Valuation

Are Angels in Denial About Exit Valuation?

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There are three variable that drive the financial return for Angel investors (and founders):

  • Pre-Money Valuation.
  • Subsequent Dilution.
  • Exit Amount.

Instinctively founders seek as high a valuation as possible. It must be a ‘good thing’ to ‘give away’ as little equity as possible. Typically, founders will seek to find comparatives to justify their valuation proposals. If company X is worth $6m then we must be too.  (Let’s put aside for the moment that the comparative being used is likely on a different continent, and probably has quite a different set of skills in its team, different experience in its founders, and different intellectual property).

And it seems many investors have been going along with this. Perhaps out of fear of losing out on ‘the best’ deals – though I have yet to meet anyone who can actually pick winners at the first round (or follow on actually) – if angels could do that then presumably the percentage of their portfolios that fail to return capital would be less than 70%.

A big part sems to be a failure to think strategically about a deal – looking not just at a first-round valuation, but at the total cash that business is going to need to get to an exit (and the resulting dilution on their ownership %), and the actual likely exit value achievable.

And this in turn is likely significantly due to the media fixation of Unicorns. Without appreciating that it’s the valuation of most unicorns that is a fantasy. Because so much talk is about $1bn companies that’s become the perceived normal – the bar against which all else is measured – and found wanting.  But over the last 10 years just 1.7% of all UK high growth company exits have achieved a value of $1bn or more.

The unicorn culture has stopped people talking about, and admitting to, the reality – most exits are much, much smaller. And no, its not because we lack ambition in the UK – the exit values in the USA are largely at the same level. As with most commercial transactions the buyers have a price band they are comfortable paying. Trying to ‘scale’ past this comfort zone (which is a reflection of the acquirer’s commercial reality) is more likely to create a non-exitable company – and certainly massively dilute the early investors, and probably the founders as well – than crate added exit value.

Triple Point and Beauhurst have produced a report looking at 2,724 exited UK companies between 2011 and 2019[1]. Of these they have exit value data on 604. It’s likely the bulk of the non-disclosed deal values will be at smaller values. Big deals are publicly announced (either publicly or in financial accounts). Small deal value announcements are likely inhibited by embarrassment under the prevailing unicorn culture.

The data shows that 87% of exit values are under £200m. But digging deeper, 51% are at £30m or less.

Most Exits are ‘Small’. www.beauhurst.com/research/Exits-in-the-UK

This is not a reflection of lack of ambition by UK founders – or a lack of UK scale up capital. The 2016 ‘Global Tech Exit Valuations’ report by CB Insights showed 54% of exits globally were at $50m or less (and they also pointed to the fact that the majority of smaller exit values are not made public, so that figure will likely be significantly overstated). Rob Witbank’s study presented to the American Angel Capital Association conference (ACA) suggested that 87% of US exit values were $50m or less (perhaps significantly impacted by the high level of ‘acquihire’ transactions, where a large tech company purchaser a small tech company just to get the technical team – the acquired company being quickly shut down. The technical skills of the team being seen as more valuable to the likes of Google than the  product they were working on).

Exit value is critical in determining the financial return on all investments made into a company, including the very first. It’s hard to see how you can get the target 10x return from a deal (the generally agreed target needed to archive a 2 – 3x return at portfolio level given the very high, 70%, level of deals that will produce a negative return) if the first round valuation is north of £3 million, and the probable exit vale will be sub £50 million (even without considering any future funding dilution, or preferential returns introduced by subsequent funders).

The report shows that 97% of exits have been via an acquisition (as opposed to an IPO), and the average acquisition exit value has remained unchanged over the past ten years. Yet data from Pitch Book shows entry valuations have been significantly increasing in the UK, with Angel and seed valuations rising from about £1 million in 2010 to £3 million in 2019.



Mean Acquisition Exit Values Flat over 10 years.
www.beauhurst.com/research/Exits-in-the-UK

There is no rational reason to accept an increase in entry valuations of 3x while exit values have remained flat. Perhaps it supply and demand – all that SEIS / EIS incentivised (dumb money) investment chasing quick deals to beat the tax deadlines. Perhaps it’s that before COVID chased them away Angel tourists thought it was cool to get into some ‘hot’ deals. Perhaps we investors have just not been looking for, and using, the realities of the data to negotiates sensible valuations, and been willing to walk away from the daft ones.

How do you calculate the ‘correct’ valuation? Comparatives have some merit, providing you are using a genuine comparative. Don’t go comparing your e commerce, shoe comparison site with a San Diego Biotech company.  The Score Card method can help focus on the key issues to be used in due diligence, but if the management team is not excellent, you don’t compensate by lowering the valuation. You just don’t do the deal.

Truth is, startups have no value. How can they, if 70% end up failing to return capital (and obviously we don’t know which are in the 70%!). The 70% are probably worth less than zero at initial funding – because your going to lose money on them.

So how does valuation actually work? The early investors need to take 20-30% ownership to manage future dilution and have a decent ownership at exit, to derive that 10x potential return. This assumes a reasonable level of investment is going in, depending on location, say $100,000+. The valuation is derived based on that percentage, and the amount of funding the company needs to achieve credible, critical value add mile stones. If the company needs £500,000, and the investors take 25%, the post money valuation is £200,0000, and the pre £1,500.000. If the company needs £700,000, that valuation is £2.8m.

(The founders get the balance of ownership, less the 15% or so that is popped into the share option pool. Always get that set up at the time of your first investment – otherwise it will add further dilution when the next investor require it).

Is that £2 million valuation sensible? Depends on how much more cash needs to go in to get to exit, and the resulting dilution on the investors. That needs to be modelled on a future looking cap table, showing each expected future round, amount, valuation and dilution effect.

And then look to see what is the probability of achieving an exit big enough to get a 10x return. In simplistic terms, a £2 million entry with no further funding or dilution needs a £20 million exit. The data we have above suggest that 62% of exits are at values above £20m. Reasonable odds, as long as there is no more dilution. But it’s a rare company indeed that gets to exit, especially above £20 million, on a single round of funding.

This suggest that you would likely not want to be going above a £2 million valuation. And yet clearly the data indicates that investors regularly are. Perhaps all the higher valuations are for companies that are just that much more ‘special’.

Valuation is important, and does need to be considered in conjunction with future capital needs, dilution and the realities of exit value. Exit values of genuine comparatives, of similar companies in the same geography. And investing on the same terms. A valuation of £3 million is a very different value when the investor has a 3x preferential return built in.


[1] www.beauhurst.com/research/Exits-in-the-UK

The Valuation Myth – Part 2

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The biggest driver of valuation is not the quality of the management team or the size of the market. There should influence the investment decision in a binary manner – if you don’t have a good team, or a big market, you don’t reduce the valuation – you just DON’T DO THE DEAL!

The biggest driver of valuation is Geography. Where is the company operating?

And specifically – how much it costs to do stuff in that location?

By ‘Stuff’ we mean something achieving a millstone that in the eye of the next round funder or exit partner adds real value. (The biggest value drivers are usually related to customer engagement / evidence that customers value the product – not tech ‘features’).

So valuations look higher in say San Francisco than Ohio simply because you have to put 4x the cash into the Valley company to do the same stuff that costs so much less to do in Ohio (salaries and rent are now almost prohibitively expensive for startups in the Valley now) – but you can’t take 4x the equity, or you would own more than 100%!

A resent analysis of valuations for Tech Coast Angels suggested they were 50% higher than the rest of the USA – due to geography.

Valuation of early stage companies is not really valuations at all. It’s not like valuing a house, or a picture, or even a traded stock market investment – all of which can be relatively easily turned into cash if you need to do so.

Early stage company valuation is really a way of expressing how the cake is being divided between the investors and the founders.

Angel investors, who are putting their time and reputations into deals, not just their cash, look for a sizable ownership percentage on an initial investment. This reflects both the perception of present risk – but also critically the level of future dilution they face as the company takes on more and more rounds of funding. It’s the ownership they have at Exit that is critical, not the ownership on initial investment.

The specific numbers will vary a bit from case to case, but for any meaningful amount of funding (say $200,000 or more), the early investor(s) will likely look for between 25% and 30% ownership.

10% – 15% will be put aside for share option incentives in the futures, leaving the founders with between 65% and 55%.

And the numbers don’t really change much whether it’s a $200,000 investment, or $500,000, or (for my groups most resent investment $800,000).

The valuation driver is the amount of cash going in – the size of the cake.

If the investment is $200,000 the valuation is likely based on the lower end of the ownership band – 25% – so a valuation of $600,000. If the cash going in is $800,000, then the higher end of the ownership range will be used – 30%, so a valuation of $1.8 million.

So quite different ‘valuations’ for the identical company. The difference driven by how much cash needs to be put in to achieve key millstones (what needs to be done to get the next round funding, or an exit).

Now benchmark that valuation against likely exit values (using exits in the location of your company) – a $1.8 million value today needs a credible likely exit value of $18 million – without the company taking on any more funding (the investors not suffering any dilution), to archive a potential 10x return – needed to get a potential 2.5x – 3x return at a portfolio level, when you account for the companies that will return zero.

Perhaps investors should be encouraged to study Geography, not Maths, to get an understudying of valuation.

The Valuation Myth – Part 1

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I was asked recently to provide some feedback on possible valuation benchmarks for a company raising its first external equity funding.

Of course the funder has been looking at valuations from Silicon Valley. Largely one suspects because they are larger than the local ones in Latvia.

The use of comparatives is a sensible way to benchmark valuations – what valuations have been achieved by similar companies?

But they are usually used badly – because the definition of what is ‘similar’ is too narrow.

Similar is not only (or indeed primarily) those in a similar industry or tech vertical.  

What is more critical are factors such as:

  • Achievements to date – critically customer engagement and meaningful revenue generation.
  • Levels of actual Intellectual property (patents applied for, granted and freedom to operate reports).
  • Experience of the management team – have they previously successfully built and exited a company?

Comparatives ignore the most critical influencers of future value for early investors.  For investors the return on investment is driven by three factors:

  • How much ownership of the company you have at initial investment (the outcome of the initial valuation).
  • How much ownership you have at exit – a function of dilution – how much more money will the company need to get to an exit, and how much of that will the initial investors be able to provide?
  • The actual exit value achieved.

Investors who only look at the first of these – the initial valuation, are likely to do badly in the end.

Providing $200,000 for 10% of the company (which gives a pre money valuation of $1.8 million, is meaningless, unless we know what future dilution we will suffer. Say the company needs $100 million of VC money to get to the exit – what ownership will you then have? And even if you have say 1%, if the VC’s have just a 1x preference, then unless the company sells for at least $100m, you will not get one penny back (did I mention that most successful exits are for around $25m – $35m?).

Valuation is not about what a company is worth today – or indeed what it is going to be worth on exit – but what ownership percentage you will have at the time of exit, and what the terms of that exit are. Those terms will not be set by you – but by the provider of the last round of funding.

Valuation therefore begins with a deep analysis of Comparatives – the comparative of EXIT values and the total funding that has been required to achieve them.

The Great Valuation Myth

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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.

What Is It Worth? Valuation of Investments

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Valuation is probably the most emotive issue to be addressed in any investment negotiation.

Both entrepreneurs and investors seek reassurance that they are not agreeing to an inappropriate (unfair) valuation that will result in them receiving an inadequate share of the anticipated future exit proceeds. Both seek to find definitive valuation techniques that will give them the “correct” valuation. Both are often attracted to the more mathematical, formula based valuation methods involving discounting future values of potential exit values to present day money values.

While many of these methodologies have some merit, it is appropriate that whatever valuation they suggest, that this is sense checked against what is happening in the local market at the time of the deal. Always compare proposed valuations with other comparators in the local market. If you and the company are not based in Silicon Valley then Silicon Valley valuations are largely irrelevant.

Bill Payne carried out a valuation survey of US angel groups collecting pre-money valuation data for pre-revenue company investments from 35 angel groups in 22 states. He found that valuations ranged from $0.8 million (Boise Ohio) to $3.4 million (Silicon Valley), with an average valuation of $2.1 million. The survey showed wide geographic variance, with, perhaps not unsurprisingly, Silicon Valley, New York City and Boston showing the highest valuations, and Idaho, New Mexico and perhaps surprisingly, San Diego at the lower end.

There are a number of factors that likely result in these regional variations. The nature of the business will have an influence, with Biotech, life science and medical devices typically funded at higher pre-money valuations than, say, software and Internet companies. Increased competition among investors for “good” deals will tend to drive up valuations. Valuations in Silicon Valley are driven by the need to have much larger investment sizes because of the significantly higher cost of operating a business there.

However the size of the investment round seems to be one of the most influential factors.  Some investment rounds can be for £2 million or more, while others may be for £100,000 or less. Since angels typically prefer purchasing less than a majority ownership, a higher pre-money valuation is more likely for a larger round size. 2016 valuations may have been up at $3.6m (notably down from a high in 2015 of £4.5m), but the Angels still took 22% of the equity

The Angel Resource Institute’s annual report (The HALO report) on Angel activity in the USA constantly shows that while valuations vary both by geography and by year, the amount of equity taken by the Angels remains remarkably consistent at between 20% and 30%.  So a higher valuation does not result in less equity dilution of the founders.

Having empirical data on local valuations will provide extremely valuable in the negotiation process, providing a “reality check” to both aspirational values put forward by entrepreneurs and “scientific” valuations produced from mathematical formula. Angel groups should seek to cooperate in collecting and sharing local valuation data to ensure their own investments start out on a solid foundation.

“First Mover” is not a Strategic Advantage.

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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.