Valuing – Early Stage Investing Series

If you have seen episodes of the popular show Shark Tank, then you’re sure to understand how simple it is to value an idea or company. All you have to do as an investor is throw out an equity percentage and a dollar amount that sound about right, and you’re in business. So what is all the talk about value being difficult to agree on?

For better or for worse, most deals in business do not follow the same procedure that ideas pitched on Shark tank follow. Outside of “The Tank”, there are numerous different ways of coming up with the valuation for a business. While each methodology involves chance and projections, most are set apart from one another by the values placed on different deal inputs. The excellent book called Winning Angels by David Amis and Howard Stevenson breaks down twelve of these various methods that different angel investors use to value a business. For our purposes, however, we will only look at three valuation methods in this article: the Multiplier Method, Rule of Thirds, and Virtual CEO.

The Multiplier Method

Although based on assumptions, this method of valuation compares the worth of a proposed idea with the worth of established competition in the industry. To decide on a valuation, you simply take a projected metric and multiply it by the revenue a similar metric generates for the competition. For example, let’s assume that we want to start a gym. Our goal is to have 1,000 memberships by the end of year two, and the industry average annual revenue on a membership is $360. To find our valuation we will multiply the 1,000 memberships by the membership fee of $360 to get a $360,000 company valuation. As David Amis and Howard Stevenson warn in their book, however, the tricky part about this valuation method is deciding on the right metric to use, since everything is merely projected.

Rule of Thirds

It’s one of the most simplistic methodologies for business valuation, and I’d guess that you might have already figured it out just by reading the name. A business is divided into equity positions of thirds with one third going toward the person responsible for the idea (founders), one third for management, and a final third to financial backers. And although the quickest route may not always be best, there is some value in finishing the valuation process quickly without haggling. After all, who wouldn’t agree that the Rule of Thirds is a fair deal?

Virtual CEO

This valuation method puts a different twist on the subject as it doesn’t involve the angel investor giving money to anyone. Instead of financial capital, the investor is expected to give significant personal and social capital to the new venture in exchange for an equity position in the company. Although details surrounding what percentage of ownership the angel will receive are not calculated with this method, it definitely changes things up by bringing in a different kind of value. Typically, however, the equity stake that a Virtual CEO will receive is smaller than that of a financial backer – although a monthly fee or salary may additionally be negotiated, depending on the level of assistance provided.


Source:

David Amis-Howard Stevenson (2001). Winning angels: the seven fundamentals of early-stage investing. Pearson Education.

What did you think? Leave some feedback! :)

4 thoughts on “Valuing – Early Stage Investing Series

  1. That was a great breakdown of the three valuation methods you identified. Rule of thirds is definitely the easiest to calculate, but I would be hesitant to use that rule if you wanted to maintain control of your company. For me, having a business that can scale and selling it is the way to go. I am interested in the idea of placing products in the marketplace that need to be there, but I don’t want to focus on any one product. I’m interested in many things…and, honestly, that is my niche: variety. I would stick with what I know and love, but I want to make my mark in different industries. Rule of thirds wouldn’t be the best because when it comes time to sell, I would want the final decision on whether or not it was time. I like the Virtual CEO method the most. Giving up equity pales in comparison to what a great CEO can bring to the company.

  2. Hi Austin,

    Like Alex, I like the compensated investor approach best, too. I think it provides a lot of value for the entrepreneur without giving up much equity, while still providing an upside to the investor. Of course, one has to find the best fit in this situation. I would imagine not many investors take this approach since the upside is limited by their time availability. The potential upside has to be worth the involvement, I would think.

    -David

  3. The Virtual CEO is a good path for an additional stream of income, but it speaks more to influence. A person’s influence can contribute greatly to the success of the start-up. Angel in vesting has different levels of rewards. This virtual position can go on the mentor side of deal. Name recognition associated with the success, could be invaluable for the investor. A voice at the table of influence carries as much value as a check.

  4. Austin,

    Great Blog Post! I like how you started with “Shark Tank”. I’ve watched that show before and it always amazed me at the back and forth they would do before reaching a deal. Sometimes I would be yelling at them to take it, what a deal and other times, I would be yelling no way don’t do it! The methods you described are much better options for someone. Each party has to know exactly what they want out of the deal before they choose which valuation method is good for them.

    ~Christina

Leave a Reply

Loading Facebook Comments ...