the investor may

have invested in three similar projects, each of which turned sour. As we

mentioned earlier, for most early-stage enterprises, the demand for equity

capital largely exceeds supply. Consequently, investors have substantial

leverage in valuation negotiations.

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Valuation of the Early-Stage Company

Second, entrepreneurs must allow for the high degree to which investors

are risk-averse. Some entrepreneurs think that venture capitalists love risk.

But investors who do are not investors for long. No investor, especially no

professional venture capitalist or sophisticated angel investor, is in the busi-

ness of jauntily taking a flyer. No investor is interested in floating out there

on gossamer wings. To the wise investor, a venture must be built on tresses

and struts. The way investors stay alive is by minimizing their mistakes. So

entrepreneurs, along with everyone else, need to cast off the misconception

that early-stage investors love taking risks. Investors try to manage risk

against return. But the popular notion of investors lovingly embracing risk is

hogwash.

A third truism is that investors will always discount projections in re-

viewing a proposal. The management principals of early-stage enterprises

rarely forecast cash requirements accurately, not because they are bad man-

agers, but because the situation is fraught with circumstances beyond their

control. As we have suggested, nearly all new deals need more money than

their management team had thought. Such discrepancies between hope and

reality are woven into the fabric of building dreams. The fictional Willie

Loman, Arthur Miller™s failed salesman in Death of a Salesman, is eulogized

this way by Charley, his sympathetic next-door neighbor: “A man has got to

dream, boy; it comes with the territory.” But Willie failed to realize that some

dreams must come to earth. Unforeseen follow-on financings are a fact of life

in early-stage investing. Follow-on financing weighs heavily in the valuation

process. When entrepreneurs say $1 million and no more will do the job, so-

phisticated investors are thinking otherwise”and with good reason.

Another truism: Acquisition or buyout is the predominant method for

achieving liquidity for small company shareholders. We have already pointed

out that the primary method of achieving liquidity is not IPO”far from it.

But the misconception remains. Too often, entrepreneurs and their business

plans say they will take their company public in five years. Given the current

IPO market and its prospects for recovery, odds are that such an event will

not occur. So entrepreneurs need to consider how that investor is going to

achieve liquidity.

Axiomatic is the truism that any valuation becomes irrelevant if the ven-

ture does not survive. Survival, survival, survival”in private investing the

word rings like a Buddhist mantra. As we have reiterated, smart investors are

risk-averse. The foremost thing they want to know is not what their ROI will

be in five years, but whether the company will survive at all. Entrepreneurs

can talk glory, displaying the infamous hockey stick projection extending