Most pre-revenue entrepreneurs determine their company valuation through calculations of Discounted Cash Flow, Net Present Value, or comparisons with the early valuation of already successful companies.
Most experienced early-stage investors looking at a pre-revenue company start with a valuation of zero.
These two starting points are obviously far apart but, neither is the right answer. Valuation of an early-stage venture is a strategy for future success.
Valuation should be determined on two primary factors, future value growth and equity position at exit and, ultimately, should be agreed in discussion. Existing cash investment and sacrifices by the founders are important but, their sum does not create a defensible valuation. Investors and founders are both betting on the future not the past.
A founder should prepare a valuation position and supporting rationale prior to engaging with investors. Setting this number in the right range sends a strong signal that the opportunity is worthwhile and that the founders know what they are doing. A credible number is always better than an ambit claim. An high valuation to concede in negotiations with investors may preclude having those negotiations. Too low a valuation may raise concerns about the founders’ business acumen but, is better than too high. What are too high and too low?
The honest answer is ‘it depends’ but, a fairly standard expectation for the first few rounds of external investment are that they will each buy about 20%±5% of the post money equity, i.e. after the investment.
Generally, the first external investor (typical role of an Angel) will want a substantial minority position. Founders need to balance concerns about control with a respect for the investors’ money. Together, founders and investors should consider future demands on equity and ensure the valuation underpins that forward strategy.
Investment terms can effectively alter the valuation through preferences, options and conversion ratios. Melbourne Angels tends to use ordinary shares to keep things simple and easy for founders, albeit a new class of shares with some special rights that better reflect the financial risk. Founders should understand the significance of investment terms and be wary of investors seeking onerous preferential rights and be confident of the value those investors will deliver.
Future value growth is an external measurement of performance. Most rapid-growth companies seek to double their valuation at least every 12 months for the first 4 to 6 years. That performance encourages investors and acquirers to pay a premium presuming that growth will continue, or accelerate as the company reaches scale. Achieving that performance for a pre-revenue company valued at $5m, or $50m is much, much harder than for one valued at $1m.
Consider, a venture valued at $5m after its Angel round of investment should achieve a value growth pattern of $10m in year 2, $20m in year 3, $40m in year 4 and $80m in year 5. There is no question that these are the right levels of valuation (or even higher ones) to be realised but, making them the minimum required is very risky. A venture that started at a $2m valuation after its Angel round would have to perform as $4m, $8m, $16m and $32m in year five. This is one of those times when there are real advantages to under-promising and over delivering and serious disadvantages to over-promising and under-performing.
Valuation is about putting the company on the path to an attractive exit in which the founders do extraordinarily well, the Angel investors do very well and later round investors all get their expected returns.
The graph illustrates this simple principle of doubling valuation and how an investor in year one can realise a 10 times return in around five years. Of course, this ignores many factors, including subsequent rounds of capital but, for now, let’s just consider the base case.
Founders, particularly first time entrepreneurs, tend to worry a lot about control and fear that ceding a large equity position to investors may threaten the future of the venture. This is not entirely wrong but, it is usually blown out of proportion. One of the most common questions from founders is, “How much of my company should I give away?” The answer is “None!!”. Equity in your company is a precious and finite resource, you never give it away. Always consider that you are selling your equity, or even better, that you are spending it to buy something valuable that you absolutely need – financial or intellectual capital.
It is up to the entrepreneur to judge the expected value added by the investor to determine if the proposed equity position is reasonable. The one truth is that value is in the eyes of the beholder so, your company is worth what the investors are willing to pay.
If you have already identified the investors you most want and they don’t like the valuation, you should consider carefully if you really want the investors who do like the valuation. At seed and start-up rounds the investors you choose to invite in as shareholders can be critical to the success of your business. Make sure you trust them to be the shareholders you want to have.
Valuation is a complex topic and interdependent on terms of investment, investor involvement, future rounds of funding, projected revenues and profits, founder capability to execute, capital intensity of the venture and other concerns. Neither founders nor investors should rely on an accountant, lawyer, or corporate adviser to set the valuation. Early-stage investors are taking a risk on the entrepreneur who must articulate the valuation rationale and understand how to reach an agreement with investors. Founders are taking a risk on the investors who should be able to articulate their valuation rationale and explain how they will add value to the business in a way that supports the valuation strategy.