The rise of online angel investment sites have changed a key calculation that investors need to make in screening potential opportunities.
In the pre-online world, angels needed to estimate a reasonable pre-money valuation for start-ups seeking financing. But in the world of online angel investing, the pre-money valuation is often a given. What the angel needs to figure out is whether the potential harvest value of the company would support it.
One good way to do this is through algebraic manipulation of the Venture Capital Method for calculating the pre-money valuation of young companies. Bill Payne, an expert business angel and mentor, published a great blog post summarizing this method, which I draw upon to show the necessary algebraic manipulation.
With the venture capital method, the investor’s return equals the venture’s expected harvest value divided by its post-money valuation. So to calculate a post-money valuation, investors take their estimate of a company’s harvest value and divide it by their desired return multiple. Then they subtract the investment sought from the post-money valuation to estimate a pre-money valuation.
On online sites for angel investing, the pre- and post-money valuations are often given. So, instead of figuring out the pre-money valuation for a startup based on an estimate of the expected harvest value, an investor can calculate the needed harvest value-based return expectations and the pre-money valuation.
The key to this effort is having an appropriately high return expectation. Studies (PDF) show that the returns to angel investments are highly skewed. Most lose the capital invested in them or barely make it back, while a small fraction (around 10 percent) provide a more than 30 times return. These few winners make up for all the losers and provide a healthy return on the investors’ capital and time.
The catch is that no one knows ahead of time which companies will provide the 30x return. Therefore, as successful start-up company investor David S. Rose points out in his book on angel investing , angels need to limit their investments to only those companies that they expect to provide at least a 30x return.
Now we need only do a little algebra to figure out the needed harvest value of the companies to make their pre-money valuations work. We take their pre-money valuations and add in the investment they seek to calculate their post-money valuations. We then take the post-money valuations and multiply them by 30 to figure out the necessary harvest value.
Consider the following example. Suppose a mobile phone game start-up is looking to raise a $1 million seed round at a pre-money valuation of $4 million. Its post-money valuation is $5 million (the pre-money valuation plus the capital raise). For this deal to work, the angel needs to believe that the harvest value of the venture would exceed $150 million ($5 million times 30X).
While no one can know for sure if a given venture will achieve a particular harvest value, investors can estimate the odds. Harvests occur when startups go public or are acquired. The value of those harvests depend a lot on the business and entrepreneur seeking financing. So angels can assess whether a business they are considering financing stands a chance of achieving the necessary harvest value by looking at the entrepreneur’s track record, the industry the company is in, and the business model being pursued.
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