An entrepreneur’s enthusiasm for their technology startup is the most important important determinant of early-stage valuation, with little differences between the approaches of venture capitalists and angel investors, according to new research from several German economists.

The paper, published last month in the International Journal of Entrepreneurial Venturing, focused mostly on German venture capitalists and angel investors, surveying 75 individuals out of an estimated total of 550 relevant investors.

When asked to choose a hypothetical venture based on six factors, 26.2% of investors chose their investment based on “entrepreneurial spirit,” or the founder’s passion and willingness to sacrifice, while 13.9% chose based on the strength of the company’s selling proposition and 13.3% chose based on the hypothetical startup’s intellectual property.  

“The German venture capital or early-stage venture capital community for tech startups is probably not comparable to the U.S. one, it’s a little smaller,” said Christoph Wessendorf, co-author of the paper. “And therefore, the feedback was not bad.”

Some previous studies on early-stage tech valuation focused on the importance of intellectual property as a signal for how mature the technology is and how innovative an entrepreneur is, while others have ranked criteria for investment decision-making in general and not just valuation. 

“But then, as you can imagine, it’s very difficult to have a comparable set of determinants or assumptions,” Wessendorf said.

For this research, Wessendorf focused on nonfinancial determinants because in the very early stages those factors usually are most influential.

“You have a long way to market, you have a lot to invest in, there is not interesting financials coming from the market where you could get any kind of market feedback,” Wessendorf said. “You’re probably just looking at liquidity and the runway."

Among the least important factors were startup experience, which 6.3% of investors said was most important, alliances with other companies, which 5.4% said was most important, and education and expertise, which only 4.3% said was most important.

“I thought, at least for technology ventures, that education or a certain kind of degree would be beneficial, but apparently not,” Wessendorf said. “So that was a surprise. And also IP and alliances is something that was not as strong as I thought it would be.”

Because of the slow timeline for obtaining patents for intellectual property, Wessendorf said it seems likely investors primarily focus on how fast the market is growing and the team behind a startup during its early stages.

A surprise to Wessendorf was that angel investors and venture capitalists both appeared to take a similar approach. He had expected more of a difference between angel investors, who are typically individuals using their own money, and venture capitalists, who typically manage a pool of money from others, in their valuation methods. 

In Germany, however, the roles have become increasingly similar for the two groups. Venture capital funds are now active in early phases while angel investors have become more professionalized, he said.

“And therefore, they probably base their assumptions on a very similar set of observations,” he said. 

The economist, who has a background in business and finance, became interested in studying the aspects of early-stage tech valuation after working on a technology startup with a friend from school and realizing how much early investors relied on a “gut feeling.” That realization went against Wessendorf’s understanding of financial theory and his experience in previous jobs where a valuation is somehow calculated in a quantitative process.

After discussing his idea with several professors, Wessendorf said he began to look into the topic in an attempt to make the valuation process a little more “structured or transparent, in order to not purely have experience and gut feeling leading to value creation.”

Wessendorf initially intended to follow his research through to translate early-stage tech valuation into monetary units, but he realized that it would require too many assumptions, such as cash flow forecasting, that would make it more difficult to obtain an objective view

Additionally, venture capitalists told Wessendorf they were much more interested in the quantification of risk and allowing each investor to evaluate for themselves how to use the information.

In order to more accurately assess early-stage valuation determinants, Wessendorf and his colleagues said more research into different fields of advanced technology is necessary, as well as the differences between early-stage venture valuation and early-stage investment decision-making.

The study “What matters most in Technology Venture Valuation? Importance and Impact of Non-Financial Determinants for Early-Stage Venture Valuation,” published Nov. 23, 2020, in the International Journal of Entrepreneurial Venturing, was authored by Christoph Wessendorf, Jared Schneider,  Martin Gresch and Orestis Terzidis, Karlsruhe Institute of Technology.