Business angels – How do you know when the price is right?

Valuing a start-up business is no easy task

Seven years ago in August 2003 an unknown company released some software which would allow people to make free voice and video calls over the Internet. A year before the company had received seed capital from a group of private investors to allow the company to develop its idea. That company was Skype.

Skype was later bought by ebay for €2.1 billion and is now an indispensible means of essentially free international communication. Those early investors made a return of around 350 times their initial investment which was no doubt heavenly for those involved at the time.

Most start-ups can only dream of achieving rapid growth of this scale and generating profits of this magnitude for their business angel backers. The reality is that most start-ups will fall at either the first or second hurdle and the angel investors who backed them will be on the receiving end of an 80% failure rate when you look deeper into the stats.

But was it simply luck that allowed those early investors in Skype to hit the jackpot? Or was it as much about the ability to know when the price and the opportunity was the right one at the right time?

The biggest problem for angel investors as they ponder whether or not to invest their cash into a start-up business is assessing its value. Investing at this stage is undoubtedly a gamble as we have explored previously on ibusinessangel.com, but with the odds stacked against a successful outcome and the cash involved, the risk needs to be a calculated one.

So how do you assess the value of a start-up when even established businesses are difficult to value?

This really is the million dollar question and unfortunately impossible to answer for even the most seasoned investor. This is because valuing even an established business is more art than science. As an angel investor you will often be expected to assess the value of essentially nothing other than an ‘idea’. Experience as a business angel or learning from the experience of fellow angel investors is really the only way to gain some idea of how much a start-up business might be worth.

According to the experts there is a simple rule of thumb. If the start-up is just an idea, it is worth maybe £10,000; if it has a credible management team in place it could well be worth £100,000 and if it has sold its product to a real company for real money then it might be worth £500,000. There is of course a question mark against all three, is the ‘idea’ a good one?

For anyone who has watched the BBC’s Dragon’s Den good ideas certainly appear hard to come by. The show has its fair share of deluded entrepreneurs valuing their businesses to highly or often presenting laughable ideas to the panel with a completely straight face. Those individuals make good television but are they representative of the kinds of entrepreneurs out there seeking the backing of angels?

More than 90% of the ideas that find there way into the Den appear to lack the Reggae Reggae Sauce to succeed!

The high failure rate on TV could well be a result of the heavy emphasis on ideas and individuals. Rather than experienced teams of managers the people presenting their ideas often lack the basic fundamental business knowledge to make a credible case for investment. Their businesses are, more often than not, valued to highly and they are often seeking guidance and direction in addition to investment.

With this in mind it is worth considering whether the person with the great idea but with no business sense is worth the risk. Whilst the idea is important and in rare cases can lead to a significant return on investment, as suggested above, a business is worth more when it has a credible management team in place who know the route to market and have a track record of delivering success in their market place. Add this to a product that is already selling and you have a more realistic chance of long-term success.

While the lone wolf entrepreneur with a good idea may offer a bargain, if you prefer to play safe, it may well be worth considering investing a bit more cash in a good proven management team. You can never really know when the price is right , but you can look at the people you are investing in and hope their  expertise will give you a better chance of a heavenly exit three years down the line.

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