How to Value a Startup Part 9: Alphabet Soup
The Hyper Team @ Venture Hype | Aug 19, 2009
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:
Filed Under: Angel Investing Basics • Valuation
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Actually, you can break even too. For more, please read Between Hell and a Homerun: One Angel’s Guide.
I agree that ROI is very important in investing but this is gamble that you have to take risk. You either win or loss, it's the percentage on how you win or loss is what you have to keep in mind. Investing is a risk and you should know how to play the game.
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Angel investing is a high risk, high reward activity. There’s no such thing as a “sure-win.” In fact, you won’t get your money back on most of your investments. It’s the few homeruns that make up for the losses and give you a nice, handsome overall return. A typical exit is within 5 years.
Angel investing is a high risk, high reward activity. There’s no such thing as a “sure-win.” In fact, you won’t get your money back on most of your investments. It’s the few homeruns that make up for the losses and give you a nice, handsome overall return. A typical exit is within 5 years.
You're return of investment is the most important part in considering investing in anything. If you aren't going to make money on it, why put money into it. You need to be sure that this is something that will make you money in the long run, but don't make the long run too long. I wouldn't want to have to wait 2 years to break even on an investment.
Absolutely. If there's a proven demand for the product or service, it's relatively easy for the founder to raise funds from investors.
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Totally unique information here! After reading parts 1-9, I feel this type of writing is the most underrated. To me the part that is most important is demand. And proof that the product or service works!