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The art and mystery of startup valuation (Or, why is my company worth more than nothing?)


As a pre-revenue company, most entrepreneurs determine their valuation based on calculations of Discounted Cash Flow, Net Present Value or using the early valuation of more successful companies deemed to be comparable.

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 and, ultimately, should be agreed in discussion. The two factors are future value growth and equity position. Any existing cash investment is certainly an important datum and sacrifices made by the founders are worthy of note but, adding all those up does not create a defensible valuation. Investors and founders are both betting their money on the future not the past.

An entrepreneur should certainly prepare a valuation position and a rationale to support that valuation prior to engaging with investors. By setting this 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 what they are doing. A credible number is always better than an ambit claim.

An entrepreneur who sets the valuation too high then intends to concede substantially in negotiations with investors may never get to those negotiations, or at least, not with the right investors. Setting the valuation too low may make investors cautious about the business acumen of the founders but, it is better than too high. What are too high and too low?

Well, of course, the honest answer is it depends but, the range is fairly standard. This article is exploring the first round of external investment (not counting family, friends and founders) for a pre-revenue or early revenue business that is seeking up to $1m in investment capital. Assuming a minority position the pre-money valuation should always be slightly larger than the investment being sought. 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.

Equity position is relative to the amount being invested and will always be particular to the philosophies of the founders and the investors. However, as a general observation, the first external investor in a venture (typical role of an Angel investor) will typically 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.

A key consideration in that strategy is the demand on equity to support future funding rounds. This is influenced by anticipating the level of involvement of the first investors in any later rounds. If the investors are unlikely to participate in later rounds then there is a much closer alignment of interests between the founders and the investors who will both suffer dilution in later rounds. If the investors are likely to be substantial participants in later rounds then the valuation strategy may reflect that in the terms of the investment (shareholders agreement).

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 which 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.

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 3 or 4 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.

The chart is a simple illustration of the basic scenario with valuation doubling every year and an exit in about 5 years at around 10 times the valuation at first external investment. This is the basic model to which most high-growth entrepreneurs and early-stage investors work. The blue dashed line indicates what many acquirers think they can achieve due to their customer base, distribution power, or other synergies, i.e. the value proposition for paying the acquisition price.

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 of investment. Good investors love value growth because it is their original investment that is growing and the risk of any subsequent investment is greatly reduced. Of course, for some investors, that is why they don’t make subsequent investments because they are pursuing the high value growth of the early investment and choose to diversify their portfolio rather than focus on a narrow range of investments.

Then there is the control issue. 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 their venture. This is not entirely wrong but, it is 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 for the investor. However, an investor that intends to fill an executive role, or in some other fashion become a substantial contributor to the execution of the business may seek a majority position.

It is 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 is reasonable that they achieve that 20%-45% equity stake discussed above. However, even those investors, if they are experienced, are likely to seek some extra control rights in their terms of investment. These are usually what can be called ‘negative control rights’. These give the investor the ability to stop the company from doing something substantially different from the proposition the investors agreed to back. These rights usually cover new debt and equity, hire and fire of executive team members, business strategy and objectives, capital expenditure and changes to the governance and shareholder structures and procedures.

It is a truism that a shareholder with only a small equity position, say 5%, can, through the terms of that investment, have complete control of a company. So, founders and investors 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 than the investor to ensure that the founders are motivated to succeed and to sell the company. The investors want to get a great return but, they usually want the founders to do even better out of an exit. 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. Do not rely on an accountant, lawyer, or corporate adviser to set the valuation without your input, involvement and, ultimately, your approval.

Early-stage investors are not taking a risk on your advisers; they are taking a risk on you, the entrepreneur so it is you who must be able to articulate your valuation rationale and have the understanding to reach an agreement with investors. This is as true for the investors, who should not rely on advisers to determine the right valuation and who should be able to articulate their own valuation rationale and explain how they will add value to the business in a way that supports the valuation strategy.

Jordan Green is an internationally sought after thought leader in early-stage investing. Founder of Melbourne Angels, co-founder and chairman of the Australian Association of Angel Investors and Case Manager with Commercialisation Australia.