Recently, I had the opportunity to attend a startup fund raising event. It was well attended with over 200 entrepreneurs and a healthy number of VC and angel investor organizations present. One of the topics that percolated to the top was the issue of valuation during the initial fund raising process.
This is certainly a sticky topic because valuation can be determined in a number of ways. Comparable company valuation, revenue multiples if they exist, amount of funds already invested in a company, the amount of product and IP, total market size, growth projections go into the mix determining what the company is worth.
Entrepreneurs and investors also have different agenda's that drive them to set a valuation. Entrepreneurs traditionally want to cede the least amount of equity for the most amount of capital. Investors highly value their financial contribution in a company resulting in them driving for a higher percentage of the company, and potentially a lower valuation to get the equity they think they deserve.
This process can certainly be stressful and contentious leading to a bad start for the relationship. It also can be short sighted if the parties involved do not think about the prospect of raising subsequent future rounds.
I have been involved in several start up fund raising and valuation efforts. My experience has resulted in the development of a contrarian view of how the negotiating parties should think about early round valuation.
In the early rounds of fund raising entrepreneurs push heavily for high valuations to keep the most amount of their company after the close of the round. They are also inclined to display the bravado factor because they are proud of what they have done and want everyone to know how great a company they have. They want a high valuation so they can get a big cash out if the company goes public or is sold. This latter point is shared by investors.
My contrarian view argues over hyping a company's valuation in the early rounds of funding is not necessarily the best approach for investors or founders. This approach could backfire resulting in long term funding objectives not being realized.
Why?
There is a very good chance that the initial business projections you use to justify your valuations will not completely pan out. All entrepreneurs want to believe that they have a killer application, a highly viral web presence and a game changing idea. This may be so but 9 times out of 10 it takes longer to realize the dream and more investment capital to make it so.
When you go on the open market for that next round of funding you do not want to be in a down round situation. If you fought for a very high valuation in round one this could be the scenario. Just because the company did not meet all of the expectations set in the first round does not mean it is not a good company. However, if you set your initial valuation very high you are going to create a perception that something is seriously broken if you do not hit all of the milestones.
This situation will make the original investors look bad and may even force them to not invest in the next round. A partner that sells a deal to his partners is putting themselves in a very vulnerable spot if the initial round valuation was considered too high.
If you do need another round you want your original investors to participate. If they do not it will make it very difficult for another VC to jump in.
If you are fortunate enough to get that next round of funding, after a relatively high initial round valuation, you could find yourself in a position where the investor does become more involved in the company after the investment.
The best approach in the early round(s) is to think about how long it might take to achieve the first real bump in revenue and traffic and price the deal appropriately. Take the ego out of the equation. What really matters is not how high your percentage ownership is or a high valuation. Think about the long term survival of your company and the need for several rounds of funding to achieve a happy exit strategy for all.
Investors are very aware of the fact that most companies are optimistic about their initial projections. If a management team is working hard and the market for the company's product or service is still large and growing the initial investors will most likely reinvest and encourage other investors to do so. Make this an easy decision for them.
This is certainly a sticky topic because valuation can be determined in a number of ways. Comparable company valuation, revenue multiples if they exist, amount of funds already invested in a company, the amount of product and IP, total market size, growth projections go into the mix determining what the company is worth.
Entrepreneurs and investors also have different agenda's that drive them to set a valuation. Entrepreneurs traditionally want to cede the least amount of equity for the most amount of capital. Investors highly value their financial contribution in a company resulting in them driving for a higher percentage of the company, and potentially a lower valuation to get the equity they think they deserve.
This process can certainly be stressful and contentious leading to a bad start for the relationship. It also can be short sighted if the parties involved do not think about the prospect of raising subsequent future rounds.
I have been involved in several start up fund raising and valuation efforts. My experience has resulted in the development of a contrarian view of how the negotiating parties should think about early round valuation.
In the early rounds of fund raising entrepreneurs push heavily for high valuations to keep the most amount of their company after the close of the round. They are also inclined to display the bravado factor because they are proud of what they have done and want everyone to know how great a company they have. They want a high valuation so they can get a big cash out if the company goes public or is sold. This latter point is shared by investors.
My contrarian view argues over hyping a company's valuation in the early rounds of funding is not necessarily the best approach for investors or founders. This approach could backfire resulting in long term funding objectives not being realized.
Why?
There is a very good chance that the initial business projections you use to justify your valuations will not completely pan out. All entrepreneurs want to believe that they have a killer application, a highly viral web presence and a game changing idea. This may be so but 9 times out of 10 it takes longer to realize the dream and more investment capital to make it so.
When you go on the open market for that next round of funding you do not want to be in a down round situation. If you fought for a very high valuation in round one this could be the scenario. Just because the company did not meet all of the expectations set in the first round does not mean it is not a good company. However, if you set your initial valuation very high you are going to create a perception that something is seriously broken if you do not hit all of the milestones.
This situation will make the original investors look bad and may even force them to not invest in the next round. A partner that sells a deal to his partners is putting themselves in a very vulnerable spot if the initial round valuation was considered too high.
If you do need another round you want your original investors to participate. If they do not it will make it very difficult for another VC to jump in.
If you are fortunate enough to get that next round of funding, after a relatively high initial round valuation, you could find yourself in a position where the investor does become more involved in the company after the investment.
The best approach in the early round(s) is to think about how long it might take to achieve the first real bump in revenue and traffic and price the deal appropriately. Take the ego out of the equation. What really matters is not how high your percentage ownership is or a high valuation. Think about the long term survival of your company and the need for several rounds of funding to achieve a happy exit strategy for all.
Investors are very aware of the fact that most companies are optimistic about their initial projections. If a management team is working hard and the market for the company's product or service is still large and growing the initial investors will most likely reinvest and encourage other investors to do so. Make this an easy decision for them.
10 comments:
Kevin,
Great article, but you needed to highlight the following in the largest darn font possible "Take the ego out of the equation". I have raised money from 5 angel investors in 3 US States and 2 countries, on the upswing and the downswing. A smart entreprenuer will treat his angel investors as partners and position for what is good for himself, the investor and the company. A smart entreprenuer will even say this to the angel investor, who Yes, wants to make a bundle, but also knows there are many hurdles to climb. No one investor wants to be an obstacle, unless they are simply looking to purchase the entire company (usually unlikely at the early stage). Bottom line, toss the ego and how hard you work out the door. It doesn't matter. It is where you are today and what you need to get to tommorrow. I run an early stage company perfectly positioned for the rebuilding of America in the residential repair and remodeling space. It is called www.MyOnlineToolbox.com. I can brag about the millions and years spent getting to where I am, or focus on what I need to capitalize on the current opportunities. I prefer the later. The right person can reach out to me and just reference this post.
Kevin,
Great article. An entrepreneur can do the estimates based on an understanding of the applications of the technology / product he or she is offering. Comparable products and services provide a baseline for the estimates. From there, you try to structure the financing to facilitate discovery of the value of the project. Provide heavy discounts in the early stages till you are able to build confidence. More than anything else, a business plan helps to articulate and communicate ideas. For the rest, you count on your luck and the macro economic conditions. We have made a breakthrough with a new mobile fuel cost reduction technology www.gasolinemeter.com which has an obvious value with fuel prices rising.
Kevin,
Great article. An entrepreneur can do the estimates based on an understanding of the applications of the technology / product he or she is offering. Comparable products and services provide a baseline for the estimates. From there, you try to structure the financing to facilitate discovery of the value of the project. Provide heavy discounts in the early stages till you are able to build confidence. More than anything else, a business plan helps to articulate and communicate ideas. For the rest, you count on your luck and the macro economic conditions. We have made a breakthrough with a new mobile fuel cost reduction technology www.gasolinemeter.com which has an obvious value with fuel prices rising.
Way too often an entreprenuer is way too close to the company to make the best deal long-term.
I tell my clients that once they create a legal entity, it is separate from their persons. It must be treated as a distinct thing, with specific needs that may or may not be in sync with what the founder wants. Too bad.
Feed the animal the best food possible (capital/terms/strategic alliances) and it will produce successfully.
Treat it as a special child or alter-ego and you will fail.
Kevin, good advice, good strategy.
Ultimately, you will need to build a financial model with financial projections. These projections will forecast your revenue and earnings for 3-5 years. You will then need to pull these earnings back into present value dollars using a Discounted Cash Flow analysis(DCF). I had a good experience with financialmodel.net, or you could try a local contact with an MBA.
This discounting business is the basics. The challenge is to find the prices to value the revenue and the cost figures. It takes an enormous amount of research to get the numbers
Kevin,
Valuations to VCs range from a calculation of risk-to-entry to discounted size-of-opportunity, and today the reality is very close to the bottom of the risk-to-entry price. I think the current valuations are highly unfavorable to entrepreneurs (as I explain in my blog) as they are asked to take the majority of the risks. That model cannot and will not survive as it is closer to micro-lending than venture capital.
In the end, sensible valuations can only be established with investors that fully buy into the disruptive value, and as such, should hover somewhere in the middle of the balance I described. So, the key is not to focus on valuations, but on the investor that understands the disruptive value. Then, and only then, can a sensible valuation be called.
My trick as entrepreneur is not call a vauluation, but have the VC call it after you've pitched them. If the VC is in the range, keep talking, if not, say thanks and walk away....
Georges makes an interesting point. The challenge is to get to a point where you can walk away. You may have a disruptive technology but there is still a discovery process involved. Enough investors have to know that you have a worthwhile technology. I guess this would imply your solution has been used by some customers before you try to make an investment deal.
I completely disagree with DG's comments...building a DCF financial model for a seed or early stage company is a guess-timate at best. Any numbers you come up with will be pulled out of your @$$ and investors will smell it simply because at that stage, you frankly just don't have the accurate data to build such a model. For seed & early stage, investors are focusing on whether or not your product/service solves a particular pain in the market, if it's a potential game changer, and if the leadership of the company has what it takes to make it big. Every naive entrepreneur will have a hockey stick growth chart in their pitch to justify a high valuation. By the way, this is coming from an MBA.
I would agree with Tony. You have to be able to spell out the pain point, the value proposition and the application. This is what I do for my business plans. The financial numbers are more credible when you are able to articulate the applications. You can compare with similar applications to get your pricing and the costs.
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