Wednesday, March 25, 2009

What is My Company Worth? Be Careful How You Answer...

What is my company worth? The answer to this question is key to successfully finding sources of equity and completing the investment process. However, this question is often one of the most difficult ones for an entrepreneur to answer. For more on this, please see below.

Determining a proper valuation of a start-up company is especially tricky in the early stages -- that is, the friends and family, seed and/or angel rounds of funding. I recently posted extensively on angel funding and how to obtain it here, here and here.

There are two dynamics contributing to this trickiness. The first I like to call the preservation ethos -- that is, the understandable fundamental desire of the founder to preserve his share of the company. If the pre-money valuation of the company is too low, the relative portion of the company purchased by the new investor will be larger -- and, consequently, the founding entrepreneur will own less of the company. A simple example, if a company is valued at $500k and it raises $500k of new money from friends and family then the post-money valuation of the company will be $1mm and the founder will only own half. In a company where several successive rounds of equity financing are contemplated, this may be an unpalatable situation for the entrepreneur/founder.

The second dynamic is what is known as valuation creep. Sometimes this is the result of a conscious effort by the founder to avoid dilution by setting artificially high valuations in early rounds. Sometimes this is simply the result of ignorance or exuberance -- i.e. if I tell everyone my company is worth millions of dollars then maybe they will be more excited to invest before it quintuples in value. The result is an unsustainably high valuation in early financing rounds.

I use the word unsustainable because in later rounds (for example an early-stage Series A round sponsored by a venture capitalist) a professional investor using proper valuation metrics will either refuse to invest at your inflated valuation or will require the next round to be a down round at a lower -- and more supportable in the eyes of the VC -- valuation. Each of these outcomes is less than ideal -- either you will be unable to raise needed new capital or the new capital will be even more dilutive than usual. It is more dilutive than usual because a down round not only is dilutive in a relative sense but also an absolute sense. In a normal up round, you are diluted relatively because additional shares have been sold, but on the other hand, you are usually better off because if the valuation per share has increased, your shares are now theoretically worth more. The value of your investment has increased. However, in a down round, not only are more share being issued (relative dilution) but they are being issued at a lower price -- which means your existing shares are now worth less and your investment is now in the red. This hurts both the founder and the friends and family/seed/angel investors that collaborated in the valuation creep.

An additional problem with setting too high a valuation in the early rounds is that this valuation will likely become a fair market value floor for option purposes -- meaning that the company may be unable to grant options with a strike price significantly less than the price in the last equity round. Stock options are an important tool for attracting and retaining talented personnel in the start-up environment and, consequently, it is important to keep in mind the impact that a financing round may have on future employee retention.

So you may ask yourself, what is the secret to avoiding valuation creep while also preserving founder value? The answer is, there isn't one. It's a matter of "touch" and "feel" and striking an appropriate balance between the various constituencies. In the majority of start-up companies, obtaining a proper professional valuation is neither efficient nor feasible. This makes the entire valuation process an educated guess for a start-up -- a guess driven more by external factors than any quantitative exactitude. The proper number is one which can be agreed upon by the relevant parties and the real risk is that the friends and family or angel investor is not experienced enough to understand the dangers associated with too high a valuation. The trick is to pick a reasonable valuation and then run with it -- there really is no magic to the process. At a later stage, the professional investors will perform a proper financial analysis and determine what valuation they think you can reasonably justify -- and you can argue with them then.

One final point -- this discussion assumes that the early investors will be taking equity in the company. This is not always the case and, quite frankly, I usually recommend that angel investors take convertible debt. For more on this, stay tuned. I have been working on a blog post analyzing what I think is the best way to handle angel investments -- I hope to post it next week.

1 comment:

  1. Hank,
    Great posting, and you illustrate points that are commonly encountered with smaller companies looking to raise funding. More often than not, you start talking about more realistic valuations, leading into a 2nd round, and it is typically coming into conflict with early investors. No doubt I'll be forwarding your link.

    Jeffrey Ishmael
    jeffrey@corpfincafe.com
    www.corpfincafe.com

    ReplyDelete

 
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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.