One entrepreneur has a company which appears to be scalable to a $30 million exit value in 5-8 years and a second entrepreneur’s venture seems to be scalable to $200 million in exit value in the same time frame. Yet, at the pre-revenue stage of development, angel investors price both companies at a pre-money valuation of $1.5 million. It doesn’t seem right, huh?
But, it is…and here is why. It is possible to grow a company to a valuation of $30 million on one or two angel rounds of investment. But, the working capital and management team necessary to grow a company quickly to sufficient revenues to justify a $200 million valuation will require raising lots more capital. So, the angels who provided the most valuable and risky financing for the gazelle that can grow to a $200 million valuation quickly are going to get diluted by subsequent investors, probably by three to five-fold. They may own 30% after the first round of funding but will probably own less than 10% at exit. So, angels simply must value both ventures at about the same price.
Scalability is a critical factor for angel investment. Because of the risk inherent in funding pre-revenue companies, they are unlikely to invest in any venture that cannot demonstrate the potential to scale to a $20-30 million in valuation in a reasonable time period (5-8 years).
So, angels won’t fund a deal that doesn’t scale sufficiently to justify investment and then tend to value all pre-revenue stage companies at about the same valuation, which is currently about $1.5 million in most parts of the US. Although there may be some variation among business sectors, this is essentially true for software companies, medical device companies, life science ventures, electronics companies and alternate energy deals, regardless of the long term potential.
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