What should you do if a person were to ask you how much his/her seed investment/stake in your company is worth?
In my experience, some of the most difficult investors to manage are among the less-sophisticated members of the angel community. From the sound of your question, I'll assume that you have only recently taken money from the investor in question and he/she is asking you for an update on his/her paper ROI. I understand fully the difficulty of answering that question.
Long Haul Ahead
Based on a statistical sampling of venture-backed startups, you have six to ten years of agonizing (and at moments, triumphant) entrepreneurial struggles ahead of you. Your angels need to understand that they are in it for the long haul. They have made an investment in a completely illiquid security. If they do not understand this fact, it may be time to begin educating them about the holding period to which they are subject. If this part of your conversation goes well, then the rest should follow. If not, you're in for a doozy.
The Majesty and Mystery of Valuation
Any valuations conducted between now and the ultimate exit are purely hypothetical, and will likely be conducted for singular reasons (usually regulatory as opposed to transactional). Valuations may be conducted in the context of IRC 409A / ASC 718 (see ), or for gift & estate tax purposes, or to support management in the context of a financing or M&A event. Each has a purpose and must be examined in context. So even if youdid have a 409A valuation to point this investor to, it's more likely to confuse the situation than clarify it. Try explaining the "Option Pricing Method backsolve" to an unsophisticated investor.
The Simplest Metrics of Value
If you want to establish a standard of value by which your investor(s) can judge you, my only advice is to make it a "near-and-clear" measure of value. Make that a relevant, near-and-clear measure. Perhaps a multiple of eyeballs (remember 1999?) is not such a good measure, while a multiple of revenue or earnings might be.
I'm inferring from your question that you are currently without earnings or revenue. I'm afraid you're left with the DCF, or Discounted Cash Flow model, as the only practical solution to the valuation question. The DCF is not terribly complicated, but it is pretty easy to screw up if you're not practiced in the art. Begin by playing with any old DCF model found online (see http://dcf-models.com/business-v...for one). But don't depend on an off-the-shelf model for your calculations. Rather, once you've come to understand the mechanics of the DCF you ought to add that functionality directly into your financial forecast model.
The Trouble with Forecasts
The trouble with the DCF is that it's based on your forecasts. The trouble with that is your forecasts are wrong. Always. That is, unless you are Comcast, with subscribers virtually locked in (or are they?) and revenue very predictable (or is it?), your revenues and expenses over the coming 3-5 years are anyone's guess. Still, you must do what you can to make an educated, dependable and reasonableestimate of your future financial performance. And then discount the crap out of those forecasts.
We rely on a host of academic studies when arriving at an appropriate discount rate for venture backed startups. For angels, you had better be offering greater than a 50% IRR on their money, so the discount rate you ought to apply to your forecast cash flows ought to be higher than 50%. We have seen (and employed) discount rates far higher than 50% with good reason. That's part of the valuation pro's judgment. The old adage in the valuation community is "you supply the forecasts, I'll supply the discount rate." One possible translation: the more ridiculous the forecasts, the higher the discount rate. Which is why I emphasize that forecasts be at all times reasonable.
OK. Now to answer your question more explicitly:
- Educate the angel about the long ride ahead, and the supremely illiquid, non-marketable, non-controlling nature of the security he or she holds.
- Derive a simple way to reasonably predict the company's future cash flows.
- Use a DCF-like method to value those cash flows, using a healthy discount rate to arrive at a valuation. Use a sensitivity analysis to come up with a range rather than a point-estimate.
- Show your math to the angel, and emphasize the difficulty of arriving at your assumptions, not to mention your conclusions
In whatever way you can, try to educate your angels through this process. If you can help them understand the difficulty (and degrees of freedom) involved in your analysis, perhaps they won't be asking you again about your valuation. Perhaps they will instead look for ways to help you increase your cash flows or reduce the risks inherent in the enterprise.