Most entrepreneurs at pre-revenue stage base their valuation on Discounted Cash Flow, Net Present Value, or using the early valuation of successful companies deemed comparable.
Meanwhile, most experienced, early-stage investors eyeballing a pre-revenue company start with a valuation of zero.
These two starting points are obviously far apart. What’s more, neither is right
Valuation should be determined on two primary factors – future value growth and equity position – and ultimately should be agreed upon in discussion.
Any existing cash investment is certainly an important datum and sacrifices made by the founders are worthy of note, but adding all those up doesn’t create a defensible valuation. Investors and founders are both betting their money on the future, not the past.
An entrepreneur should prepare a valuation position and a rationale to support it prior to engaging with investors. By setting the number in the right range the entrepreneur is sending a strong signal to the investor that the opportunity is worthwhile and that the founders know their onions.
An entrepreneur who sets the valuation too high with the intention of making substantial concessions in negotiations may put would-be partners off. Setting the valuation too low may make investors cautious about the business acumen of the founders, but, it’s better than too high.
What is too high and too low?
The honest answer is it depends. However, the range is fairly standard.
Assuming a minority position, the pre-money valuation should always be slightly larger than the investment being sought. For a pre-revenue or early-revenue business that’s seeking up to $1m in investment capital, the range of pre-money valuation is from $200,000 – $1,200,000. Or, to put it another way, 20%-45% of post-money equity.
It’s all relative
Equity position is relative to the amount being invested and will always be particular to the philosophies of the founders and the investors.
As a general observation, the first external investor in a venture (typical role of an Angel investor) will want a substantial minority position. At the same time, the founders need to balance their concerns about control with a respect for the investors’ money. Together, the founders and investors will need to consider future demand on equity and make sure that the valuation underpins that forward strategy.
Future equity demands
A key consideration in the above strategy is demand on equity to support future funding rounds.
If early investors are unlikely to participate in later rounds, there’s a much closer alignment of interests between them and the company’s founders who will both suffer dilution.
If the investors are likely to be substantial participants in later rounds, the valuation strategy may reflect that in the terms of the investment (shareholders agreement).
Angel investors K.I.S.S.
Investment terms can effectively alter the valuation through the use of preferences, options and conversion ratios in the case of convertible notes.
Traditionally, Australian angel investors have used ordinary shares to keep things simple and easy for the founders.
The emerging trend is for early-stage investors to use preference shares that better reflect the financial risk of the investor. In these circumstances the preference delivers a return of capital before converting the preferences into ordinary shares that then participate prorate with all other shares in any distribution.
Founders should be wary of investors seeking more onerous preferences and be confident of the value those investors will deliver.
Absolute measurement of performance
Future value growth is about the external, absolute measurement of performance.
Most early-stage companies pursuing rapid growth are seeking to double their valuation at least every 12-18 months for the first three or four years. That level of performance encourages investors and acquirers to buy in at a premium which assumes the growth will continue at that rate for some time.
Achieving that performance for a pre-revenue company valued at $5m or $50m is much, much harder than for a company valued at $1m.
Good investors love value growth
Many founders suffer from the false assumption that competent early-stage investors will fight value growth because it will result in dilution of their investing power in later rounds.
Good investors love value growth because it’s their original investment that’s growing and the risk of any subsequent investment is greatly reduced.
Of course, for some investors that’s why they don’t make subsequent investments; they’re pursuing the high-value growth of the early investment and choose to diversify their portfolio.
Who wears the pants?
Founders, particularly first time entrepreneurs, tend to worry about control and fear that ceding a large equity position to investors may threaten the future of their venture.
This isn’t entirely unfounded, but it’s usually blown out of proportion.
Experienced early-stage investors rarely want a simple majority of equity, especially in Australia where it comes with certain legal and taxation implications. However, an investor that intends to fill an executive role or become a substantial contributor to the execution of the business may seek a majority position.
It’s up to the entrepreneur to judge the expected value added by the investor to determine if the proposed equity position is reasonable.
For investors who intend to be proactive through a non-executive director or similar role, it’s reasonable that they achieve the 20%-45% equity stake discussed above.
Even those investors, if they’re experienced, are likely to seek some extra control rights in their terms of investment. These are usually called ‘negative control rights’, which give the investor the ability to stop the company from doing something substantially different from the proposition the investors initially agreed too.
These rights usually cover new debt and equity, executive team hire and fire, business strategy and objectives, capital expenditure and changes to the governance and shareholder structures and procedures.
It’s a truism that a shareholder with only a small equity position – say 5% – can have complete control of a company through the terms of that investment. So, founders need to think more holistically about the issue of control and not focus on the equity position alone.
Experienced early-stage investors usually want the founders to retain a larger proportion of equity to ensure they’re motivated to succeed and sell the company. This is a core presumption in the alignment of interests.
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. Don’t rely on an accountant, lawyer, or corporate adviser to set the valuation without your input, involvement and, ultimately, your approval.
Jordan Green is an internationally sought after thought leader, speaker and educator on early-stage investing. Leading Australian Angel investor, founder of Melbourne Angels and co-founder of the Australian Association of Angel Investors.
