Start-up companies that need capital for production or marketing can seek funding from angel investors, also known as seed investors. After due diligence and reviewing a company’s valuation, these outside investors are willing to hand over significant sums for a percentage of the company.  But how does anyone put a value on a business that is pre-revenue or has only minimal sales and no cash flow?

“Valuing a start-up company is like a kaleidoscope: you turn and turn, looking at many variables until it all comes together. Valuation is part science but mostly art, made up of hunches and guesses,” said Jim Troxel of Development Capital Networks. Troxel led a Seed Investing seminar, organized by TMAC and the McAllen Chamber of Commerce, that was attended by entrepreneurs ready to shift their businesses into a higher gear.

Troxel explained that angel investors seek young companies which have not fully established commercial operations. Angels typically represent the second round of financing, after the first round of capital infusion from friends and family. According to Troxel, angel investments accounted for $17.6 billion nationally in 2009, which is approximately the amount invested by professional venture capital funds.

While angel investors often make decisions based more on instincts than on due diligence, they nevertheless are going to ask how the value of the start-up is justified.

“Projections are never conservative enough for investors,” Troxel said. Investors review all the risks involved in their participation: the technical risk (will the product work?), the market risk (will customers buy it?), the financial risk (will it make enough money to cover expenses?) and the management risk (is the team going to be able to execute the plan?).

Different valuation methods are used by entrepreneurs and examined by investors. The complex formulas include the Venture Capital Method and the First Chicago, based on projected earnings times multiples which are compared to the multiples of same-industry public and private companies, 15 and 10 respectively. The Berkus method uses a scorecard based more on the perceived value of strategic relationships, management capability and existence of a prototype. The pre-money value of a company includes the entrepreneurs’ contributions to date: concept, funds and management.

Whatever the method, investors receive either convertible preferred stock, common stock or convertible notes for their money. Investors are interested in the return on their investment, when it will be realized, plus how much of the company will they get for their investment in the start-up C corp. Because of the inherently high risk of start-ups, they ask for a high return on their investment. Some expect a 66 percent ROI with a five year exit plan in place, according to Troxel. Nevertheless, investors don’t want to reduce the management team’s ownership to less than 50 percent. Below that threshold,  entrepreneurs may feel less committed.

For more of this story by Eileen Mattei, pick up a copy of the July edition of Valley Business Report, on news stands now, or visit the “Current & Past Issues” tab on this Web site.