This is the first of a six part series on different methods used by angel investors to arrive at pre-money startup valuations. Below is a brief description of each of the most popular methods. Detailed descriptions will be published over the next few weeks:
The Scorecard Method:
This method compares the target company to typical angel-funded startup ventures and adjusts the average valuation of recently funded companies in the region to establish a pre-money valuation of the target. Such comparisons can only be made for companies at the same stage of development.
The Venture Capital Method
The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the most useful methods for establishing the pre-money valuation of pre-revenue startup ventures.
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
(in the case of one investment round, no subsequent investment and therefore no dilution)
Then: Post-money Valuation = Terminal Value ÷ Anticipated ROI
The Dave Berkus Method
Dave Berkus is a founding member of the Tech Coast Angels in Southern California, a lecturer and educator. He has invested in more than 70 startup ventures. Dave’s valuation model first appeared in a book published by Harvard’s Howard Stevenson in the middle nineties and has been used by angels since. The valuation is based on 5 metrics whereby investors add up to $0.5 million for each of the 5 categories.
The Cayenne Valuation Calculator
This calculator uses 25 questions to size up the progress of the new venture and calculate a pre-money valuation for investment purposes. In many cases, the outcome from answering these 25 questions indicates that the company has not made sufficient progress in development to justify investment.
The Risk Factor Summation Method
Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit.
Good practice suggests using at least three methods to first estimate the appropriate pre-money valuation and then using those results to finalize the valuation. For example, if the three methods give approximately the same number, simply average the three. If one method seems to be an outlier, use the average of the other two. Alternately, if one method is an outlier, calculate the pre-money valuation using a fourth method, in an attempt to find three methods in close agreement. If the three methods are uncomfortably different, feel free to use one or even two additional methods to arrive at a fair valuation.
The Scorecard Method is my favorite and it can be used as the primary valuation method. I like the Risk Factor Summation Method, but only as a supplemental methodology because it considers factors not always included in investor considerations. The other three methods are all valuable, but should, in my opinion, be used in combination with the Scorecard Method.