I think there are three fundamental truths regarding the valuation of early stage businesses by potential investors:
The first is that a pre-money valuation is ultimately an outcome of negotiation, rather than a mathematical calculation of discounted cash flow or any other metric of potential company performance.
The second is that, despite the typical non-reliance on formal calculation, investors’ views on valuation are in some way based on a perception of risks and potential return of the investment—or, put another way, of the interaction of fear and greed.
The third is that pre-money valuation is just one of many funding terms and conditions important to investors and companies, and not necessarily the most important one, though it might arouse the greatest angst.
Investors typically arrive at reasonable valuation conclusions after a process of due diligence. For an early stage investor, due diligence is undertaken to refine initial impressions of factors affecting investment risk and return. There are no “rating agencies” (as in the world of bond investments) that offer third party risk assessment. There are no widely followed “buy side” analysts (as in some public equity markets) who package critical market, financial and other analyses. And finally, there are almost no early stage investments by angel groups or venture capital firms undertaken based on prepackaged offerings marketed through private placement memoranda.
In large measure, at least in organized angel groups and venture capital firms, due diligence work is done by deal leads and other participants in a very hands-on way. They review market data and customer feedback; analyze competition, pricing and distribution strategies; study financial statements to understand margins, burn rates and hidden liabilities or inflated assets; gauge technology risks and product development plans; and of course assess management through reference checks and face-time. Only in the area of legal due diligence do early stage investors typically outsource some of the work required, although the use of student interns by organized angel groups to assist with parts of the process is becoming more common.
Investors’ decisions to move forward to negotiate valuation and structure a deal (usually through one or more lead investors) is the most positive outcome of a favorable due diligence process. The goal is to position the investor for a strong upside while mitigating perceived investment risks, particularly those that surface as most critical during due diligence. The implication is that an early stage company must be prepared for an interactive, potentially lengthy process of dealing with investors’ concerns as they surface in due diligence to set the stage for negotiating and closing a deal at an attractive valuation.
So what is an entrepreneur to do? The first task is to convince the investor that the company should warrant investment at all. This is accomplished by creating interest in the potential opportunity, which is why an outstanding elevator pitch, introductory PowerPoint and one- or two-page executive summary are so important. The second task is to convince the investor that the proposed terms of the investment offer an attractive potential return, given the risk factors.
If a company initially suggests a pre-money valuation much too high—or too low—it raises questions for an investor about whether the company has done its homework regarding valuations for early stage companies of its type (or has done its homework about anything, for that matter) and whether there can ever be a meeting of the minds. To me, it is better for a company to go for a valuation that is “in the ballpark” than strike out in the first at-bat trying to swing for the fences. Alternatively, a company can initially indicate a range for its suggested pre-money value, perhaps a bit on the high side but definitely not out of the ballpark. This suggests both reasonableness and flexibility, good traits to convey to potential investors.
But how can you get an idea of what valuation is “in the ballpark”? Finding out more about the businesses and final terms of other recent investments by the investor you are “pitching” is essential. Why did they decide to fund and support the most recent three or four companies that they have backed? Have other investors recently funded companies like yours, and if so, on what terms?
The critical task is to try to look at your company in the same way that the investor will when assessing risks and potential returns, and review your strengths (and weaknesses) on the following important dimensions:
Quality and breadth of the management team – Have you been able to attract others with strong credentials who share your vision of the company’s potential, and what are they committing to make the business a success?
Size of the addressable market – Who does your product or service appeal to, and how much is presently being spent to relieve the pain your company addresses?
Uniqueness and quality of the technology – Do you really have a process or product that is truly unique and can’t be, at least with some effort, worked around or duplicated?
Evidence of customer traction and a high revenue growth rate – If you are a pre-revenue or early revenue company, what is your best evidence of the potential for rapid revenue growth?
Capital and sweat equity investment to date – If both are very limited, what about the company has helped create substantial value?
Future financing needs – If significant future investment (in the tens of millions or more) is needed, to even begin to produce strong revenue growth and profitability, how high a value can be supported for the company at this stage of its development? And what is the risk of a “down round” in the future?
Future profit margins – As the business scales, can it develop strong gross margins and significant bottom line profitability?
Exit options – Are there many bigger players that could acquire the company if it can begin to execute and scale?
Management coachability – Is the team really willing and interested in getting the non-financial input that early stage investors can provide to help the business grow?
Deal terms – Putting aside valuation, is the company flexible with respect to the investors’ other objectives in the financing?
This last point is worth considering further. Your negotiation over valuation will probably start, and end, at a more favorable point if you are prepared to offer the investor:
*a “first out” for the investment, through a liquidation preference and a participating preferred structure (rather than just convertibility to common) to enhance return on investment (ROI), particularly in the case of a middling overall company performance;
*a redemption provision in five to seven years, if the company is successful but decides not to be acquired, to enable the investor to monetize his investment and not get locked in as a minority shareholder;
*one or more board seats and a strong set of investor protective provisions including a vesting period for founders’ shares and reasonable anti-dilution protection, in the event of a future “down round,” to address areas of particular vulnerability.
Even the most enlightened and flexible CEO will inevitably look at the opportunity being offered investors to fund his company in a different light than will the people writing the checks. Investors will be very aware of how difficult it can be to get a product to market, gain strong customer traction, and build revenue and ultimately profitability. Since more early stage companies fail than succeed in executing their business plans, most investors know that product development risk is usually higher, capital requirements more substantial, market acceptance slower, management team-building more unpredictable, follow-on funding more expensive, and exits more delayed than most CEO’s project from their perspective as the entrepreneurial founder and chief fundraiser.
These challenges are why entrepreneurs should not expect investors to get too excited about their ROI projections based on a five-year scenario fraught with uncertainties, especially if the company is a recently formed, two person, pre-revenue organization with little funding to date and major future capital needs. Certainly don’t think that a 20 percent return is acceptable, as the potential investors are probably thinking that, given the risks, they need to see the possibility of a 20x return!
So how can this advice for neither over-valuing nor under-valuing your company be summarized?
Do your homework on how investors are structuring other early stage investments and valuing other early stage businesses. Research the “comps.”
Try to be realistic about the risks and prospects of your business, looking at it as an investor not a member of your circle of family and friends would review it, at least for the purpose of getting an idea of a range of values that might make sense to a third party.
Try to address investor risk factors as they emerge during due diligence intelligently; do not deny them or evade them.
Remember that value is only one of the terms, and not necessarily the most important one, that needs to be negotiated to close a funding.