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Investment Valuations of Seed- and Early-Stage Ventures
Luis Villalobos
This exceptional article oers insightul explanation and key details o how angel investors determine valuations, why entrepreneurs and investors oten have dierent perspectives or angel returns, and what steps angels and entrepreneurs cantake to quickly fnd common ground on this critical topic.
Article
Some early-stage investment negotiations resemble a game o Texas Hold-’em poker. Each player withholdsinormation and tries to convince opponents that his hand is better than it actually is. But valuation negotiations arenot card games. Unlike poker, the objective o investment negotiations ought to be or investors and entrepreneursto share inormation as openly and completely as possible and to work together toward a common goal o buildingsuccessul companies.
Why ocus on valuation?
At the time o investment, valuation is the core determinant o return or investors. Inother words, the return to investors is based on the increase in the valuation o shares they receive in exchangeor their capital. Understanding valuation is critical to successul investing. Unortunately, valuation is the mostmisunderstood part o the investment process and oten leads to contentious negotiations that get the entrepreneur-investor relationship o on the wrong oot.
What is the problem?
Most entrepreneurs and investors have oblique points o view—in other words, their viewsdon’t intersect. In act, the two sides don’t even speak the same investment language. More undamentally, neitherunderstands what I call “divergence” o valuations. Understanding divergence can reduce contentiousness and ensurethat negotiations build an eective working relationship between investors and entrepreneurs.
What is divergence?
Divergence is the dierence between the growth rate o the company’s valuation and thevaluation o the shares investors receive due to dilution by subsequent investors and other actors. Even in successulventures, divergence, in act, tends to be between 3x and 5x.A simple example may help make the point: An investor unds at a $4-million post-money valuation and receivesshares valued at $2 each. The company is sold in ve years or $60 million, which is a 15x increase in companyvaluation. Due to dilution, however, the value o the investor’s shares will almost certainly not have increased 15xto $30 per share. They might instead have increased only 3x to $6 per share. In this example, the increased valuationo 15x divided by the increase in the investor’s share value o 3x demonstrates a 5x divergence. (For a detailedtreatment I wrote, see “Valuation Divergence,” starting on page 21.)
What do angels target or returns?
Some angels target 5x to 10x ROI (cash-on-cash return on their investment)in our to eight years, which yields an internalrate o return o between 25 and 75 percent.(In the accompanying table, the target numbersassume that divergence o between 3x and 5xtimes is actored in.) Other angels simply target30x ROI without divergence.The two approaches are eectively equivalent:I you assume 4x divergence (the midpointbetween the expected range o 3x to 5x) andmultiply that by a return o 7.5x (midwaybetween the 5x and 10x range), then you get30x, which actors in divergence. These ruleso thumb are not sacrosanct; they refect twocommon approaches.
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