Valuation Advisor
The valuation of your startup is key
as it determines how much of the company you retain and
the percentage ownership by the investor. At the outset
it is important to remember that it will be much better
to own a smaller percentage of a large success than a
large percent of a startup that doesn't get off the
ground.
Unfortunately the topic of valuation
with a VC can quickly submarine your startup. Since the
market corrections of early 2000, the "cost" of VC
capital has gone up, that is to say, the pre-money
valuations of startups has gone down, resulting in an
increase of percentage ownership by VC's in return for
their investment. If a VC inquires about your valuation
during your initial interactions and your numbers are
out of the ballpark, you may be dismissed out of hand as
uninformed or inexperienced. Better to be unspecific and
communicate the key message of flexibility.
This section of the Toolbox will
address a few methods and messaging when discussing
early stage technology company valuations, but before
proceeding further, here are the definitions of a few
key terms:
Valuation - a general term describing
how much your business is worth to an investor.
Pre-money valuation - the somewhat
subjective valuation of your startup prior to the VC
actually investing capital in the business. This amount
is negotiated between the VC and startup (usually with
the assistance of counsel) and may be based on a number
of factors (discussed in more detail below).
Post-money valuation - this is the
total amount of the pre-money valuation plus the actual
investment made in the startup by the VC.
VC ownership percentage (or the "cost
of capital") - this percentage is the amount of the
actual investment divided by the post-money valuation.
The startup retains the balance. Note that over
subsequent rounds of funding, which also include new
valuation assessments (hopefully higher!), that the
startup's percentages will likely "dilute".
Cap table - short for "capitalization table", this is a
summary spreadsheet reflecting the ownership by the various
parties in this negotiation. Cap tables typically reflect pre-
and post-money ownership for initial financing (e.g. "Series A"
VC funding) and forecasted subsequent rounds anticipated to
achieve liquidity. Several examples of well-known companies can
be found at
http://www.nesheimgroup.com/publications_tables.html.
"Hair on the deal" - VC lingo
describing undesirable factors surrounding early stage
investors in the startup, typically by friends, family
or angels. Often pre first-round "angel" or "family and
friends" funding will attach a valuation on the startup
that makes subsequent fundings undesirable to a VC. An
alternative to avoid this problem is to seek "bridge"
funding that takes the form of debt convertible to the
first round, or "Series A" valuation terms, and may also
include additional "warrants" in consideration for this
early stage funding.
Term sheet - this is the document
issued by the VC firm for startups they wish to fund.
The term sheet includes a great deal of information,
including proposed valuation and actual funding amounts.
Again an experienced counsel is invaluable in
understanding and negotiating the terms of the offer
from the VC.
Determining and discussing valuation
is an extremely challenging and delicate matter. Should
your initial meeting with a VC go well, this may be a
question asked toward the close of your meeting time. If
a VC inquires about your "valuation," they are seeking
to know if you're in the "ballpark" and are an informed
entrepreneur about the relative value of your startup.
The term relative is key. Think of
early stage startup valuations as similar to the
relative "comps" on real estate. VC's are interested in
determining a valuation that is comparable to other
company fundings in your marketplace. Their underlying
goal is to negotiate the most favorable ownership
percentage for the investment capital they intend place
at risk in the venture. The ideal scenario is that both
parties exit the negotiation believing that the deal is
fair, although they would have both liked to have
received more value on their side of the deal.
As a well-known Texas-area VC has put
it... "valuation is mainly of interest only if the
startup's performance is mediocre... if the business is
a great success, everyone wins and the issue is moot...
if the deal goes south, the valuation is meaningless...
it is only when the business achieves mediocre
performance against expectations do investors and
entrepreneurs potentially quarrel over relative
ownership and rights."
Research and do your homework. There
are several ways to determine valuation for your
startup. Know that with most of these methods the amount
is subjective and may be difficult to base on objective
facts. At the end of the day you may need to rely on the
fairness of your investor to propose a valuation that is
consistent with other known "comps" and also consistent
with other relative valuations in his/her existing
portfolio.
A no-cost method to research and
potentially establish valuation is by searching for
similar companies that have recently received funding
via online information sites. While the amount of
funding may be readily available, the pre-money
valuation may not be. Sources for recent, searchable
fundings include:
localbusiness.com,
Capital Growth
Interactive and
vfinance.com.
Each of these sites provides free, keyword searchable
databases of technology startup fundings that may be
useful in comparing to your company's funding target.
Another, possibly more justifiable
method is to use a professional valuation firm like
Venture One.
This firm offers a "Comparable Valuations Report" for a
fee of $1,295.00 that specifically addresses your
company's market space and locates comparable business
fundings and valuations that you may use in your
negotiations with a VC firm. Having said that, it is not
advisable to enter a term sheet negotiation by waving a
Venture One report in front of a VC and stating that
this is the valuation you expect. Rather you should use
this tool as backup to substantiate your position as the
negotiations unfold.
On a final note, traditional methods
of deriving a startup company's valuation through
discounted cash flow (DCF) models, or assigning value to
individual key contributors or forecasted sales and
multiplying by a factor are not highly weighted, or may
even be dismissed by the VC. However, check with your
legal counsel about the value of assessing the impact on
valuation for the intellectual property owned and
developed by the startup.
If a VC asks about your valuation at
the end of your initial meeting, try not to be coy, but
avoid answering with a specific number if possible. The
VC is most likely interested in your thought process
used to arrive at a valuation over a specific number. In
many cases you might suggest a range, for instance, a
$6-7m pre-money valuation on a $3m investment for a
post-money of $9-10m. In any case, flexibility is the
key message you want to convey -- along with the fact
that your primary interest is launching the startup
about which you are passionate, and while changing the
world through this startup you also intend to make a
great deal of money for yourself and for the investor.
VentureWire Alert is a new, free daily e-mail
service providing top headline news, a summary of each
day's developments, including recent fundings, and
coverage of general trends in the venture capital
industry. There are also 2 excellent books on valuation
by Alex Wilmerding:
Term Sheets & Valuations: A Line by Line Look at the
Intricacies of Venture Capital Term Sheets and
Valuations and Deal Terms - The Finer Points of Venture
Capital Deal Structures, Term Sheets, Stock Options and
Getting Deals Done.
The Nesheim Group sells a spreadsheet program
called
QuickUp Equity
that can be used to price and plan any round of funding
on any date, from seed to IPO, for Friends & Family
rounds, Angel deals, Venture Capital preferred stock or
Corporate Strategic Partner deals. The Nesheim Group
also has a
Cost of Capital chart and a
VC Pricing Guide that can help with pricing rounds of
funding.
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