Have Valuations of Early Stage Companies Gotten Too High for Angels?

early stage valuations

Data from the law firm Cooley LLP indicates that valuations of early stage companies came down from the stratosphere in the fourth quarter of last year, declining from $19 million to $16 million. That’s good news for investors.

Valuations had reached such heights that investors were pulling back, unable to generate sufficient returns to justify the risk of making early stage investments.

The valuations of early staged companies had jumped dramatically in recent years. The typical seed stage company was valued at $4 million in the third quarter of last year, up from $2.5 million two years earlier, the Halo report explains (PDF). Similarly, the median Series A valuation skyrocketed from $8.3 million in September of 2013 to $19 million in the third quarter of 2015, data from law firm Cooley LLP shows.

That’s a problem for the economics of early stage investing. Given the riskiness of investments in young companies, many investors figure that only one-in-ten of their portfolio companies will succeed. So, they look for startups that could generate a 30-times return in around six years.

If an investment portfolio is composed of a single 30-fold return, accounting for ten percent of its value, the investor is earning three times her money over six years, or an internal rate of return of roughly 20 percent.

Now think about what happens if the companies that used to be valued at $2.5 million are now being valued at $4 million. The exit that used to generate a 30 X return now produces only an 18.75 X return. Because only one-in-ten investments will pan out and provide a return, the 1.875 multiple generates only an 11 percent internal rate of return.

Rising valuations also lower returns by reducing the odds that an exit will occur. Higher valuation raises expectations of company performance. As a result, fewer people exceed the bar, reducing the odds of the next round of financing and the chances of a successful exit.

Moreover, the odds of a successful exit also decline because investors and entrepreneurs need to hold out for a higher sales price to generate the 30-fold returns on the new valuation. So now, instead of selling the business for $75 million, the investors hold out for $120 million.

Because the odds that companies get bought goes down with the price that buyers have to pay, raising the target price reduces the chances of a positive exit. We don’t have good enough data to know how much you reduce your probability of an exit by holding out for a higher price. But let’s say that boosting the sales price target from $75 million to $120 million reduces one’s ex-ante probability of a big win in the portfolio from, say, one-in-ten to one-in-twelve. Now, the 30-fold return on the top performing company generates a 2.50 return for the portfolio, or a 16.5 percent IRR.

Over the long term, modest increases in valuation aren’t a big problem. But when valuations rise rapidly over the short term, like has happened in recent years, angels find it harder to make money off backing early stage companies. And that generally causes them to cut back on their investment activity.

Early Growth Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.