As an angel investor you regularly get approached by startup founders with an ask for euro X investment at a pre-money valuation of euro Y. What does it really mean and how can you determine whether you are offered a good deal or not?
Since 1980s investors have been using a startup valuation method developed by professor William Sahlman from Harvard Business School. It consists of three elements or steps:
– estimate the terminal or exit value of the company;
– estimate the required future value of investment to provide the investor with a sufficient rate of return;
– estimate the ownership share required to achieve the targeted return.
Let’s take a hypothetical example. A company has developed a prototype of a new widget, performed market research and testing and strongly believes in its commercial potential. It is now looking to raise euro 500,000 to start manufacturing, marketing and selling the product. The founders believe that in five years time they can grow the business to euro 5 million in annual sales while maintaining a 25% ebitda margin. They are confident that by year six the company will be an attractive target for a strategic investor to buy. Recent transactions involving companies in similar businesses have been based on valuations of 10 times ebitda.
This startup is now looking to raise euro 500,000 at a pre-money valuation of euro 2 million and has approached you as an angel investor. The minimum investment size (or ticket, in the language of the startup world) is euro 10,000. You have done your due diligence and assessment (more on that in some future note) and feel comfortable with the investment. But is the valuation right?
To answer that you must decide for yourself what is the return you would expect from such an investment. You may believe in the business (would make no sense to invest if you feel otherwise!) but there, for sure, are risks involved. You will also have to hold this investment for five years at least. All facts considered, you may believe that the minimum acceptable return for this would be receiving five times your initial investment, or 5x, upon exit.
On the proposed terms your investment of euro 10,000 would get you a 0.40% stake in the company with a post-money valuation of euro 2.5 million (10,000/(2,000,000+500,000)). Having achieved ebitda of euro 1.25 million in year five the company can look for an exit at a valuation of euro 12.5 million (10 times ebitda). Your share of the proceeds from this transaction will be euro 50,000 (12,500,000 x 0.40%), which equals five times your initial investment. Or, using another popular metric to measure investment returns, your internal rate of return from this investment will be 30.8%.
In real life things seldom are as straightforward. For example:
– in most cases the company will need more than one round of capital raising. Unless you are prepared to participate in all of them to maintain your 0.40% share, your stake will get diluted in the process. Some sources suggest that it is reasonable to expect your stake to decrease by a half. Dilution is going to reduce your share of the proceeds and your return on investment to 2.5 times only.
– any estimate of an exit value is based on today’s information and comparisons. These may hold true after five years but there’s hardly any certainty about it. A lower ebitda multiple of 9 would reduce your return to 4.5 times initial investment.
– the company’s growth trajectory may be slower than envisaged by the founders. Delaying exit by a year (all other terms remaining the same) would still generate your 5x, but the internal rate of return will decrease to 25.8%.
Professor Sahlman’s formula establishes the fundamental links between your expected returns, your share in the capital and the company value. Any other constraints or complications can be added at will when analysing specific investment cases. My personal favourite advice comes from Paul Silva, a business angel: “A pre-money valuation of an early stage startup is whatever amount which is needed to give investors a 10x return assuming that the company does half as well as it projects in twice as long and having raised twice as much money as the founders today think they do need”.
This note was first published on Medium.com on 15 October 2023.
