Winning Angels: the seven fundamentals of early-stage investing
Valuation was the hardest concept of investing for me to understand before I read this section. I couldn’t understand how you place value on a business other than profit, equity, and the trend of how the business had performed. Profits and equity are worth, and value can be more than just worth to an investor. A simplified way of looking at value is an internship; an intern works for a company to gain experience that is not compensated with income. Essentially an intern is buying experience with free labor. When looking at valuation, it can be described as “what you are willing to exchange for something you want (Amis, D., & Stevenson, H. H., pg. 145).
Some Angel investors have been known to describe some of the reasons they invest as; contributing, having fun, and giving something back (Amis, D., & Stevenson, H. H., pg. 145). While these types of investors are looking to make a profit, they try not to overlook what they can gain beyond financial compensation. They can gain a deeper understanding of an industry, feel a sense of accomplishment by helping a business launch or grow, and sometimes it can just be fun to be part of the team on the cutting edge. This perspective of looking beyond only gains and building portfolios is a reason why Angel investors should not be confused with typical venture capitalists.
Finical gains are important since no investor wants to lose money (even though it is an accepted fact), there must be a way to evaluate a business to determine how much of an investment is appropriate for a proposal. There is no one set way to value an investment proposal; investors have different approaches for valuation. Some of these approaches are simple and straight forward; other approaches rely on calculations or future gains. The approaches have different ways of valuation and have different amounts of time to place value and involvement in the business.
The five approaches that most of Angels investors use are; Quick and Easy, Academic/Investment Banker, Professional Venture Banker, Compensated Advisor, and Value Later (Amis, D., & Stevenson, H. H., pg. 146). Within each of these approaches there can be subcategories such as within Academic/Investment Banker there are multiplier methods and discounted cash flow. Without getting too in-depth I’ll try to cover the simple pros and cons of the approaches.
Quick and Easy – this technique is used by investors that have a set amount that they are willing to invest without extensive research into the company. Pros: The process can be done rather quickly. Cons: some businesses don’t fit the mold to qualify.
Academic/Investment Banker – this technique requires skill and knowledge of calculations and other similar businesses. Pros: using the values of other businesses, a baseline is easier to establish. Cons: even with using other businesses scale can cause a lot of calculations that are not straightforward.
Professional Venture Capitalist – this technique uses multipliers and discounted cash flow to calculate how much of a business the investor needs to achieve a minimum ROI. Pros: calculations are fairly accurate and can predict if a venture should be avoided. Cons: the calculations are based on hypothetical numbers that might not come to fruition.
Compensated Advisor – this technique places value on what the investor brings to the business other than finical investment such as; experience, connections, as well as the possibility of investing later. Pros: no financial risk upfront and is rewarded with a portion of the company to advise and influence. Cons: can be time extensive for investor and the entrepreneur might not be looking for this kind of relationship.
Value Later – this technique is getting the business to a place for substantial growth and then capitalizing on that growth by locking in a good rate for that round of investment. Pros: the investor doesn’t even worry about valuation and doesn’t have to worry about dilution on the next round of investing. Cons: there is no guarantee that there will be a second round of investment because the entrepreneur doesn’t have control to get the most value at that time.
What does all this mean to the entrepreneur?
There are investors out that use different measurements to place value on a business, with this knowledge the entrepreneur aware of techniques. Investors are afforded the ability to be choosy on whom they do business with by accepting or rejecting proposals. However, the entrepreneur can shop around and look for the best offer and terms for their business. All too often the entrepreneur thinks that the offer on the table is the only choice they will receive (while that it is a possibility) and they must receive it. Shopping around before committing might lead to a more advantageous offer in the long run.
Amis, D., & Stevenson, H. H. (2001). Winning angels: the seven fundamentals of early-stage investing. London: Financial Times Prentice Hall.