How to Value a Startup Part 9: Alphabet Soup

If you’ve been following our “How to Value a Startup” series (part 1, 2, 3, 4, 5, 6, 7, 8), you already know that we recommend a collage method that helps angels derive a number of valuations to get a fuller picture of the “art.” We’ve been on the quest for numerous valuation models and ah ha! We stumbled on an article that makes us think “#$#^%*, wish we wrote that.”

In his article “An Angel Investor’s Thoughts on Valuation,” Bob Aholt does a great job of talking about three key valuations that most angels will have more than a passing familiarity with: exit multiple, ROI, NPR, and IRR. [1] (For newbies, that’s “Return On Investment”, “Net Present Value”, and “Internal Rate of Return”).

Briefly,

• Exit Multiple is the gain divided by initial investment. It measures how many times the investment has generated for your invested capital.
• Return on Investment (ROI) measures the expected return that the angel will receive from what they put into the business.
• Net Present Value (NPV), according to Investopedia, is “the present value of a time series of cashflows” – how much your business investment will earn over time, expressed in today’s dollars.
• Internal Rate of Return (IRR) measures a company’s potential expansion.

We resisted writing about these formulas for a while, primarily because each one was treated separately and seemed to lack context. What we like about Aholt’s article – and the aspect that made us wish we had written his article – was the context he put the numbers into.

While he does reference NPV and IRR within the context of the entrepreneur’s presentation to an investor, his focus is exactly where most angels would want: Return on Investment.

Aholt describes a series of “validation points” that can prove the ROI assumptions. Those validation points include:

• The idea the company has
• Proof that the idea works
• Customers who agree
• Sales of the product or service (customers backing up their point of view with dollars)
• Gross margin
• Operating profit
• Positive cash flow

Not only are these milestones critical to Aholt (and to other savvy angels) but there should be a timeline to back up the assumptions, and (of course) a sense of realism in the projections.

In startups that have some kind of income, ROI, NPV, and IRR are three “go-to” valuation strategies that should exist in every angel’s valuation toolkit to contribute to the collage valuation method. And, we would agree with Aholt when he suggests that ROI is the one that angels are really interested in.

In the collage of valuations, if your potential investment earns an income, you’ll find NPV, IRR, and (especially) exit multiple and ROI to be the alphabet soup you’re looking for!

Note:

[1] An Angel Investor’s Thoughts on Valuation