High Life. Dealing with angels? Watch your step

Among all forms of equity investing, ascribing per share value can be most tricky in a start-up. At the same time, given the trickiness, it is also the easiest. This article will seek to explain this apparent conundrum.

Let’s start with basics. When investing in equity shares, an investor has to form a view of the per share value she is comfortable paying. If the company is listed in the public market, the price is a given. All that the investor has to decide is, whether the prevailing price makes the stock worth investing.

In unlisted companies, there is no ‘available’ price. Hence, the price of investment is a matter of negotiation between the buyer and the seller.

The added complexity in start-up investing is that there is hardly any performance history to go by. Within start-ups also, there can be many stages. In absolute seed investing, you could be investing in an idea, and no actual business on the ground. Then you can have a situation, where a product or prototype is ready to launch, but hasn’t been launched yet. The next situation could be a case where the business is launched, some revenue is coming in, but EBITDA breakeven is a few quarters away. These three cases typically lie in the 0-24 months of lifecycle of a start-up.

The other factor is that there is no previous external investor. All investment so far is by the promoters, at ‘par’ value. So there is no internal benchmark to go by. When the angel investor puts money in a start-up, that’s the first time a premium is being paid for the start-up’s equity.

In theory, there are many methods to come up with per share value of equity.

In the secondary market, the most popular method is what is called ‘relative valuation’. Here, one uses multiples such as price-earnings, or EV/EBITDA, or price-to-sales (P/S) or price-to-book to arrive at a valuation. Here, you take a number like P/E from a set of comparables, and apply that to the company you want to value.

This is not easy to apply to start-ups because a typical start-up may have no profit and loss (P&L) metric to show.

In other words, let alone net profit or EBITDA, it could be pre-revenue. Or even if the business is launched, it would be just one or two years old. Revenue may not be enough to even apply a price-to-sales (P/S) multiple.

The other popular valuation method is the so-called discounted cash flow or DCF method. The problem with this method is, there are too many assumptions involved. You need to do at least five years of forecast, and use assumptions to arrive at the applicable cost of capital and terminal value. Other than in certain predictable businesses like utilities, in other cases, using DCF is no better than witchcraft. This brings us to what actually happens in the real world.

This may sound Zen-like, and perhaps is. The seasoned angel investor knows that there is really no way to value a start-up. It would become a google, or it could die an unseen death.

In other words, the mindset of most angel investors is simple: “I don’t know if it is a unicorn or a write off”. Of course, theoretically, one can try to use scenario analysis, assign possibilities and arrive at a number. This again is going towards witchcraft.

In a nutshell, it is hard to devise a method that is statistically honest and yet captures both possibilities and outcomes inbetween. Once you accept this axiom, the conclusion is quite simple, isn’t it? No method.

That is what happens in real life. Most angel investors really have no method; they simply negotiate. Their mental range for negotiation depends on a few simple things — stage of the business, sector, and prevailing market conditions. For example, in current climate, valuations in the angel world would easily be down 30 per cent compared with a year ago.

Ignoring market conditions, there is a general range in which angel deals happen. On a paper plan, where an accelerator or seed investor would put in money, the pre-money valuation (post-money valuation minus the funds raised) can range from ₹1-3 crore. This may inch up a little, if the business is ready to go commercial. For businesses that have at least three to four months of revenue history, pre-money valuations in India can range from ₹3 crore to ₹10 crore; rarely more than that.

The exceptions to the above range can be if the promoter has a stellar track record or there is some surety of revenue scale up, or an intellectual property value.

One simple way to totally avoid a valuation discussion, particularly if there is strong difference of opinion with the promoter, is to invest via convertible preference shares wherein the angel’s price is determined once the Series A investor (venture capital, who chips in as first-time investor) comes in. You can convert to common shares at a discount to Series A. This method will typically need a cap and floor on valuations though.

Also, as an investor, while one should try to drive down values to the above-mentioned numbers, one must also keep in mind the lifecycle requirement of fund raising. If, for example, the promoter is too naive, and ends up parting too large a stake very early on, it may create problems in future fund raises.

The writer is a partner at Wisdomsmith Advisors LLP, a financial advisory firm, which also runs an angel platform Wisdom Angels

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