Valuations are down during this recession!

November 20 2009 No Commented

Valuations are down during this recession!

The pre-money valuation of a new venture is the valuation just before an investor writes a check. The post-money valuation is the valuation of the startup just after investors checks are cashed for a given round of investment. Therefore: The pre-money valuation plus the invested monies equals the post-money valuation.

The pre-money valuation is critically important to investors because it defines the share of ownership (equity) their round of investment will purchase. If angels invest $500,000 in a startup with a negotiated pre-money valuation of $1.5 million, the post-money valuation is then $2 million. A $500,000 investment in equity then purchases 25% of the company ($500K ÷ $2 million = 25% ownership). 

Valuation at the startup stage defines the potential upside for the investors.   If a new venture has a potential market valuation for a cash sale of the company to a larger firm five year hence of, say, $20 million, having invested at a post-money valuation of $2 million provides the investors with the potential for a 10X return on investment (ROI). ROI = Exit Valuation ÷ Post-money valuation, – in the very simplest case of no subsequent investors or other dilution of the first angel investment.

So…why should valuations be lower during a financial crisis? Clearly many entrepreneurs are attempting to raise money to start companies. At the same time, angel investors are somewhat more reluctant to write checks during a recession. After all, it is their money they are investing! So, we expect valuations to be lower during a recession. But…how much lower? Typical angel seed/startup deals during 2005 to 2007 in the US were closed at pre-money valuations of $1.5 to $3 million and many above that range. Experienced angel groups, such as the Ohio TechAngels (Columbus, Ohio) sought to invest at pre-money valuations of $1.25 to $1.75 million during the peak in the last business cycle. On the other hand, some angels chose to invest at valuations above the ranges described above.

What’s happening now? I have been investing as an angel since 1980 (> 50 deals) and have invested in only one seed/startup deal at a pre-money valuation of less than $1 million. But, the last deal I invested in was a $300K round of investment at a pre-money valuation of $400K. And, I have heard of many seed and startup deals closing at valuations of less than $1 million.   It is simply a sign of the times.   Entrepreneurs with quality deals are forced to offer higher equity stakes (equates to lower pre-money valuations) to raise money from reluctant angels during this recession.

What more could angels ask for – high quality deals at low pre-money valuations! It’s a GREAT time to be an angel!

Bill Payne is the 2010 BNZ University of Auckland Business School Entrepreneur In Residence.