I am sure you must have heard other investors say “What is this company’s valuation” or you have seen TechCrunch publish an article about how “start-up Y has achieved unicorn status and is now valued at £1 Billion.”
The word valuation is consistently used in combination with how much the founder is raising and how much equity you will be receiving as an investor. But it seems like valuations are something of a dark art, not always straightforward. So what are valuations, how do they work and how should we think about valuations?
Ultimately, the market determines the valuation of a startup. Keep reading on to see why we believe this to be true.
What are valuations?
Valuation refers to the process of determining the current worth of a startup or company. When angel investors invest in early-stage startups, they are essentially buying a portion of the company, and the valuation directly affects the price they pay for their equity stake. Therefore, it’s crucial for angel investors to carefully consider the valuation before making an investment decision.
There are a number of reasons why valuations matter. The most important reason is that the valuation of a startup determines how much money you will invest to acquire a stake in the company. In return, this will directly affect the potential return you will make on your investment. A higher valuation means a larger investment for the same equity stake. Valuations also affect future potential exits. A high valuation during an exit is like a double-edged sword: if the valuation is high and a company gets acquired then you will get a higher return on your equity ownership, however, a higher valuation might also mean that it will be more difficult for a startup to be acquired.
Lastly, as the venture capital and angel investing ecosystem has shown in the last few years in the Web3 and Crypto market valuations can also indicate the performance of a market. An unrealistically high valuation may signal that the company is overvalued, while an extremely low valuation may raise concerns about the startup’s potential for growth and success.
Mathematical example
I know this might sound very complicated so let’s take a look at a simple example to illustrate how valuation can affect an angel investor’s investment and potential returns.
Let’s picture an imaginary startup, AngelTech, which is seeking a £500,000 investment from angel investors. The founder is willing to give up 20% of the company’s equity in exchange for the investment. Therefore, the pre-money valuation of the company (the value before the investment) can be calculated as follows:
Pre-money valuation = Investment amount / Equity offered Pre-money valuation = £500,000 / 0.20
Therefore the pre-money valuation = £2,500,000
Now, let’s consider two scenarios with different valuations:
Scenario 1: Low Valuation
AngelTech receives a £500,000 investment for 20% equity, as mentioned earlier. However, this time the angel investors negotiate a lower valuation for the company. They agree on a pre-money valuation of £1,000,000.
Post-money valuation = Pre-money valuation + Investment amount Post-money valuation = £1,000,000 + £500,000 Post-money valuation = £1,500,000
In this case, the angel investors now own 33.33% of AngelTech (since £500,000 / £1,500,000 = 0.3333). If AngelTech later becomes successful and is acquired or goes public at a higher valuation, the angel investors will have a higher potential return on their investment because they own a larger stake in the company.
Scenario 2: High Valuation
Now, let’s consider a different scenario where the angel investors agree to a higher pre-money valuation of £5,000,000 instead of £1,000,000.
Post-money valuation = Pre-money valuation + Investment amount Post-money valuation = £5,000,000 + £500,000 Post-money valuation = £5,500,000
In this case, the angel investors only own 9.09% of the company (since £500,000 / £5,500,000 = 0.0909). If AngelTech later achieves success and is acquired or goes public at a higher valuation, the angel investors have a lower potential return on their investment because they own a smaller stake in the company.
Conclusion
This simple mathematical example demonstrates how valuations can significantly impact angel investors’ ownership stakes and potential returns. As an angel investor, it’s essential to carefully assess the valuation and its implications before making an investment decision as this will directly impact your future returns during an exit.
Truth is, in 2023 the financial markets have been experiencing rising interest rates and high inflation. As a result, the cost of capital has gone up and therefore there is a direct impact on the investor’s appetite to invest. Therefore, referencing the example above, the AngelTech startup will be more likely to take a lower valuation in this market based on what investors are willing to pay. In this scenario, you could say founders are usually price takers rather than price setters when it comes to valuations.