Angel Investors Rely On Gut Feel Over Data

Laura Huang, assistant professor of management and entrepreneurship

New research shows that early-stage angel investors rely on instincts over data when looking for their next home run.

As the first source of external financing for most entrepreneurs, angel investors play an important role in the success of burgeoning startups. But investing in young businesses is always a risk. So what convinces an investor a venture is worth betting on—the product? The market data? The confidence and charm of the entrepreneur?

According to research by Laura Huang, assistant professor of management and entrepreneurship, the answer might be found in an unexpected place: the gut. In her paper “Managing the Unknowable: The Effectiveness of Early-Stage Investor Gut Feel in Entrepreneurial Investment Decisions,” coauthored by Jone L. Pearce, a University of California, Irvine, management professor, Huang examined the ways in which angel investors make decisions. When she was speaking to investors for her research, she says, one theme kept turning up: “They would talk about the size of the market; they would talk about the product. But they kept coming back to: ‘Well, then I rely on my gut feel,’ or, ‘Then I invest based on my gut feel.’”

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Decisions, Decisions: How to Choose Your Investors

Karthik Sridharan W’07/ENG’07, Co-founder and CEO of Kinnek

Properly choosing your investors is one of the most important, but often overlooked, aspects of building a tech company. As an early-stage entrepreneur, you’re constantly dealing with so many major existential questions (“Will our company exist next week?”, “Why can’t we convince a single person to invest any money in us?”), that the matter of deciding between multiple investors seems like a real first-world problem. I had many friends volunteer the advice that “beggars can’t be choosers” in those early-stages; they figured we should just take money wherever we could find it. Boy, am I’m glad I didn’t listen to them!

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Should An Entrepreneur Get An MBA?

Should An Entrepreneur Get An MBA?

By Eurie Kim WG’09, investor at Forerunner Ventures

When people ask me whether they should get an MBA if they want to start a company, I respond with: It depends. Do you already have an idea and a team? If not, what type of company do you want to start? Have you started a company before? What do you think you will get out of an MBA that you can leverage in the company building process? The answer to the question depends on where you’re starting from and where you’re trying to go.

Forerunner Ventures webpage2

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How to Approach VCs as a First-Time Entrepreneur

By David Klein, Wharton MBA alumnus, co-founder of CommonBond

When people ask me, “When is the right time to talk to VCs?” my answer is, “Yesterday.” Why? Because many entrepreneurs – especially first time entrepreneurs – never really feel “ready” to talk to VCs. “Everything has to be perfect… Results aren’t good enough yet… All ducks must be in a row.” Right? Wrong.

First Wharton borrowers - smaller
CommonBond’s first Wharton borrowers.

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How to Value a Revolution

By Ravi Viswanathan (ENG’90/WG’98)

It’s an exciting time to be a venture capitalist. As an investor at NEA in Silicon Valley, I’m seeing some of today’s greatest technology and business revolutions up close:

  • Software-as-a-Service: the new model for business applications
  • Cloud computing: enabling unprecedented infrastructure performance and flexibility
  • Payments: now being integrating into mobile devices and apps
  • Education: democratized and globalized for the first time ever

But these revolutions also present a challenge. Eager investors are driving valuations to extremely high levels. In the public markets, fast-growing leaders like Workday are trading at 25x forward revenue. In the private markets, zero revenue companies such as Instagram are being valued at $1 billion or more.

No matter how great the company, long-term investment success requires a careful approach to valuation. Ignoring fundamentals leads to disasters like the 1997-2000 tech bubble. On the other hand, big valuations often reflect big opportunities, even if the companies are small at the time. Valuations often just get ahead of companies’ true progress. We saw this during the bubble as well, when the stock prices of great companies (Amazon, eBay, Intel, etc.) crashed, despite ultimately achieving long-term success. The devastation was even more brutal for venture-stage companies. Being early can be just as bad as being wrong.

How should VCs think about valuation when we make venture-stage investments? A Wharton class may advise a DCF, but due to long-term uncertainty and the large volume of deals we evaluate, this is impractical for day-to-day work. Similarly, a rigorous comps-based analysis is difficult, since many of the startups we back are unlike any companies that have existed before.

At NEA, we find opportunities by looking for fundamental technology, disruptive transformations, great teams, and big markets. Once we identify something exciting, we think about a range of components of value to determine an entry valuation that will lead to strong returns when the company IPOs or gets acquired down the road:

  • Company stage: early stage companies must have appropriate valuations to compensate investors for the time it will take to build the company and the risk involved
  • Growth rate: faster growing companies will get big faster, justifying higher valuations
  • Market size: a company that is credibly attacking a big market, or trying to create a potentially big market, will get a higher valuation
  • Achievable market share: even if the market is huge, the startup has to be a credible attacker
  • Profitability and strategic importance: some markets and technologies are more likely to support profitable or strategically important companies, leading to higher valuations

As a very rough example, we can look at Workday (a leading enterprise SaaS company) and Palo Alto Networks (a leading network security company):

  • Workday is trading at 25x revenue and Palo Alto at 6x revenue. So, Workday has about 4 times the revenue multiple of Palo Alto.
  • However, if you divide the revenue multiples by consensus estimates of future revenue growth, Workday then has a 0.42x multiple and Palo Alto has a 0.16x multiple. Based on this adjusted measure, Workday’s multiple is only 2.6 times that of Palo Alto.
  • Analysts believe that Workday’s total available market (TAM) is ~$19 billion in HCM and Financials, and assume it will get 25% market share (=$4.75 billion). For Palo Alto, they see a smaller TAM of ~$10 billion, and 20% market share (=$2 billion).
  • If you take the companies’ adjustment multiples, you can make yet another adjustment, and divide by the expected market share (0.42x/$4.75 for Workday and 0.16x/$2 for Palo Alto). Now these adjusted measures come to 0.09x and 0.08x. Surprisingly close, even though Workday has a revenue multiple much greater than Palo Alto Networks.

On this “twice adjusted” basis, then, these two leading companies actually trade pretty close together. Although this is a very rough analysis, it explains much of how public and private markets place values on fast-growing companies.

For venture capitalists, a thought process like this offers a workable heuristic for heavier-grade valuation exercises such as DCFs. We need to be both disciplined in thinking about the company’s future value, but not so disciplined that we’re frozen in our tracks by the challenges of uncertainty. Venture capital is high risk, low liquidity investing, so these tools are critical to moving forward confidently.

RaviViswanathan_headshotBios: Ravi Viswanathan joined NEA in 2004 and co-heads the firm’s Technology Venture Growth Equity effort and Energy Technology investment practice.  Prior to NEA, Ravi worked at Goldman, Sachs & Co. as co-head of the technology practice in their private equity group. Ravi has also worked for McKinsey & Company and Raychem Corporation focusing on R&D in various materials systems. Ravi received an MBA from Wharton and a PhD in Chemical Engineering from UCSB. Ravi also earned a BS in Bioengineering from the University of Pennsylvania. He currently serves on the Wharton Entrepreneurship Advisory Board.