As a professional accountant I have a natural bias to historical information.
For the most part accounting deals with the presentation of financial information at ‘cost’. With the introduction of international financial reporting standards (“IFRS”), this may have begun to change, however North American accountants still use historical cost for small (and medium-sized) private businesses. ‘Value’ in contrast to cost, is usually inferred with reference to financial performance.
However most startups haven’t been around long enough to have any measurable profitability. In the words of Eric Ries (author of the Lean Startup):
To be honest, in far too many of my companies, the accounting was incredibly simple anyway: revenue, margins, free cash flows – they were all zero.
In other words, standard valuation methods that start with “EBITDA” (earnings before income tax, depreciation and amortization), would invariably result in a valuation of zero…and yet somehow Mr. Ries’ companies were able to get funded.
As consumers we make valuation decisions all the time. We purchase computers, vehicles, houses and breakfast cereals. As a professional I know that advising someone else on the value of something as complex as a business, requires a great deal of judgement and analysis. My professional training provides a theoretical basis and some rudimentary methodologies for a valuation assignment, each of which starts with historical cost.
As I’ve said already, when it comes to valuations there is a fundamental problem with start-ups: historical information doesn’t exist. From the perspective of most accountants valuing start-ups goes like this:
“Show me results. Until then this start-up is worthless.”
When I was first introduced to angel investing and learned how angels value early stage companies, it soon became apparent that their approach to valuation violated all of the principles that I had been taught. What’s more, their valuations were almost always wildly wrong. I set about researching a better approach to the valuation of start-ups.
However it soon became clear that more accurate valuations wasn’t going to improve the return on investment (“ROI”) for angel investors. They don’t value based on historical information. They ‘evaluate’ the management team and their ability to execute a business concept and a plan effectively. In other words they are evaluating the potential for returns in the future. Based upon their evaluations, angels provide startup capital to these early stage companies, knowing that most will fail.
In spite of the high failure rate, investing in start-ups can be very profitable. US angels are achieving internal rates of return on their portfolios of more than 20%. Try and do that on the stock market today!
When this realization began to sink in, my focus shifted from building better valuation methodologies for start-ups, to improving the ROI for investors. I knew that, with our more generous tax incentives in Canada, there is a potential to achieve even better returns – particularly for BC residents.
What’s more, it became clear that too much of the money invested by angels, ends up ‘stranded’ in under-performing companies. As we’ll see later on, this amounts to more than half of all their invested capital. If angels could build strategies to lessen the extent of stranded capital, their ROI would increase significantly.
However investing in start-ups is risky. Successful angel investors conduct extensive due diligence before they invest. In spite of this more than half of their investments will fail (see MONEY for STARTUPS). Which means that their valuations are almost invariably wrong – since it could be said that they probably undervalue the successful companies. From my perspective though, the successful angels themselves provide a great deal of the value to successful companies.
Investing in start-ups is hard and it’s a numbers game. An inexperienced investor taking on one or two start-ups is more like betting on ZERO in roulette, than investing. To be successful you need a diversified portfolio, you have to add value and you have to spend time with the companies you invest in. Of course that presupposes that you have valuable experience to add. If you don’t, you’ll need to invest with other experienced investors, relying on them to provide value to portfolio companies.
Unlike companies on the stock market, investing in start-ups can involve designing the corporate structure and the shape of the investment itself. You’ll need to agree with founders on valuations and often even the type and features of securities. Should you buy convertible debt, or preferred shares?
It’s true that you can’t rely on the past to predict the future when it comes to investing in start-ups – since start-ups don’t have a past. However if you’re planning to invest with an existing angel group, you’ll want to know how well the group has fared in the past before signing on. After all it is the angels themselves who provide much of the value, and understanding the past is still the best way to predict the future.