There are three methods commonly used for valuation:
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Asset valuation: Looks at the value of assets minus liabilities
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Relative valuation: Looks at similar companies’ valuations in the past
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Discounted cash flow: Sum of future cash flow, with each year into the future discounted more heavily
It is important to bear in mind that the approach to valuation often determines the ongoing relationship that you will have with the entrepreneur going forward and can be demotivating if you have negotiated very heavily to bring this down.
The key aspects for you to identify are:
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Have they established a reasonable initial value?
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Does this give you a possible 10 x return one day?
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What is the basis for their valuation and does this seem realistic and sensible?
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Are they flexible in their approach to valuation and prepared to negotiate?
A share options package can be used to give the entrepreneur a better effective package in the end, provided that they attain the targets set out. Each ‘option’ typically grants the right to purchase shares at the price of the last round. Typically the options are only exercisable on exit. On exit, the option can be used to purchase shares at the low, last-round price. They can then be sold at the exit price (at a profit).
Doing Your Due Diligence:
It is vital to do effective due diligence prior to investing to review all the aspects of the deal. This provides you with the opportunity to investigate the key aspects of the business and the investment proposal before committing to an investment. Research has shown that doing at least 20 hours due diligence considerably increases the chances of a more positive outcome from the investment.
Whilst you may decide to commission external technical support, in order to reduce transactional costs of investment, many angels do their own due diligence drawing on their own knowledge base and business and professional contacts to support their investigations. If you are investing as part of a syndicate, this is normally shared between the investors, each taking on areas where they have the knowledge or expertise or key contacts.
There are four key areas where you should do your due diligence:
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Management: this covers issues about checking out the teams’ experience and competence and what they are bringing to the business. You should also make your own assessment through interviewing the entrepreneur and team to identify their capacity, passion and commitment to execute the business plan and take the business forward to high growth. CLICK HERE for Downloadable Factsheet on Management Due Diligence
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Finance: this aims at ensuring there are no “black holes” in the accounts, or areas of the finances of the company that will have an impact on the investment and ongoing growth of the company (such as existing debts); ensuring the projections and forecasts are reliable. CLICK HERE for Downloadable Factsheet on Financial Due Diligence.
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Legal: this covers key aspects of the business establishment; ownership and shareholding; employment contracts; ownership of IP; existing commercial contracts etc. CLICK HERE for Downloadable Factsheet on Legal Due Diligence.
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Commercial: this covers issues relating to the Product and technical issues; market and competition.
CLICK HERE for Downloadable Factsheet on Business
CLICK HERE for Downloadable Factsheet on Market
CLICK HERE for Downloadable Factsheet on Technology
