For those of use entering the world of angel investing with a background in evaluating publicly traded equities, the valuation process for this investment class can be a real challenge. PE multiples and comps are very difficult to apply to companies that are not only pre-earnings but in many cases pre-revenue. The earlier the life cycle of the company, the less data points exist to determine a reasonable valuation.
In this post, I will outline some of the valuation methods you may want to consider for evaluating these early-stage investments (Note: please click on the title links to learn more about these methods):
The Berkus Method: First published in the mid-nineties by Dave Berkus, this method basically enables the company to earn it’s valuation based upon five parameters which include: the quality of the idea, the prototype, the management team, strategic relationships and stage of product roll-outs. For each of these parameters, the company can earn up to $500,000 implying a maximum valuation of $2,500,000.
The Scorecard Method: Also referred to as the Bill Payne Method and the Benchmark Method, the Scorecard Method was developed by Bill Payne to determine the valuation of pre-revenue companies. The first step in applying this method is to establish the average pre-money valuation of comparable pre-revenue companies which share the same region and business sector. Once the average valuation is established, this method allocates that value to seven components which consist of: quality of the management team, market opportunity, the product/technology, the competitive environment, marketing and sales, need for additional financing rounds and “other” factors specific to the company. The third step is to compare the target company with the “average company” against each of these parameters to come up with the valuation. This link provides a valuation worksheet for this methodology.
The Venture Capital Method: The term Venture Capital Method was first used by Harvard Business School Professor William Sahlman in a 1987 HBS Case. This method involves forecasting a future/terminal value for the target company and then discounting that value back at an appropriate hurdle rate to come up with a current valuation. The terminal value is determined by applying industry multiples to projected future revenue and earnings streams.
Whichever method or methods you chose to incorporate into your valuation of a potential angel investment, the return you will able to achieve on your investment will be based on:
- What dollar amount you invest (current and follow-on rounds)
- When you exit
- The exit valuation
- The percentage of the company that you own at exit ( remember for many of the companies in your portfolio, subsequent rounds of investment will be required to grow the company to exit)
- The type of security that you own (common stock, preferred stock…) and any liquidation preferences which may impact the distribution of sale proceeds