Worthworm’s Analytic Engine Explained
Valuation is part art, part science, and at Worthworm, we’ve developed a sophisticated analytic engine to provide a credible pre-money valuation (PMV) that entrepreneurs and investors can feel confident sharing and defending. Take a look under the hood, and learn about the three modules that drive Worthworm’s analytics: the Input Question Module, Comps Module, and a Real-Options Technology Module.
Determining how to value a business is part art, part science, and at Worthworm, we’ve developed a sophisticated tool to provide a credible pre-money valuation (PMV) that entrepreneurs and investors can feel confident sharing and defending. Worthworm’s power lies in its analytic engine. One of our founders, Paul Jackson, is an aerospace engineer by trade and has a deep interest in using data to solve business problems. His passion for business engineering guided the development of Worthworm’s analytic engine and interactive tools. Here is his explanation of the three modules that drive Worthworm’s analytics: the Input Question Module, Comps Module, and a Real-Options Technology Module.
Input Question Module
The tool’s analytics are driven by about 100 questions in the Worthworm questionnaire, whose answers define the maturity and market potential of a venture. They represent the types of questions commonly asked by seasoned angel investors and venture capitalists, such as those considered in the Dave Berkus Method, the Venture Capital Method, the Scorecard Method, etc. (Note: We don’t apply a discounted cash flow analysis because most seasoned investors don’t consider it a valid method for valuing early stage ventures.)
We have taken these questions, added others that we think are important, and categorized them by key valuation drivers, including:
- Industry & market size
- Product maturity
- Competition and barriers to entry
- Product differentiation (related to competition, innovation, customer validation, etc.)
- Sales methods & capability
- Delivery capability
- Management team completeness & strength
- Future rounds of investment required
- Projected ownership dilution
- Resources required to deliver at scale
- Projected exit value
- Exit multiple (price-to-sales)
- Other risk factors
The answers to these questions and nearly 1,100 analytic parameters in our analytic engine (developed in cooperation with a Stanford University finance and entrepreneurship professor) create a richly dimensioned, non-linear view of a venture’s maturity and potential. This non-linear nature causes numerous happy and unhappy coincidences to occur in the calculated PMV that may or may not have been predictable.
The result from this stage of our analysis is then blended with the valuation that results from the Comp Module, described below.
Worthworm’s comp values were obtained through a well-known third party firm that we contracted to build a comp table for our exclusive use, based upon the sustained pre-money valuations of ventures in each of their angel rounds. This firm learns about angel-funded ventures when a Series A round is concluded, and they researched such ventures’ financing histories with respect to angel fundings in order to build our comp table.
Therefore, the data we purchased is knowingly biased in that it only includes ventures that ultimately secured venture capital. Each angel funding comp that makes up our comp table reflects a venture’s business sector and segment, geographic region, and sustained pre-money valuation by angel round.
Our research indicated that out of all variables that may influence valuation, including projected exit value, geography, vintage year, business sector, etc., the highest correlated drivers for angel investment opportunities are:
- A venture’s maturity
- The uncertainty surrounding how a venture fairs with respect to each of the key value drivers described earlier
Many other factors tended to be much less significant in comparison to these two factors. Even though the price-to-sales multiplier used to project exit value is important, it turns out to be highly damped and is strongly correlated to maturity.
Our overall valuation module blends the effect of current market conditions (price-to-sales ratios, market size and growth, etc.) with the more stable and well-known historical sustained values (the comps) to generate a valuation. In this way, the model accommodates current market effects and past trends, segmented by business sector and geography.
The blended valuation resulting from these first two modules is always provided in a context of risk and opportunity (a risk bar), which is where Real Options come into play.
Real Options is a retooling of the Nobel Prize-winning Black-Scholes Options model commonly used in finance. Although it’s great for finance, there are many limitations with the Black-Scholes Options model, such as the “risk-free” rate, the discount calculation itself, and the parameter of sigma (measure of uncertainty) when applied to non-financial assets. Real Options methodologies were invented, in part, to accommodate input variables common to “real” assets, such as when there is limited knowledge and it’s impossible to exactly describe a future outcome.
With respect to many of the questions in Worthworm, the user is asked to identify how confident he or she is with the answer on a scale of low, medium, or high. These inputs are used by our Real Options algorithms to identify areas of risk and opportunity in the context of a venture’s value. For example, an entrepreneur could diminish the level of uncertainty or risk associated with a key value driver by conducting additional research, which could improve the venture’s PMV. Similarly, our Real Options algorithms identify where there is an opportunity to increase the venture’s PMV by allocating financial resources to a key valuation driver.
We anticipate that the insights gained through our Real Options module will spark strategic discussions between entrepreneurs and investors to ensure that the proposed uses of capital will lift a venture’s value to its greatest level in the least amount of time, which is a common objective that the parties should share. In addition, because Worthworm can measure uncertainty at a given moment in a venture’s evolution, it helps users make more informed decisions today, as well strategically manage the venture on an ongoing basis.
Not the “Holy Grail,” but a significant step toward shifting the conversation
We don’t claim that Worthworm is the “Holy Grail” of determining an accurate or non-negotiable PMV. But, our hope is that it takes the guesswork out of the valuation process and standardizes due diligence to bring entrepreneurs and angel investors closer together from the outset. When the two parties have a stronger, more reliable starting point, it shifts the focus from calculations and methods to a more productive conversation about the business’ future.
Curious about how much your venture could be worth? Or looking for a world-class teaching tool? Or are you trying to do due diligence on potential deals? Then try a subscription to Worthworm, and let us help you.