Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote this article on a growing techqniue used by angels to evaluate companies. Her full article (with her permission) appears below:
Scorecards are ubiquitous in baseball, helping coaches, players and fans understand the factors that led to a victory or defeat. It turns out that scorecards come in pretty handy for startup business investing, too.
This past October, I enjoyed watching my hometown Kansas City Royals become the World Champions of baseball. Their scorecard was easy to understand, what with runs, hits, and great pitching stats. Those stats were the factors that led to their World Series win.
Angel investors are using a similar concept for determining the value of the startups that approach them for financing. They look at the factors that make a new business more or less valuable in a valuation scorecard. The factors are just different, like industry sector, market size and quality of the management team.
Before we jump into the details of the scorecard, it’s important to understand first why company valuation is so important to angels and entrepreneurs. The bottom-line is that it is part of the critical calculation of determining how much of the company the investor owns for their investment. Marcia Dawood, an experienced investor and board member of the Angel Capital Association, walked new investors through the important calculations in a recent webinar.
Dawood explains there are two types of valuation – ”pre-money” is the company’s value before an investment and “post-money” is after the investment. And an investor’s percent of ownership equals the size of the investment divided by the post-money valuation. We use both to determine percentage of ownership.
For example, if a company has a pre-money valuation of $2 million and raises $500,000, then the post-money valuation is $2.5 million. The investors own 20 percent of the company (by dividing the $500,000 by $2.5 million).
Sometimes entrepreneurs back into a valuation when they know how much they want to raise and how much of their company they are willing to give up. Investors can do this too. Dawood says, “Think about Shark Tank. Mr. Wonderful says ‘I’ll give you $200,000 for a 10 percent stake in your company.’ Divide the $200,000 by .10 and you get a $2 million post-money valuation and after subtracting the $200,000 investment, you get a $1.8 million pre-money valuation.”
The numbers in the calculation can have a huge impact on your success in an investment, so it is important to be comfortable with the final pre-money valuation and the elements that get you to that number. You don’t want to buy company stock for too high of a price. So how do you do that?
There are several ways to value startups, but the most popular method used by angels to determine a pre-money valuation is the Scorecard Method. Bill Payne, a long-time angel who also led the webinar, uses a real estate analogy to explain the method: it appraises startups using comps.
The Scorecard Method is used for comparing target companies to similar startups, such as business sector, stage of development and geographic location. You compare your target company to the norm for several factors and then adjust the median by your appraisal of the target. These days it is easier to find data on investments and valuations of entrepreneurial firms on the Internet.
The main parameters, or criteria, of the Scorecard Method, in order of importance, along with their respective weights, are: entrepreneur, team, board (30%), size of opportunity (25%), product/technology (15%), sales/marketing (10%), need for more financing (5%) and other (5%). You can change the percentages according to your own preferences about what is important to a startup’s potential. Put them into a column.
Next , approximate how the company you’re trying to determine a valuation for stacks up in each of those parameters against similar startups. If you think the management of the target startup is 20 percent stronger than the other similar companies, for example, then use the number 120 percent in the comparison column for the parameter. Do the same for the other criteria. When you are finished, multiply the two numbers in the row and post that number in an adjusted weighting column.
Tally the numbers in the adjusted weighting column and multiply that sum by the pre-money valuation for similar startups. You end up with a chart with a final valuation scorecard like this:
This should be fairly accurate as long as you have a good starting value and use a similar stage of development, a comparable business sector and a like location.
Obviously, you want to keep in mind that if the seed stage valuation is too low, entrepreneurs are going to eventually be diluted after multiple rounds. As a result, their interest in driving the company is going to be diminished. If the seed stage valuation is too high, the entrepreneurs and the investors have undervalued the financial contribution.
The Scorecard Method, along with the Venture Capital Method and the Dave Berkus Method, are only three of the many methods used by angels in appraising a pre money valuation of a startup company. It is best to use multiple methods, then make a decision from there as to what you think is appropriate for your company and the company you are investing in.
Besides these methods, the Angel Resource Institute offers other ways to learn valuation. There are also some ACA webinars which are chock-full of good information.
Payne recommends that angels try multiple valuation methods for each investment opportunity. Essentially, establishing benchmarks helps make something that is very subjective more objective.
Angels who get a 10X plus exit return have hit one out of the park. Hitting it out of the park goes a long way toward establishing a winning portfolio. And, with a quality business model, good management and a scorecard, it is a whole lot easier to tell if you are winning, in finance – or in the World Series.
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