Due Diligence

The Great Valuation Myth


Some years ago I was asked to assist a life science start up in Scotland with their valuation. They had an interesting technology, and had received interest from potential investors. There was however a significant difference between the valuation that the investors were willing to provide and the valuation that had been calculated on behalf of the start-up by a firm of professional accountants using a mathematical method.

Remember, this company did not yet actually exist, other than as a project, in theory, and a few pieces of paper in somebody’s bedroom.

The Mathematical Valuation Method – the accountants had taken the forecasted profits of the company over the future three years, and divided this total by provided by three in order to come up with a “weighted average” profit for the company over a three-year period. They then deducted 60% on the basis that this was a “projection” of profitability. Why 60%? Who knows? There really was no logic to this, just the selection of an arbitrary discount number. It could as easily have been 50% or 70%, (or 100%, given it remains unprofitable to this day!).

The accountants then produced a price earnings value (PE value) arrived from an unnamed and unidentified publicly quoted life science-based company from the London stock exchange. The PE ratio is a calculation of the earnings a company is making divided by the price at which it is currently quoted on the stock market. Fundamentally you multiply the earnings by this number to arrive at the value of the company. They chose a company with the PE value of 8.5. Again this is entirely arbitrary and we have no idea the validity or comparison of this quota company to that of the start-up.

Thy then discounted the PE value by 25% because of “marketability” (i.e. if you invest in the start-up you can’t sell the investment very quickly, whereas you could instantly sell a quoted limited company), and also apply a further 25% discount because obviously the quoted company is “much bigger” (and actually exits, with products, sales  and stuff). Together this amounted to a 50% discount against a quoted company. Why 50%? Again there is no logical reason for this. Purely arbitrary.

The accountants then took the specified price earnings ratio of now 4.25 and multiplied by the discounted projection of profits, to arrive at a “risk-adjusted valuation” of £3.9 million.

A start up, that does not exist, has no employees, has no office, no factory, no product, no customers and no suppliers, was apparently worth nearly £4 million.

This in context the average pre-money valuation of companies achieving funding in Scotland at that time was around £600,000.

The calculation produced by the accountants was clearly absurd. Unfortunately it had been produced by a firm of “professional” accountants and the founders knew no better than to just assume that any investors offering them less were merely ripping them off.

What was required was someone who was not going to be an investor showing the founders the reality of the actual data relating to valuation in Scotland. Showing them data on actual valuations achieved over the last 5 years helped the founders realis the “professional” valuation was simply nonsense. The accountants had done a text book “MBA” valuation, but had not bothered, or did not know how, to reference this against local reality.

In the end the investment was made, at a pre-money valuation of £800,000. Higher than the prevailing local norm of £600,000, and higher than the new angel group who did the deal wished they had agreed to following a few years of slow progress. Down rounds were to follow.

Whatever valuation methods are used the outcome must be tested against the local reality.

How Do Angels Deal with High Risk Investing?


Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable: they decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work. For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought, on the basis that it is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1], with 85% of all returns coming from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

A key role for “training” therefore needs to be providing nascent Angels with an understanding of the characteristics of the Angel market, tactics to deal with the high risk, and thus confidence to join with others in making their first investments.

Experienced Angel educators suggest that individuals new to Angel investing tend to seek out training on subjects such as valuation, looking for the “correct” valuation method or formula, reflecting a desire to reduce uncertainty (and perceived risk). In practical terms valuation training will likely highlight that there is no “right” answer, instead presenting a number of different methodologies, and suggesting that several should be used in each case and the results compared, but that local comparatives are likely to be the most significant influencer. Many of those new to investment struggle with this lack of a definitive answer but gain confidence when they see that all Angels face the same issues.

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.

Angel Decision Making – How do they get to Yes?


Reading the available  academic research and discussions with experienced Angel investors suggest that “technical” subjects (valuation, financial modelling, technical due diligence) play a relatively limited role in the overall decision-making process, significantly due to the lack of “hard facts” in so many aspects of an Angel type investment. It is not a formalistic driven process. There is no proven formula for success, and no hard data to put into a formula should one exist.

Rather, decision making is based on a mix of technical analysis and intuitive assessment (what Angels frequently refer to as their “gut feeling”), with recent research suggesting that intuitive assessment is favoured over technical analysis[1].

The typical Angel decision making process begins with a subjective assessment as to whether the investment is likely to ‘fit’ with their personal investment criteria rather than a technical analysis. This may include location, amount sought, knowledge of and interest in the sector, and their own ability to add value.

Experienced investors rely heavily on their prior experience and previous investments to inform their present decision making and typically prioritize their intuitions about the entrepreneur over process and “hard fact” (e.g. business viability data).  Finance, in terms of the financial structure of and projections for the venture, is the most important criterion for both nascent and novice Angels but ranks only fourth for experienced investors[2].

The Learning Process

Investors who may now be classified as experienced consistently said that initially investing with other, and then more experienced, Angels had been their most valuable source of learning.  A number added that they had learnt more from failed investments than successful ones!

This suggests that the most effective way to improve the skills of new Angels is through engaging with experienced Angels in actual real investments. How do they get that engagement? Join an existing, active local Angel group, attend their meetings, help with the due diligence and join in a few syndicated deals.


[1] Managing the Unknowable: The Effectiveness of Early- stage Investor Gut Feel in Entrepreneurial Investment Decisions, Laura Huang and Jone L. Pearce, Johnson Cornell University, 2017.

[2] Heuristics, learning and the business Angel investment  decision-making process, Richard T. Harrison, Colin Mason & Donald Smith, 2015.

“First Mover” is not a Strategic Advantage.


Far too many times I see company barely past the idea stage claim “First Mover Advantage” as a justification (or at least a major one) for their proposed pre investment valuation.

More likely, this should go on the other side of the evaluation equation – it’s a disadvantage.

  • “Google? Not the first search engine.
  • Facebook? Not the first social network.
  • Groupon? Not the first deal site.
  • Even in the mists of software industry time: MS-DOS – not the first operating system.

It’s not about having the idea first – it’s about having the best execution of the idea. Who can quickly and effectively engage with a profit paying customer base. It all comes back to the effectiveness and skill of the management team. So when doing due diligence look for real evidence that this management team have the experience, and skills and focus needed to rapidly engage with a critical mass of paying customers.