Note: This article is the fourth in an ongoing series on valuation and capitalization. To learn more about the financial mechanics of early stage investing, download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.
Over the years, Christopher and I have interacted with hundreds of startups. Whether as an advisor, mentor, investor or just as an observer, the issue of valuation has been a major part of our conversation with each of these companies. And, given how widely reasonable people can differ on this subjective topic, I have to admit, it can be one of the most difficult, contentious conversations you will have as an investor.
Think about it. You are giving the entrepreneur advice on how to value her startup. The lower the price, the better the deal is for you, the investor. That doesn’t sound like an unbiased conversation to me. And it sure doesn’t sound unbiased to the entrepreneur.
So let’s ask Christopher how he goes about the process of determining a reasonable valuation for an early stage company and then manages the discussion with the entrepreneur so that both sides end up in a good place.
Christopher, what is so hard about valuing a startup company?
How do you value an early stage technology company that has a partially completed product, no revenue and three employees? How about just two engineers, a Powerpoint slide deck and an office mascot? If the founders in these example companies tried to sell their businesses out-right, they would be lucky to get anything for them.
A great idea with no market validation may have plenty of future potential but is worth almost nothing at inception. Backing it with a team capable of executing helps a bit, but you still can’t value the business on financial metrics. No revenue means no revenue multiple. It also means no EBITDA, and therefore no EBITDA multiple. A price-sales multiple gets you to zero, as well. So obviously, we have to come up with another approach to placing a fair value on the company that will ultimately result in a successful financial outcome for both the entrepreneurs and the investors.
The valuation does not have to be precise or perfect, but it has to be close enough to get the gears of commerce turning. To the extent there is some imprecision, you might be surprised to learn the benefit of that imprecision is virtually always in the entrepreneur’s favor. How could that be, you might ask, given the relative power imbalance with investors having the money startups need? It boils down to the realities of startup life and cap table math. The first financing round valuation generally needs to be above what the company is really worth to make the “founder economics” work.
What do you mean by “above what the company is really worth”?
Building a startup is a really hard, risky and initially low-paying job. Most people who choose to do it are motivated, at least in part, by the long-term view that their startup stock will be worth a great deal down the road. That gives them the motivation to start, and the will to continue on, despite the risk, the low pay, the opportunity cost of market salary jobs passed by, and the frustrations and difficulties of getting the product built and into the hands of customers.
Given that long term stock appreciation is the motivating factor, it’s vitally important to make sure the founding team retains a good chunk of ownership in the company. And there is the rub. Two engineers, a Powerpoint business plan, and a dog aren’t really worth anything in a present value sense. Nobody would pay much to buy that package as an out-right buyer. But that same team needs serious money to get off the ground and become a company. And the founders need to be motivated. So there is little choice but to assign a somewhat artificially high valuation at the first round.
Let’s look at the math. Suppose you have three founders owning 33% each of a company which needs $1.5M to get off the ground. You assign a pre-money valuation that is an accurate reflection of the true value of the “assets” of the company (team, Powerpoint, dog). To be overly-generous we’ll say $100,000. So the investors put up the $1.5M, at a pre-money of $100,000. The investors would end up owning 93.75% of the company on a post-money basis and the founders would each own 2.1%. And, that’s before creating an option pool or taking on subsequent dilution from raising additional rounds of financing. That just is not enough incentive for founders to quit their current jobs, risk their mortgages or other financial commitments, and take on the uncertainty and hassle of founding and growing a startup.
So a different and less accurate, but more pragmatic valuation has to be assigned. To help you figure out how to assign such a valuation we are going to take a look at the different methods out there, explain some of their shortcomings, and propose an alternate method we developed over years of trial and error and we think works more reliably.
Before we delve into valuation approaches, can you provide us with a brief explanation as to why setting a fair valuation on a company is treated with such great importance by both the investor and the entrepreneur?
Equity investing as a mechanism is really genius if you stop to think about it. It is sort of the keystone of modern capitalism. Can you think of a more perfect mechanism to align interests, allocate risks and share upside than to divvy up the ownership of a company into infinitely divisible shares and give those shares to the different stakeholders in proportion to the contribution they’ve made? With the simplest equity deal, nobody wins unless everybody wins, and risk of failure is borne by all in proportion to their ownership.
The key point to understand is that, with equity investing, having a valuation ascribed each time needed resources come in and shares go out is the fulcrum on which the entire process balances. Companies need resources (money) to grow. They get those resources in exchange for a percentage of ownership (i.e. a share of the upside and the downside). The valuation set on the company as the resources are coming in determines what percentage of the company is given for those resources. The challenge is that the valuation is subjective. And the challenge is compounded by the fact that everyone involved needs to agree - both all past contributors of value, and the present potential contributors (for example, every participant in a financing round). Getting all that done in a somewhat efficient manner can be fiendishly complex.
Fortunately there are some norms and practices that make it easier to navigate, and there are also some harsh realities which constrain the valuation ranges quite a bit. Investors who do these kinds of deals all the time generally have a pretty good handle on these issues. Entrepreneurs may only do it a handful of times in their career and may need some help. This is one of the main reasons I view valuation discussions as more of an education process than a negotiation. A big part of what I am doing is explaining the realities of the situation and helping the entrepreneur appreciate the constraints - those on them and those on me.
What kinds of realities are you talking about in these valuation discussions?
It is pretty simple, really. There are two main constraints:
What the current investor “market” will bear
What this transaction is likely to do to the company’s position in the future.
Current market conditions boil down to the tension between what the founders and existing stockholders will give up to get more resources, and what the investors are willing to contribute for a certain amount of stock. Is this a hot, in-demand deal with lots of attractive features, or does this company have some drawbacks? We will talk a great deal more about this in subsequent articles.
Future market conditions require speculation about where the company will be when this money runs out and what the next valuation give-and-take might look like at that time. This should be a vitally important question to investors and it is one to which Ham and I feel people don’t pay enough attention.
To illustrate why this is so important, let’s give an example I have used many times before. If the company needs $1M now, the founders (and any existing investors) might be willing to give up a quarter of the company to get that $1M. In other words, they might agree to a $3M pre-money valuation to get $1M in the door (resulting in a $4M post-money and 25% ownership for the new investors.) If the investors are willing to put up that $1M in exchange for 25%, then you have a deal that works under current market conditions.
But one of the things that influences (or should influence) the investor’s decision about whether to accept 25% (or put the money up at all) is speculation about future market conditions. Investors understand that they will be heading into uncharted waters. They know that $1M is almost certainly not the only money this company is going to need. Growth consumes cash. The company will have to go back out into the market for more money. And at that time, a new valuation process will begin. Experienced investors know that by coming in on an early round, you are not only assuming the risk of company failure, you are assuming the risk that future rounds might be offered on unattractive terms, even if the business has not completely failed.
So the smart investor asks herself “What will that process look like? Might future investors be unwilling to give as good a deal as we are?” At the present moment there is clarity. Everyone agrees that the morning after they do the $1M/$3M deal, the company will indisputably be worth $4M because they just valued it at $3M at arms’ length and it has $1M of cash on the balance sheet.
But what about the future? The company plans to take that $1M off the balance sheet and spend it on people, product and progress. The critical question is this:
Will the company still be worth at least $4M once it doesn’t have $1M in cash on the balance sheet?
That is the key question because, if the company is not worth $4M next time it goes out for money, it may not be able to raise money again on good terms. If future investors are not impressed with where the company is at, they might offer poor terms. Not only will the current investors experience the normal expected arithmetic dilution from the future round, they will also experience economic dilution. Economic dilution is caused by a new round with a pre-money that is below the post-money on the previous round. Not only is their percentage stake smaller, it is also worth less than it was before. (For more on this distinction between arithmetic and economic dilution, see Beating the Odds: Startup Pathways to Success.)
So what does that mean in terms of arriving at a valuation?
If you follow the logic of this all the way through, you arrive at a key insight: it is really the post-money valuation that matters. Even though all the discussion will be about the $3M pre-money, the experienced investors are all focused on the $4M post-money. They are making a bet that this team can combine what it has with the $1M investment and build a $4M+ company before that $1M is gone. So what appears to be a discussion about how much of the company the investors get for their $1M is really a speculation about whether the company can get where it needs to be before it is forced to be re-valued by the market.
If the assessment is that the company can make some value-inflecting progress like finishing the product, racking up a convincing number of initial sales, showing some good unit economics on each transaction, and building its team, then maybe investors will accept a $3M pre-money and a $4M post-money. But if the work to be done is too daunting to accomplish with that $1M, investors have two choices.
Option one is to pay a lower valuation. This accomplishes two things:
It gives the investors a greater percentage ownership of the company to reward them for taking the risk, and insulates them against likely future dilution. So for example, they might give a $2M valuation which would mean they own 33% rather than 25%.
It lowers the post-money valuation to $3M instead of $4M, making it far more likely that the company can get a future round done at a valuation that is flat or positive relative to the new post-money of $3M.
Option two is a little bit counterintuitive. If you are worried about the post-money, the alternative option is to give the company more money. This is counterintuitive and risky because it drives the post-money up even farther. But, it gives the company more resources to achieve what it must achieve before going out to raise again. For example, instead of giving $1M on $3M pre-money, assume the investors give $1.5M on a $3M pre-money. Instead of owning 25% at a post-money valuation of $4M, they now own 33% of a $4.5M post-money ($1.5M of $4.5M). Investors get higher percentage ownership by providing the company with more runway to hit key milestones.
If there is sufficient investor demand to come up with the extra money, this second alternative can be a great path forward. It is like the difference between playing offense and defense. Lowering the valuation is a defensive move - biding your time and letting things play out carefully without sticking your neck out too far on post-money. Increasing the size of the round is an offensive move. You are compounding the post-money problem if the bet is wrong, but you are bringing in more resources for the team to succeed and you are owning a bigger slice of the company.
As you can see from this example, figuring out the round size and getting valuation as close to “correct” as you can matters a lot to both sets of stakeholders. If you put it too high, the company may not be able to raise again, or may be forced to raise on very weak terms that hurt everyone. But if you put it too low, the founders (and possibly other early investors) who took all the risk of getting this started might give too much away and lack motivation to continue when the going gets rough.
Closing reminder: valuation is not the only term in a deal. There are lots of other tools used to allocate various risks, but to keep the example clear, we are focusing on the valuation question. If you are interested, here’s more on how other deal terms affect investor returns.
In Part II of this article we'll take an in-depth look at four of the most common methods for valuing early stage companies and the limitations of each.
Want to learn more about the financial mechanics of early stage investing? Download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.