Approaching Early Stage Valuation

By 2016-03-29Articles

by Jose Camacho

One of the the most – if not the most – debated topic when it comes to investing in startups is their valuation. Many methods and metrics have been invented to discover the value of a company at a given point in time, often subjective and subject to interpretation. The truth is that the price paid for a company or an investment, mostly reflects a consensual agreement, a common ground between the maximum price an investor is ready to pay for a perceived future value and the minimum price for which an entrepreneur is ready to sell its shares. if there is an overlap between both visions, the investment happens.

Reaching agreement on price demands more psychology and negotiation skills than technical analysis, this is even more true when it comes to valuing startups but one needs to start somewhere.

Size matters, but not only

In financial markets the price of listed companies is determined by the market, listed companies are generally very large,  established with recurring revenue and predictable margins. Hundreds of financial analyst are constantly looking at the stock price, for a company like Google it is not uncommon to see more than 2 million shares exchanged on a single day. Market price is assumed to be the best approximation to the true value of a company. Assumption that is of course limited as markets can be irrational as well.

Private companies are more difficult to value as the shares are not freely traded and there is significantly less scrutiny on them. For the large and established, it makes sense to compare them with other similar companies (for which we know the value). this method is generally called the comparables method, in which certain metrics are compared, for example the revenue, or the operating profit or EBITDA are generally established metrics to compare.

The issue arises when there is not much to compare, either because there is a lack of metrics (no revenue, no ebitda, no traction) or because the business model is so innovative that there are only very few companies that could be compared. Unfortunately angel investing combines both issues making the price discovery more complex.

What do do then?

Establish a basis of discussion and validate the rationale: generally, entrepreneurs have an idea of the value of their company  when they approach to investors either because of their expectations (which could be unreasonable) or because they have (hopefully) a better understanding of their sector.

Having a good understanding of the rationale for their valuation allows often to select those entrepreneurs that have done their homework.

Do your homework: While many companies claim to be truly innovative, disruptive and unique, chances are that they are not that different and it is likely that there might be a few others, perhaps far away working on the same product, service or type of customer. Nowadays, the abundance of websites tracking transactions and investments in early stage companies has reached an acceptable level of maturity in developed markets. there are a number of providers that can give access to valuable information and perhaps to identify similiar ideas or investments which can be used as a guidance for the value of the company you are looking at.

Ask your peers: People are generally happy to to disclose the performance of their good investments but not always happy to disclose the price they paid for it in the first place. However, it is generally a good practice to check with other investors whether they have seen comparable companies. Collective intelligence becomes very useful in these situations and one can learn a lot from others successes and mistakes.

Look at the big picture
Angel investing is about supporting great ideas with huge potential, keep in mind that you are going to support the entrepreneur in his journey. He is taking much more risk than you are and you are both hoping to win at the end. Identifying the right value at a given point in time is important but certainly less important than defining the strategy and executing the idea.

Some investors use the valuation discussion to educate themselves about the industry and discover the entrepreneurs vision and capacity.