Entrepreneurship University
College of Entrepreneurial Studies (CES)

Valuation and Company Stages

The Valuation Process

It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/ venture capitalist relationship. This relationship revolves around a tradeoff. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of the company, possibly a majority stake. The venture capitalist seeks to value the venture to provide a return on investment commensurate with the risk taken.

Entrepreneurs seek to raise as much money as they can while giving up as little ownership as possible. Venture capitalists strive to maximize their return on investment by putting in as little money as possible for the largest share of ownership. Through the negotiation process, the two parties come to agreement. Entrepreneurs understand that excess funding costs them equity. Venture capitalists must leave company founders with enough ownership to provide incentive to make the business succeed. To balance their individual goals, both parties should agree on one mutual goal—to grow a successful enterprise.

The first step in the negotiation process is to determine the current value of the company. The most important factor in determining this “pre-money valuation,” or the value of the venture prior to funding, is the stage of development of the company. A business with no product revenues, little expense history, and an incomplete management team will usually receive a lower valuation than a company with revenue that is operating at a loss. This is because the absence of one or more of these elements increases the risk of the venture’s not succeeding. Each successive stage commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks.

Stage I
Ventures have no product revenues to date and little or no expense history, usually indicating an incomplete team with an idea, plan, and possibly some initial product development.

Stage II
Ventures still have no product revenues, but some expense history suggesting product development is underway.

Stage III
Ventures show product revenues, but they are still operating at a loss.

Stage IV
Companies have product revenues and are operating profitably.

The best way to build value in a company is to achieve the goals and milestones within the time frames designated in the business plan. As milestones are achieved, risk is reduced and subsequent rounds of financing can usually be raised at more attractive valuations.

“Pre-money” and “Post-money”

Once a venture capitalist has expressed interest in a company, the next issue will focus on the valuation of the company, how much will it pay for the company and for what percentage of the company? Venture capitalists use some arcane terminology when discussing valuation. The terms “pre-money” and “post-money” refer to what they think a company is worth before and after the investment.

For example, when a venture capitalist says, “it’s worth $3 million pre-money, and I want to own 40% post-money” means that the venture capitalist thinks the company is worth three million before any VC financing, and since he wants to own 40% of the company after they have invested. Thus they are willing to invest $2 million

$2m investment / ($3m pre-money value + $2m new money) = 40%

If the venture capitalist knows how many shares are outstanding, he can provide the entrepreneur with a price per share. Translating valuations based on share prices is fairly easy for pre-money and post-money valuations.

The two following equations will determine what percentage an investor will want to own after closing the deal:

  • Shares outstanding pre-money/(1-percentage investor wants to own post-money)
    = Shares outstanding post-money
  • Shares outstanding post-money-Shares outstanding pre-money)
    = Shares to be issued

For example, if there are 6 million outstanding shares pre-money and the VC wants to own 40% of the company, then 10 million shares must be outstanding post-money

6,000,000 pre-money shares / (1-40%, or 60% of post-money shares) = 10,000,000 post-money shares

10,000,000 post-money shares – 6,000,000 pre-money shares  = 4,000,000 shares to be issued

Of course, price discussions will involve negotiating. Valuing a company is not easy and is more difficult with a start-up which has little if any operating history. Venture capitalists will often base their valuations on the projections provided by the company and on other deals done in the industry. Getting information on what similar companies were valuated at can help the entrepreneur get the right valuation.

An entrepreneur should determine with the venture capitalist how the reservation of shares for later issuances of stock options to employees will work. If the venture capitalist wants to take into account these reservations then add the number of reserved shares to the number of stocks outstanding pre-money to the equations above. If the reservation of shares is not taken into account in the valuation, its issuance will dilute the ownership interests of both the founders and venture capitalist.

After receiving an offer from a venture capitalist, an entrepreneur should inform any other venture capitalists of the offer and ask if they are still interested. If they have done their due diligence and are still interested, the other VC’s will usually make their offers and valuations quickly.

Going with the highest bidder is not necessarily the best option. An entrepreneur needs to consider which VC will make the best partner and fit for the business. Additionally, an entrepreneur’s comfort level with a VC is important as well.

The final price will also depend upon who the entrepreneur wants to deal with and how much the business needs to raise. Usually there is only one stock price per round for tax reasons and for the sake of fairness. Once the parties agree on the valuation, it is usually set unless some materially adverse event occurs or information discovered. Avoid venture capitalists who feel that all items are negotiable before the deal closes.

If the plan is of interest, the entrepreneur will be contacted for the first of what will generally be several meetings, and the venture capitalist may begin the due diligence process. Since venture firms are in the business of making risk investments, one can be certain a thorough analysis of the company’s business prospects, management team, industry, and financial forecasts will precede any investment.

Prepare for the Negotiation Process

Following due diligence, the successful venture will then enter into the negotiation process, where the structure and terms of financing will be determined. The entrepreneur must carefully prepare for this next step by becoming familiar with the various structures of venture capital financing and preparing a bargaining position after consulting with an attorney who has extensive venture capital experience. Attorneys will give guidance on the issues worth fighting for. Issues to consider are: vesting, salary, stock restrictions, commitment to the venture, debt conversion, dilution protection, downstream liquidity and directors. The negotiation will involve most or all of these issues in addition to price per share. However, price-per-share concerns should not be the overriding interest; the end result of this process must be a win/win situation in order for the relationship to progress successfully. The last step is to document and close the transaction, resulting in a term sheet, investment agreement(s) and, finally, the closing.

Place a Realistic Value on the Emerging Enterprise

The usual progression of financing of a new firm, new in that it has sprung from the ideas and energies of its founders as opposed to a spin off or a divestiture, follows this path:

  • Friends and Relatives, who invest up to $500,000, depending how much faith they have in the founders and how much risk capital is available in the immediate vicinity.
  • Early Stage, in which a local “band of angels” invests as individuals but usually agree as a group on the total amount, up to a million and half dollars. They usually put a fellow angel on the board to watch the store and because one of more of them come from the industry of the new firm, they tend to look at the value of the technology, any prosperity concepts and intellectual property (a novel dot.com address will often qualify).
  • Venture Capital Land, this used to be defined as $5 million to $20 million, but the VCs have been sliding down into the Early Stage space because they can get a peek at more of the hot emerging firms before they explode. They demand detailed often voluminous business plans with lots of spread sheets of projections but they really rely on the Executive Summary, that is, the three minute read or as long as it takes to down in the elevator before having lunch. The object here is to take a large position, keep a close rein on the firm and be out of it in two to three years.
  • Investment Banker, who traditionally would only look at successful and relatively mature firms doing over a $100 million, can be the last step before
  • the Initial Public Offering, that is, “going public.”

Because underwriting and marketing a public stock issue is so lucrative, it has become competitive and so the Investment Bankers have begun investing in firms normally considered by the VC’s, essentially buying the future underwriting business. Because so many financial functionaries have hung out their shingle as “Venture Capitalists,” this disparate group is important because the way they value emerging firms has become the bellwether of raising capital for the emerging enterprise, both from friends and relatives as well as Investment Bankers.

Use of Proceeds

It should be apparent to the new team that if they are going to be given a check, they should be prepared to tell the potential investors in detail what they are going to do with it. According to Jim Schultz, managing principal of the Open Prairie Venture Fund, a Springfield, Illinois, based start- up fund, We can often offer advice on how they can effectively husband their money with leasing or licensing rather than expending valuable cash at the outset.”

In the end, it is the “devil in the details” of the business plan and how well the new management team is prepared to articulate them to the many audiences they will face in generating the initial and follow-up investment for their enterprise.

Wishing you success,

John B. Vinturella, Ph.D.

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