Valuing Start-Ups in the Angel Round

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

How do you value a company in the concept stage, looking for the angel round, when the traditional indicia of value are far in the future... revenues, customers, cash flow and (some day) net profits?

This question plagues angel investors when a promising start up is raising its seed round of financing. Various suggestions have been made ... for example, focus on the management. Try to figure out what kind of value the key manager's energy, experience and (sometimes) track record should entail.

Observers with an investment banking background occasionally try to create a discounted cash flow analysis, based on the company's projections after having applied a deflator to take the element of risk into account. None of these methods have proven to be either reliable or satisfactory and so, in most instances, the investors fall back on a "comparables" approach.

What kind of pre-money valuations, in other words, is the market generally giving to start ups in their seed round? This approach has the virtue of a seeming precision but the flaw is obvious. It is hard, if not impossible, for entrepreneurs and angels, drawing on their own resources, to figure out what the "market" is doing. Reliable statistics are few and far between.

Professional investors, with a number of deals in front of them at any one point in time, may have a sense of the market but the angel round implies that the professionals are waiting in the wings. Accordingly, sophisticated advisors are telling the entrepreneurs and angels to postpone the valuation/pricing decision until the first professional (some times called the Series A) round is closed.

A typical structure entails a security which is labeled a bridge loan, convertible into either common or preferred stock at a price per share (or in the case of preferred stock, a conversion price) tied to the price of equity in the forthcoming Series A round. Usually the angel round price is discounted off the hypothetical Series A round price, the discount running from 20% to 30% in most cases. If the Series A round is not closed by a date certain in the future, then the default option is a price which is quite favorable to the investors and penalizes the entrepreneur. It is usually not contemplated that the bridge "loan" can be called and the holder or holders demand repayment.

The virtue of this structure is that it postpones the pricing decision until (i) the company has made progress and the indicia of value are easier to ascertain and (ii) the pricing is established by professionals who have a keener sense of market conditions. The defect, of course, is that, if the Series A round does not take place in a timely fashion, the angels are taking, in effect, pot luck. However, in the early stage universe, pot luck is more the rule than the exception.