Digital Ventures

Valuation has to be one of the most contentious and fought over topics in funding as a whole and in particular when raising angel funding. Typically both parties always want a good deal and this is where the law of supply and demand comes in.

The golden rule: the value of anything is what someone else is prepared to pay!

In most cases there are a lot more people chasing money than there are people to provide it this means that funders have the upper hand. However, if you have a proposition in a hot area and have the funds to take your time in negotiations you can turn the tables.

Angels are rightly trying to maximise their investment as it tends to be at a very risky stage of any business and also to mitigate for any dilution down the road, another big fear. The issue is often when they try to beat up the valuation to a level where it reduces the incentive for the management and founders.

Also, it can often be a macho thing where angels want to be seen to be doing aggressive deals and getting into deals on the cheap this is made worse by the odd valuation rules of VCTs, VCs and funds, especially in the UK and Europe.

Another key to a good valuation is to have a business that can get a US style valuation early stage companies are much more highly valued in tech in the US, mainly as exits are more readily available and these are at much better multiples than in Europe.

From an entrepreneur’s point of view, it’s critical to remember to get a balance between all the time and hassle it takes to raise funds and the valuation try to raise money as a sensible value for all parties and get the deal done.

Don’t let your ego and the need to own as much of the company as possible get in the way of getting good funding partners and the cash to get your business moving and actually towards an exit. Only when you exit will you make any money at all, a smaller piece of a pie than has a decent value is much better than all of something worthless.

Don’t forget that too high a value can also hurt you later if you need to raise new money and times are hard, in this case you may have to do it at a much lower value (a down round) and this will really upset everyone and get you back to square one focus on a win-win deal.

Don’t be bullied into a bad deal however, and don’t listen to accountants and UK metrics if you have a hot business leverage the golden rule get as much demand as possible for your shares and then use this to drive up the price. Try to find reasonable valuation comparables in your spaceand stage of business and use this as a benchmark.

So how do you value a business?

Valuing a privately held business depends on many variables that mesh together in a complicated analysis that is both an art and a science. While there is no one right method to use, valuation professionals apply certain methods depending on the type of business, the methods typical to your industry and then a combination of those methods are applied and averaged with more or less weight assigned to methods based on their usefulness. Some of the commonly employed business valuation methods include:

Industry rule of thumb method. This “ballpark” method compiles statistics on a given type of business sold during a specified time period and then calculates an average of all the selling prices. The method works well for average-performing business, but not so well for those falling outside the average.

The Book Value method. This method is based on a business’s accounting records, whereby liabilities are subtracted from tangible assets, such as stock, equipment and property. Variations of this method may be applied to make adjustments for intangible assets, such as patents owned or deferred financing costs, and various market factors not reflected on a financial statement that also affect a business’s value.

Capitalized earnings method. While there are variations of this method, “capitalization” is essentially based on the expected return on investment. In effect, the investor determines the rate of return for assuming the risk to operate a business, whereby the amount of risk is proportionate to the amount of return required. Then the business’s profit/earnings (based on the current or projected year or three-year historical average) are divided by the capitalization rate. The value of
the business subsequently depends on the investment amount required to earn the desired rate of return.

Multiples method. There are two commonly used multiples methods. “Sales” multiples are based on a business’s annual sales and an industry multiplier value (Often used to determine the valuation ceiling for a business).

“Profit” multiples are based on Nett profit (or earnings before interest, taxes, depreciation and amortization – EBITDA) and a market multiplier.

None of the above is the final word

While these methods are useful, they still don’t paint a complete picture. No valuation formula can account for every variable that comes into play, such as: company size, industry, customer base, growth potential, competitive positioning, product mix, technological capabilities, and management talent. Often a business’s value to a particular buyer or investor is in excess of all these valuation methods when there is an important synergistic value or competition to buy into a business.

The key to a premium as ever is more than one bidder!

1. They want to see a project that solves an identifiable business problem rather then see an elegant solution to a problem that doesn’t exist.
   
2. They want to understand why your solution gives an “unfair” advantage in the market place, and that the company is positioned correctly both in the market and the industry.
   
3. They want some sort of external confirmation of the efficacy of the solution.
   
4. They want to know all about the team, their skills, experience and motivation to deliver the project
   
5. They want to know what has been achieved so far.
   
6. They want to know what is needed to get to cash self sufficiency, what investment will be spent on and what milestones can be used to measure progress.

The sales collateral is the business plan and the presentations to the customer, the investor.

From an Angel point of view, the valuation of the company will be determined by:

1. They credibility of the management team
2. The chemistry between the entrepreneurs and the investors
3. The validity of the proposition and how it is presented
4. How well the entrepreneurs understand the needs of the investor
5. And on the negative side, how desperate the need appears to be

Based on all this the investor will take a view as to the future value of the company, the funds needed, the length of time to exit and the return required to reflect the risk. They may take into account prospective dividends, loan repayments and interest if loan capital is taken into the structure of the deal. They will also take into account the human factors associated with any negotiation.

Which way is the best way?

In the end it will often come down to personalities and triangulation between several factors to agree the final value that makes everyone happy.

Remember financial people usually need a justification for everything and this includes why they paid the agreed price at the time. They will want to refer to this later if you need to raise more money and also as a justification to others.

An interesting juxtaposition with the US market shows that US investors have many things in common with UK/Europe
an Investors but their way of valuing businesses can be a lot more casual and shoot from the hip than the accounting based models here.

Valuation, a US angel perspective:

Angels price your company based on its potential capital return in the future. The share of the potential gain they ought to get in return for their investment depends not only on the amount of money they contribute but also on their time, reputation, contacts, and opportunity costs (that is, money they might be making doing something else).

By the same token, your company’s future returns to the angels are not just financial. Your angels could also enjoy such intangibles as the excitement of launching a start-up, a sense of contributing, and an opportunity to give something back to the entrepreneurial world.

Most commonly, angels value a company at a lower price than the entrepreneur would. For example, let’s say you have a young company that’s presently little more than an idea and a team.

From the angel investors’ point of view, ideas are cheap. It’s the execution that adds value. And potential investors haven’t a clue, at this stage of your company’s life, whether you and your team will be able to execute.

While every deal is different, here is a valuation model that was created by Dave Berkus, a full-time angel and founder of Berkus Technology Ventures LLC, in Los Angeles. (See box, below.)

What’s your fledgling company worth?

So now you know how angels are likely to value the deal. Price your company accordingly. Of course, you can always ask for more. The risk? You won’t be taken seriously.

A final word:

If you follow the golden rule and do the groundwork to get interest in your business from many parties then you will have the option to control the terms and value.

If you leave it so that you need the money and are in a corner (the usual approach) then you will have the value thrust upon you you decide.