Back to basics: valuations - how do you work it out?

Now you know what a valuation is, how do you figure out what your valuation is?

The short answer to this question is simply “whatever someone will pay.” It sounds trite, but it’s true.

There are plenty of online resources describing the various methods for estimating your valuation; lots of places to get differing opinions on what the valuation “should be”; companies galore offering to (charge you to) help you “determine” your valuation; and places you can go (like a workshop) to learn about the strategies and techniques more.

All of these are nice, but fundamentally investors don’t care what other people (especially those with no skin in the game) think. For our money, all that matters to us is what we think this company is worth. That’s the right valuation.

Back to basics: pre- vs. post- complications

Four, more complexity between “pre-money” and “post-money”

Imagine a company that has previously raised a $100,000 convertible note whose terms require it to convert into equity if the company raises $500,000 of equity capital. Now it raises $500,000 on a $2 million pre-money valuation. What is the post-money valuation?

Per the last post, one would imagine $2M pre-money + $500k of money = $2.5M post money valuation, with the new investors owning 20% of the company ($500k/$2.5M). Right? No.

When a deal is done, there is often more complexity than simply “new money”. In this case, the conversion of the convertible note into equity; other times, the creation of an option pool for future employees.

To account for these complications, we actually calculate as follows:

  • Pre-money valuation = current number of shares multiplied by proposed share price
  • Post-money valuation = post-transaction number of shares multiplied by proposed share price

Back to basics: pre- vs. post-money valuation

Third, the “pre-money” vs. “post-money” confusion

Angels speaking in terms of “pre-money valuations” can lead to some confusion. Entrepreneurs often think in terms of “share of the company sold” and the cost of that stake in the company. So, for example, they might say “we are selling 25% of the company for $500,000.”

Multiplying each side by four: 25% of the company => 100% of the company; $500,000=> $2 million. So my valuation is $2 million.

This math is right, but that is not the pre-money valuation. It’s the valuation of the company including the investment that has been made – because the shares are purchased and the money goes into the company. So once we’ve invested, the post-money valuation is $2 million in this scenario.

To get the pre-money valuation, we have to subtract “the money” – i.e. $500,000 from $2 million. In angel language, this is a deal with a $1.5 million (pre-money) valuation.

Got it? Good – because this mistake appears quite a lot.

Consider this TechCrunch article from early March: on Dragons’ Den (Shark Tank with posher accents) M14 industries negotiated “a deal £80,000 for 20 percent equity, giving the young startup a £400,000 pre-money valuation.” No it didn’t.

Or a pitch we recently saw from an otherwise compelling company: “raising $350k for 10% equity, a $3.5M pre-money valuation.” No it isn’t.

 

Back to basics: what is valuation?

Continuing our “back to basics” snippets (see here on basic deal types and here on the types of angel groups), we are going to have a few posts about the “economic” terms of angel investments.

First up, what is “valuation” all about?

Most people get the basic idea about buying stocks. Apple’s share price is $139. There are a lot of Apple shares, so that if you would buy them all at $139 per share the total cost would be $730 billion. That’s Apple’s market cap, its valuation.

Angel deals work the same way. We buy shares in a company. When we speak about “valuation,” we mean the share price multiplied by the number of shares, to give a total valuation.

So, for example, we might invest in a company at a $2 million valuation.  This means we buy shares at a price that means if we bought all the shares in a company it would cost us $2 million.

This doesn’t mean we’re investing $2 million, or that our shares are worth $2 million, or that the company is receiving $2 million.

Other myths

Here are a couple more misconceptions and myths.

I don’t have time to be an angel investor. False. Members of our group attend a 2-hour meeting 10 times a year. (Obviously many do more than that serving on diligence teams or reviewing their findings, being active mentors, advisers, or board members to portfolio companies , etc. – but none is required.) Investors in our funds like the VentureSouth Angel Fund II as entirely passive – no time commitment required.

This is just for men. False. Nationally, around 25% of angel investors are women. Some funds, like our coinvestment partner The Jump Fund, are women-led and focused on female entrepreneurs. Every VentureSouth group has a strong showing from female members, and all meetings are open to spouses. All are welcome.

What else have we missed?

Myth #8: There aren’t enough unicorns in the southeast

This “myth” is true – there aren’t many unicorns in the south east, and none in the Carolinas. There are also virtually no IPOs in the south east – perhaps six in North Carolina and one in South Carolina each year.

Certainly if your investment thesis is to find the next unicorn, Greenville SC is not the best place to do it. But that is not what we are looking for.

We do have a couple of companies where an IPO is a reported goal or a feasible exit. Proterra, for example, just raised $140MM from VCs and has incredible momentum – and an IPO is an obvious possibility.

But those are the exceptions not the goals. As I outlined in “Stand-up comedian entrepreneurs in America,” we aim for companies whose goal is be acquired for $20 million to $50 million (and perhaps more if things go very well). If we can turn an investment at a $2 million pre-money valuation into a $20 million exit, investors are very pleased with their 10x return.

This is absolutely feasible in the southeast. The Carolinas are good at business formation: for example, NC is ranked #8 and SC #14 for startup formation by the Kauffman Foundation, and entrepreneurs (and everyone!) are moving to the Carolinas from everywhere else. We pride ourselves on a tradition of lighter regulation (SC ranks #14 for lightness of small business regulation according to Pacific Research) – though perhaps more than we deserve (NC ranks in the worst half). So there are plenty of candidates and a business climate supportive of growth.

And on exits the regime is also good. “Small cap” M&A (deals of, say, $25 million or less) generally doesn’t make headlines, but it happens often. According to Watermark Advisors’s December 2016 “Watermark Wire” report, the median deal size in South Carolina in 2016 was $31 million and in North Carolina, $27 million – that is, most deals are done at values of $30 million or less.

And there are a lot of them. Watermark tracked $900 million-worth of M&A where information was disclosed. By number of deals these were around 25% of the volume, so the total acquisition activity in SC alone could be $3 billion a year. For North Carolina, it was multiples of that.

This is the exit process for our companies. Acquisitions for $35 million, undisclosed amounts of similar sizes in private transactions that do not make TechCrunch headlines but do generate positive investment returns.

Myth #7: It takes too long to reach exits

This is too often, unfortunately, true. Startup companies take a long time to mature into middle market businesses that large companies are interested in acquiring. Everything takes longer in a startup – from building up a base of engage clients to replacing your laptop when it breaks down.

VentureSouth has several portfolio companies in its portfolio that are past the “3-5 years” that is our target “hold period.” Other nearby funds are still working on companies they invested in during the early 2000s. (This is not necessarily bad. The “home run” multiples in the angel returns studies take a long time to come to fruition!) But no-one has infinite patience, and we have to prove that returns can occur before the investments are inherited by our children.

And we have done that. The average investment time for the successful exits from the VentureSouth portfolio is 1.6 years. Our shortest was 3x our investment in 3 months (a 2800% IRR). So if you set out to invest in companies with a 3-5 year plan and the capacity for an “early exit,” get management and investors aligned towards that, and give companies the tools, processes, and advice to execute them, you can get capital returns in a reasonable time frame.

Myth #6: It costs too much to be an investor

Finding deals yourself; conducting your own diligence; negotiating a deal; paying attorneys to create a suite of transaction documents; paying accountants for tax returns each year; chasing management teams to provide the information to monitor your investments; finding ways to assist your companies to grow; and figuring out how to get your investment back again. The cost of that in terms of time and capital is high. So, yes, it can be expensive to be an angel investor.

In VentureSouth, we do all this centrally, and define the price for it. The time commitment from members then becomes a couple of hours a month for meetings (for active members) or zero (for passive fund investors). The cost is the annual membership fee or fund management fee (for the deal flow, diligence, negotiation, and administration) and carried interest (for monitoring, assistance, and exit). You can learn more about our costs here, here, and here.

Doing this for over 200 people leads to significant economies of scale, as you can guess. (One deal for 60 people is obviously much less cost than 60 separate deals would be.)

Is it expensive? It depends on your perspective. Consider our most recent fund, the VentureSouth Angel Fund II. The management fee is 2% of capital per year – not dissimilar from an actively managed ETF expense ratio, and identical to the typical private equity or venture capital fund’s management fee. (The “2” in the “2/20” structure.) The carry is 10% - half the usual “20%”.  

Then factor on top the value from being part of a group - the networking from being part of a group of business and community leaders, the intellectual challenge of evaluating companies, the satisfaction from helping entrepreneurs realize their dreams, education opportunities, and free food at meetings – and the membership fee seems pretty reasonable.

Myth #5: Angel investing is for philanthropy or fun, not making money

Angel investing is about making money. VentureSouth itself is a private business (a SC LLC), not a government entity and not funded with public dollars. (Venture Carolina is a separate 501c3 non-profit that provides education for entrepreneurs and investors, funded by private donations.)

We get paid primarily from carried interest – that is, we take a share of the capital gains investors make from good investments. (A much smaller share than the IRS already takes incidentally; and aside from Trump coming after us “paper pushers…getting away with murder”.) We don’t get paid if investments lose money.

But aside from business structure and incentives, members know that the primary focus of our groups is attractive financial returns. Our motto is “Make Money. Have Fun. Do Good” – in that order.

Is that true more widely? Do angel investors make money from angel investing, or is their activity simply (even if inadvertently) philanthropic?

Certainly returns on deals vary; they vary over time, geography, investment strategy, and level of good luck. But there are studies that suggest that, done properly, angel investing is a legitimate “asset class” capable of generating positive returns. Our series of posts last year (starting here, then with more analysis here, here, here, and here) we outlined the overall conclusion that angel investing as an overall asset class beats public market investing by 3x.

Investors in our groups have made money investing locally too: overall, the 11 investment rounds that we have exited successfully have generated a 60% annual rate of return.

Myth #4: You need to be an expert

Nope. Most people (nearly two-thirds) that join VentureSouth tell us that they are becoming angel investors for the first time.

This is not deliberate: we are not seeking out people that do not know what angel investing is. Finding them, educating them, and then helping them navigate how to be an effective angel is not the most efficient operational model!

But it is necessary, because in the Carolinas there is not a long history of angel investment. In New York, it’s hard to move without bumping into an angel investor; in Anderson, it’s quite a bit easier. Our operating model is to find people that could be interested in becoming an angel investor, and then give them the tools they need to decide.

These tools include:

Educational events. Taking a look at our events page will give you a flavor of the educational events available to members. We start with a new member orientation session and instruction packet, to help new members understand the basics. We have online webinars and in-person educational sessions on specific topics pertinent to angel investing – from “intro to deal terms,” to “valuations of early stage companies,” to “executing exits” – covering the whole range from investing to realization. We also provide access to the Angel Capital Association’s suite of educational topics. If we had a bigger budget, we would love to do more of these activities.

In house expertise. The VentureSouth team do this, and nothing else, full time – and we are beginning to know what we’re doing. We unashamedly steal the best practices from across the US – in part thanks to Matt’s presence on the ACA’s board of directors.

Established processes. We screen, evaluate, and invest in a standardized way. This month’s deal is compared to all the others we have considered, so a new member can quickly and easily “calibrate” this opportunity against earlier ones – even if they hadn’t seen those ones.

Support from our sponsors. Banking services, legal documents, accounting and tax returns – headaches that a startup entrepreneur (or us!) cannot afford the time or capital to learn about on their own. Thanks to Wells Fargo, Nelson Mullins, Bauknight Pietras & Stormer, and many others, we have the resources to tackle all the technicalities of angel investing; new angels are in safe hands.

Myth #3: It takes a long time to build a portfolio

It simply does not take a long time to build a portfolio of angel investments. When we published the first article, there were 13 investment opportunities available to our members, so you could create a pretty well-diversified portfolio immediately in theory.

This wasn’t an unusual position. Currently (mid-March) we have 12 open rounds available, of which five are new since the first article – a combination of new investment opportunities that have successfully navigated our diligence process and follow-on rounds in existing portfolio companies.

VentureSouth members invested in 15 companies last year (8 new ones and 7 follow-on rounds). Our Palmetto Angel Fund fully invested its capital in 2½ years, and the successor VentureSouth Angel Fund II has already called and fully invested 25% of its capital, only six months into its investment period.

Of course, investing individually or as part of a single angel group limits your deal flow and extends the time it takes to create a portfolio. But larger groups can tackle the workload of diligencing and monitoring a diverse portfolio. We aren’t quite as prolific as Tech Coast Angels (the #1 angel group in the US), who have invested in an average of 20 deals per year since 1997, but for the last few years we have not been far behind.

---

Myth #2: You need to invest a lot of money

Following the math in the original article, you can create a portfolio of investments as a VentureSouth member for $50,000 (10x $5,000 investments) to $100,000 (20x $5,000 investments). The minimum commitment to our previous sidecar index fund, the Palmetto Angel Fund, was $25,000; it invested in 18 companies.

In general, advocates of angel investing say your angel portfolio should be at most 5% of your investable assets – this is a risky asset class after all. $50k of investment translates to $1 million of investable assets – approximately the accredited investor definition.

So you don’t need millions of dollars to be an angel investor. The returns from angel investing are probably not going to change your overall portfolio return substantially (it’s hard for 5% of your portfolio to change its overall direction), but they could be a nice bonus that is not correlated with the rest of your portfolio.

And you don’t necessarily need to invest using "unused" cash. Many of our investors use a small proportion of their retirement accounts to fund their angel investments. If you just made this year’s IRA contribution and weren’t enthusiastic about more public equities at the “new normal” of 20x P/E, perhaps a self-directed IRA commitment to a VentureSouth sidecar fund might be an alternative this year?

Myth #1: Not many people can be angel investors

Anyone can invest in early stage companies. (You can invest as an “unaccredited investor” in certain situations or platforms, subject to limits on how much you invest and rules on how many other unaccredited investors are investing with you. But for simplicity, we’re only talking about accredited angel investors.)

To be an angel that invests in multiple companies with management teams you don’t already know, you really need to be an accredited investor. That does not mean you need to sit an exam and receive “an accreditation.” It simply means you have a certain level of net worth or annual income.

These levels are defined by the Securities and Exchange Commission, at $1 million of net worth (excluding your primary residence) or annual income over $200,000 for individuals (for the last two years and expected this year) or $300,000 for couples.

(There are potential changes to this definition, to allow people with “expertise” (e.g. CFAs) to be angels even if they don’t hit the thresholds, or to index-link the thresholds, but this doesn’t really change the overall point.)

So how many people are there that could be angel investors? The national Angel Capital Association estimates over four million people in the US are accredited by wealth. An estimate by Deloitte put the figure for millionaire households (a pretty good proxy) in South Carolina at around 110,000 in 2010 and 190,000 by 2015, and for North Carolina around 287,000 in 2010 climbing to 431,000 by 2015.

(Here is the pdf of that study. The study was from 2011, and, given the economic growth and inward migration to the southeast since, the total is probably nearer the 2015 estimates.)

How many actually are angel investors? The ACA again provides a national estimate of 300,000 people making an “angel investment” in the last two years, similar to the number of angel investors calculated by the University of New Hampshire’s Center for Venture Research of 304,950 in 2015.

Data for the Carolinas specifically is not available (as far as I know). Assuming angels are spread proportionally by overall population (an obviously wrong assumption), there would be around 14,000 active angels in the Carolinas. Assuming the ratio of millionaire households according to the Deloitte survey (so roughly 621,000 millionaire households in the Carolinas of a total 15.5 million millionaire households) multiplied by 300,000 active angels gives around 12,000 active angels in the Carolinas. I would guess it is a good bit lower in reality.

Whatever the exact figures, there are a good number of people making angel investments in the Carolinas, and many multiples more who could be.

Myths of Angel Investing: This Month's Posts

In my last two Upstate Business Journal articles (here and here), I’ve tried to debunk a few myths and clear up a few misconceptions about angel investing.

There are a few areas that word count limits my ability to explain and cite sources, so over the course of the next few posts this month I’m going to expand on the eight topics, to explore where the misconceptions come from and provide a bit more detail on my clarifications. Hope they prove useful.

Don’t have time to read those articles? No problem: the myths are:

  1. Not many people can be angel investors
  2. You need to invest a lot of money
  3. It takes a long time to build a portfolio
  4. You need to be an expert
  5. Angel investing is for philanthropy or fund, not making money
  6. It costs too much to be an investor
  7. It takes too long to reach exits
  8. There aren’t enough unicorns in the southeast

What To Do With An Idea

I read children’s books every day- admittedly, not always for pleasure, but definitely by choice.  My wife and I have a bunch of kids, and I cherish the quiet moments before bedtime when I get to read one of the many Llama Llama books on our shelf or hear my daughter giggle when we read Too Purply. My 7 year old doesn’t necessarily like for me to read to him anymore. He likes to read his Diary of a Wimpy Kid books to me (which are actually really good). My 8-month-old twins could care less what I read to them because they just want to eat the pages, but my go-to these days for them is Jimmy Fallon’s book he wrote to try to get his daughter to say Daddy, appropriately named DaDa

My 3 year old is a different story. She LOVES books; so much that we have to cap how many books she gets at bedtime or she would stay up all night.  She recently grabbed a book off her bookshelf that I had not read to her yet, but the title itself caught my attention- What Do You Do With An Idea by Kobi Yamada.  It’s about a kid who had an idea.

The idea in the book is portrayed as a golden egg with legs and wearing a crown.  He didn’t know where it came from, why it came to him, or what to do with it. At first, he tried to walk away from it, but it kept following him. He started to embrace it, but he still kept it hidden and didn’t talk about it. As time went on, the idea grew larger and he became friends with the idea because it made him happy. With apprehension, he started to show people his idea. They laughed at his idea, said it was no good, and that he was wasting his time with this weird idea. At first, the boy believed them and thought seriously about abandoning his idea, but quickly realized they didn’t know his idea like he did. It didn’t matter to him that his idea was different, weird, or crazy. He then spent even more time with his idea and before long; he couldn’t imagine life without his beloved idea. Then, all of a sudden, his idea (remember, it’s an egg) changed right before his eyes, spread its wings and took flight. The story concludes with the boy stating that his idea “wasn’t just a part of me anymore, it was now a part of everything. I then realized what you do with an idea…you change the world.”

What a powerful lesson for entrepreneurs who may be wrangling with an idea of their own. I’m blessed in my role at VentureSouth because I get to work with many outstanding people who are best friends with little golden eggs that have the potential to change the world.    

Tweet your golden egg to @Charliebanks11.

Charlie, Managing Director- VentureSouth

Back to Basics: types of angel groups recap

Over the last month we've outlined the thinking behind why VentureSouth groups are organized the way they are.

Starting here we outlined the basic types of angel groups, then tried to explain the pros and cons of each part of our structure (of a network of angel membership groups, run by a professional team, whose members meet in person to help individuals invest their own capital in early stage companies across the southeast).

Hopefully you found it useful. We know this structure doesn’t work for everyone all the time, and we will continue to modify and improve – adding more committed capital funds and working on ways to provide better “virtual access” to our investments, for example. And we are always looking for constructive criticism, so if you have it please let us have it!

 

Back to Basics: why across the southeast?

Why “across the southeast”?

This balances two offsetting requirements.

1) Diversification. We make many investments in South Carolina because of where most of our groups are – but we can’t invest exclusively in deals in Charleston (let alone Spartanburg or Anderson) because there are not enough high quality opportunities in a small geography. Diversification is critical to early stage investing – and that means looking for the best deals across a sufficiently wide area.

2) Supervision. Angels make money by evaluating companies and helping them succeed. Companies based two states away from our members are much harder to supervise and assist, so reduce our chances of making positive returns.

So we settle on “across the southeast” – with almost all of our investments in the Carolinas and Georgia.

Back to Basics: why "early stage"?

Why “early stage” (not “seed” or “growth” stages)?

We use “early stage” to mean companies that are beyond just an idea, have a team in place, have created a business plan and strategy, and can provide some evidence of traction (ideally some initial revenue). They do not necessarily have a long history, wide user base, or profitable operations.

We think early stage is a good place to invest. It is impossible to judge whether an idea will be successful, so “seed investing” is too hard for us. Having some evidence of traction or a product / market fit – enough to give us at least some estimate of the potential of a company – mitigates some of the investment risk. Even then, we know we will make some investment mistakes, but there is less guess work.

On the later-stage “growth” side, VCs typically need to a lot more traction and deploy much more capital. This means they write larger checks at higher valuations, and therefore need bigger exits to generate good returns. This can obviously be extremely successful. But there are not many large VC funds in the Carolinas, suggesting it’s hard to do it here (for reasons that go beyond this post). Hence we focus on early stage companies.

Back to Basics: why private capital?

Why individual private capital (not public or institutional funding)?

1) No strings. Grants or other public funding for early stage investment, if it even exists in a particular market, comes with significant strings. These might be obvious (e.g. can only invest in companies in South Carolina – which limits the opportunity for diversification); or they might be subtle (e.g. job creation must be an important element of the investment criteria – which neglects companies able to generate substantial value without necessarily creating jobs). But public money comes with strings that private individuals’ capital typically doesn’t have.

2) No strings – again. Similarly, funding from a large institutional investor comes with implications. A corporate investor, for example, might want preferential services from portfolio companies that may not be in the best interests of the company or other investors. Private individual capital tends to have fewer “other considerations” – and because each individual is writing a much smaller check they have less ability to negatively direct a company.

But of course both public and large institutional investments can be great sources of capital. We don’t have many around the Carolinas interested in investing in early stage companies, so this part of our structure is as much through necessity as choice!