How important is pre-money valuation? Pre-money valuation is critical when it comes to a funding, since it may ultimately determine whether a founder has a stellar, good, poor or, sometimes, no exit. However important the pre-money valuation, it is not the most important consideration when taking money, particularly when taking it from VC’s. I am constantly asked to evaluate offers from different firms, and often it comes down to pre-money valuation. My advice is often the same: the most important consideration (particularly for first time startup entrepreneurs) is the value add that an investor can bring to the table. I almost always advise clients to take the lower pre-money offer if there is the potential for a far greater value add from that firm, as opposed to another, offering a funding at a higher pre-money, but there isn’t the same value add potential. Chance are, the long term effects of the value add (increased value of the company), will more than offset the lower pre-money.

What is my pre-money valuation? This is the one question I always dread coming from my startup clients, but one invariably asked. I had to deal with this twice yesterday, and therefore thought it worthy of a posting. In addition, I am always focused on the end game, however far off it might be, and that is the exit. My goals in advising clients are always the same—and that is to very early on help the entrepreneurs develop and implement an appropriate funding strategy, so that they are more likely, from a financial perspective, to have a successful exit. I am often asked what I consider to be a successful exit for founders, and to me it is one where the proceeds received are commensurate with the level of effort and time devoted to the startup. I have had clients spend a year on a company, and a founder walks away with $10.0MM after an acquisition. On the other hand, I have had others that have devoted 5-10 years of blood, sweat, tears and deprivation, and walk away with the same or less. In my mind, the former, rather than the latter, was a successful exit. Very often, it begins and ends with the question as to whether or not, at the early raises, the company sold an appropriate funding instrument (debt versus equity), and where equity was sold, was the pre-money valuation at each raise appropriate?

This question, as to what is a company’s pre-money valuation, is one to which there is generally no right or wrong answer. The one thing that I can say with certainty, is that I have never yet had a client call me with uncontained and uncontrolled exuberance and excitement, following a meeting with an angel or a VC, informing me that they just received a term sheet with a pre-money valuation that far exceeded their expectations (in a positive way) as to what they thought their startup was worth. On the contrary, it is most often the case that a founder calls me following a meeting, dejected and despondent, relaying the significant divide between what they believe their company is worth, and the pre-money investors are offering. If I didn’t get the question as to my views on the pre-money valuation before the entrepreneur engaged in capital raising activities (which is rare), it’s a virtual certainty that I will be asked, at this point, what I believe the company’s pre-money to be.

Pre-money: What it isn’t, and what it is. Firstly, what it isn’t. Determining pre-money valuation is an art, and not a science. This is true especially for early stage startups, particularly those that are pre-revenue. Secondly (and what it is), the pre-money is whatever the market is willing to bear. Notwithstanding that a startup entrepreneur might believe their company to be worth $25.0MM, if they are consistently offered financing from different investors at a $5.0MM pre, then that really is the pre-money, since that is all the market is willing to pay. If the founder feels strongly that he or she will give up too much of the company at the offered pre-money, we often go back to the funding strategy that we had developed, and determine (i) if bootstrapping to another value inflection point is possible, (ii) if we could do a smaller raise to get to a meaningful inflection point, (iii) target different investors, who are less valuation sensitive, or (iv) do a convertible debt offering, to get to the next value inflection point.

Tools to Help Compute the Pre-money Valuation.

Discounted Cash Flow Analysis. The one client who posed the question yesterday has a stellar business model, has been in existence for about two years, and generated approximately $400,000 of revenue for 2011. The founder CEO is looking to raise funds at a $50.0MM pre-money valuation. For a recurring revenue model, you might ask how one achieves such a lofty valuation? The client, as with many others, used (paid a consultant to produce) the discounted cash flow model (DCF). A DCF model forecasts several years of revenue and expenses, typically three to five years, and then discounts the resulting revenue to a present value. A DCF model looks and feels great, particularly where the underlying assumptions upon which the model is based, appear reasonable (at least to the entrepreneur). Entrepreneurs are happy with this model, because it give an “objective” answer to the perplexing question as to what the pre-money valuation really is. It can also be tweaked nine ways to Sunday, and an adjustment to any of the variables/assumptions or the discount rate applied can move the bar up or down with a simple keystroke. The primary issues with a DCF approach are that early stage startups have no (or very little) historical data upon which they are building their model and upon which they have based the assumptions, which often reflect that the company will be doing a gazillion Dollars of revenue in three years. Whenever I sit on committees tasked with evaluating business plans, there is always a collective sigh when presented with these kinds of projections. A quote related to Beachmint’s raise resonated with me. “… ecommerce companies have a pretty clear business model. That sounds like it should be a good thing for whetting investor attention, but the unfortunate truth is nothing ruins a wildly speculative valuation like real revenue numbers. Real revenue numbers usually get multiples off existing revenues, not multiples off the promise of what they could be.” This is not to say that a DCF model has no utility. In my view, it may be a worthwhile exercise for earlier stage companies, but it is definitely so for later stage companies, that have some historical financial data upon which to base their assumptions.

Comparable Companies Analysis. An alternate valuation methodology to the DCF analysis is known as the market multiples analysis, or comparable companies analysis or direct comparison analysis. This methodology is often used to value companies with high growth potential, but that have a limited operating track record. The underlying rationale for utilizing this method to value a company is that companies that are similarly situated should sell or be funded at similar valuations. This is great in theory, but probably not so for most of my clients, because of a number of factors. Firstly, for many of my clients that have disruptive technology or who are doing something that, while possibly similar to others, has significant and distinctive value propositions to all or most others in the space. Secondly, it is extremely difficult to find reliable data on comparable companies that get funded, as this is typically held close to the vest. Although companies have to make securities filings when issuing securities (usually with the SEC, which are publicly available), which includes the amount raised, one cannot ascertain from these filings the pre-money valuation upon which the raise was based and the shares priced, and it is therefore of little value to the market multiples approach. Thirdly, and somewhat of an intangible, is how much traction the company has achieved, in what period of time, and where they are on the hockey stick. Companies that have achieved, and are poised significant ramp in a short period of time, and are likely to continue along that trajectory, are likely to obtain a higher pre-money valuation than another that is on the upswing, albeit not along the same trajectory.

Multiples. For later stage companies, multiples are used, whether its multiples of revenues, sales etc., and this is very often a good starting point. For example, if you are a SaaS company, there are reports published as to the multiples on trailing twelve month revenues that are given on exit, which are often very useful in determining a basis for valuation on funding. Take a look at Software Equity Group ( who produce quarterly and annual reports in this regard. Depending upon where you are on the hockey stick, SaaS company multiples might be anywhere from a 3-5 times trailing twelve months revenues.

Pre-money Valuation Based on the Stage of the Company. Very often, early stage startups receive pre-money valuations based simply on where they are in terms of their life cycle. This is probably most true where founders employ a funding strategy which includes bootstrapping, friends and family, angel and then institutional investors. It’s driven, at the end of the day, by the desire to sell an appropriate piece of the company, given the stage of the company, and looking ahead to the future raises, so that, upon exit, the value which may be received by the founder(s) is commensurate with the time and level of effort expended in getting the company to exit. (I have often found that most mediocre to poor exits for founders (as opposed to other shareholders who may do well) typically can be traced back to a poor or nonexistent funding strategy at the initial stages of starting the company, often where too much of the company was given to investors for too little money, or equity was sold when it should have been convertible debt that was sold).

The following are what I often see in the early funding rounds. When doing a friends and family round (often, getting to proof of concept), I typically see raises of $100-$200K, at a pre-money of approximately $1.0MM. Angel rounds are typically $250,000 to $1.0MM (funds utilized to achieving some level of technological development, and perhaps bring on key personnel), and the pre-money valuations are generally in the $2-$4.0MM range. Institutional rounds are typically for at least $3-$7MM (to be utilized to either complete development and launch or to launch and achieve some scale), and the pre-money valuations are generally in the $5-$15.0MM range. Of course, much of this depends on many factors, some tangible, such as whether or not an effective a funding strategy was employed, how long the entrepreneur was able to bootstrap, how significant the value inflection points when funds were raised, and intangibles, such as the team, whether they are serial or “first timers.” I have often heard investors say that their investment criteria dictate that they have to own X% of the company, which also drives the pre-money valuation.

How to Increase your Pre-money Valuation?

Target appropriate investors for the stage of your company. Your pre-money valuation (up or down) may be significantly impacted by your targeting the right investors (ignoring, for the purposes of this posting, non-dilutive capital raising avenues, such as government grants (SBA, NIH, NSF, DOD, Venture Debt, Commercial Banks). I typically look at targeted investors as falling into one of the following camps: Friends an family, high net worth individuals (as opposed to angels, who are either organized groups or funds, or who routinely invest in startups at the very early stages), angels and angel groups, strategic investors, and VC’s. Your pre-money valuation might differ significantly, depending on who you are targeting as potential investors in your company, and the types of securities for which they may have an appetite (convertible debt may be appropriate for a seed/angel round, rather than equity, which could significantly reduce the founder’s dilution and thereby increase the ultimate upside on exit).

As you probably know, VC’s are funded by limited partners (LP’s), and the ROI attributed to a fund is a significant factor in determining whether or not a VC will be able to raise a new fund from current or new LP’s when the fund comes to the end of its investment life. To that end, the ultimate ROI is addressed in the term sheet you will receive from a VC, and the two provisions effecting the economics of the deal which are found in the term sheet are the pre-money valuation and the liquidation preference (multiples and whether or not the series of Preferred Stock being purchased by the VC is participating or non-participating). One of my VC contacts that invests always reminds me, that he can only invest if he can see a clear path to taking $50-$60MM back to the fund, and that can only really be achieved by (a) a low pre-money valuation, or (b) investing a lot of money in the company—and guess which is most often the case? Contrast this with strategic investors, who are not so much driven by ROI, but typically by some other advantage that can be gained by the investment, such as co-marketing, exclusive marketing, licenses, manufacture or distribution rights (and this is a topic for another posting, since, if the hooks are too broad or too deep, it will make your company unfundable from any other investor, and possibly unattractive to any other acquirer, which will ultimately reduce your upside on exit). Obviously, the targeted investors have to be appropriate for the stage of your company—it is typically of little use approaching most VC’s for a $500,000 investment, since they are usually only interested in investments of $3-5MM and above. Similarly, it is of little use approaching most angel groups for a $5.0MM investment, since their ceiling is typically $1-$1.5MM for investment.

Bootstrap. One of the surest ways to increase your pre-money valuation is to bootstrap, bootstrap and bootstrap, for as long as you possibly can (assuming that you are not involved in a company where the outcome is binary or it’s a first to market wins play, in which case you may not have the luxury of bootstrapping). The longer you self-fund the company, the greater the value you are building, the greater the premoney when you undertake the raise, and therefore the less dilutive the offering. In addition, I have clients that “bootstrap” with government funds, and if you have a product that could be government funded—don’t overlook this possibility.

Tell a great story. Prepare collateral materials that tell the story, and that place the company in the best possible light and position to get funded. Be sure to demonstrate and articulate your compelling value proposition, in your executive summary (see the posting on January 19, 2012) and slide deck, what every investor looks for: (i) a management team, with relevant core competencies, deep domain expertise and experience, that has demonstrated success, and is likely to execute to a future plan; (ii) that there is a significant pain in the market, or it is coming; (iii) you have a solution that addresses the current or future pain, and it is a solution that people will pay for; (iv) the addressable market is significant; (v) your company has an “unfair”, sustainable competitive advantage; (vi) measurable milestones for success; and (vii) a product with good margins.

Build/create barriers to entry. Although I am not an IP attorney, I often bring one of my IP partners to an initial client meeting. I believe that it is critical to build barriers to entry as early as possible. Provisional patents are relatively inexpensive, and although there are tradeoffs to filing provisionals rather than utilities, most startups have to make hard choices early on. Filing a single provisional may not be enough. It is critical to develop a patent strategy, and most clients go into investor meetings able to clearly articulate a strategy for building a wall around what they are doing, even if they have only filed a few provisionals at the time of the meeting. It shows your thoughtfulness and strategic thinking as to how you will differentiate yourself in the market. Developing and implementing an IP strategy early on can and hopefully will, provide you a sustainable competitive advantage.

Brand recognition and traction. Unless you are deliberately operating in stealth mode, try and brand your company and product early on. The more buzz you can create early on, the more likely it is that investors will come to you. In addition, there is nothing like demonstrating traction in the market place (customers) to help build the pre-money.

Create interest among many. Probably one of the most important things that you can do to increase the pre-money valuation, is to create interest among many. If you have more than one term sheet on the table, the chances are you are going to have some leverage in negotiating the valuation. Nothing like a little competition to drive valuations. I want to add a cautionary note here. I do not advocate shotgun blasts to all VC’s in the valley, in the hopes of landing a term sheet. Please don’t misconstrue creating interest among many as advocating the shotgun approach. However, what I do advocate is identifying a number of VC’s that “get” your space. Then review the venture partners within those firms, who have the core competencies that would be a terrific value add, given your stage of development. So, if you are looking for scaling money, and there is a venture partner in a firm who invests in your space, and in his or her prior life, they built a company and exited for $500MM, chances are they really get scaling—the pains and most efficient ways to accomplish it. If you (or your advisors) reach out to these VC’s (perhaps 3-5), with an explanation as to why you think they would be a great fit, you are likely to get an introduction and a meeting. When I make introductions for my clients, I am always up front in that we are talking to 2 or 3 other firms, so that there are no surprises and/or bad blood down the road. The end goal is the same, and that is to have more than one investor interested in the company (which also provides a sanity check for founders when they consistently hear a pre-money valuation from multiple parties, even though it might be less than they had expected/hoped for).

When is Final Really Final? The Federal Circuit Wrestles with Conflicting Court and PTO Decisions Relating to the Same Patent

Yogi Berra, the sage of baseball and life, once said, “It ain’t over until it’s over.” In many respects, that philosophy applies to district court patent infringement litigation that advances in parallel with proceedings in the U.S. Patent and Trademark Office to invalidate one or more of the patents in the litigation.

It has long been a strategy for a company facing charges of infringement in district court to initiate an action with the PTO to invalidate some or all of the patent claims at issue – by ex parte re-exam, inter partes re-exam or, since the passage of the America Invents Act in 2011, inter partes review. Because court cases and PTO proceedings progress at different speeds, it is typical for the court and the PTO to reach a decision at different times. When those tribunals reach conclusions at odds with one another – say, the court finds the patents valid and infringed and the PTO finds them invalid – the litigants are forced to continue the fight until the situation gets sorted out. Within the past year, the Federal Circuit has issued three decisions which bring some clarity to this murky area. This article exams those decisions.

Fresenius USA, Inc. v. Baxter International, Inc.

In the first, and best known, of these cases, Fresenius USA, Inc. v. Baxter Int’l, Inc., 721 F.3d 1330 (Fed. Cir. 2013), the court held that the cancellation of claims of a patent owned by Baxter and asserted against Fresenius by the PTO in a re-exam proceeding after judgment had been entered in Baxter’s favor in district court served to vacate the judgment and end the matter with Fresenius prevailing. The history of the litigation is torturous, messy and long, having begun more than ten years before the Federal Circuit rendered its most recent (and probably last) decision in the case. Before it got to this point, the court case involved a jury trial, two appeals to the Federal Circuit and the entry of a judgment in Baxter’s favor, while the ex parte re-exam involved a finding that the patent claims were obvious, an appeal to the Federal Circuit and a cancellation of the claims. In the end, the critical facts were that the Federal Circuit had affirmed judgment of invalidity in 2009 but remanded the case to dispose of issues relating to damages; following the “final” judgment on March 16, 2012, the court granted Fresenius’s motion to stay the judgment while the parties cross-appealed on damages issues; and the PTO issued a certificate cancelling patent claims on April 30, 2013. The issue facing the Federal Circuit this time was whether the cancellation of the claims after final judgment had been entered but while that judgment was stayed ended the litigation in Fresenius’s favor because the cancellation of the patent claims extinguished Baxter’s cause of action.

In the majority decision issued on July 2, 2013, Judge Dyk (joined by Judge Prost) vacated the district court judgment in favor of Baxter and remanded with instructions to dismiss. Because both sides – and the court – agreed that “the cancellation of a patent’s claims cannot be used to reopen a final damages judgment ending a suit based on those claims,” Id. at 1340, the issue came down to whether the “final” judgment on invalidity that the district court had entered and the Federal Circuit had affirmed in 2009 was final enough. The court held it was not. Even though the Federal Circuit’s affirmance of the judgment of invalidity had brought to an end court proceedings relating to invalidity, “it did not end the controversy between the parties, or leave ‘nothing for the court to do but execute the judgment.’” Id. at 1341, quoting from Mendenhall v. Barber-Greene Co., 26 F.3d 1573, 1580 (Fed. Cir. 1994). Therefore, at the time of the PTO’s cancellation of the claims, the district court case was still “open” and the judgment was still vulnerable to the PTO’s decision.

Judge Newman wrote a dissent, the first two sentences of which neatly summed up her concerns:

The court today authorizes the Patent and Trademark Office, an administrative agency within the Department of Commerce, to override and void the final judgment of a federal Article III Court of Appeals. The panel majority holds that the entirety of these judicial proceedings can be ignored and superseded by an executive agency’s later ruling.

Fresenius, 721 F.3d at 1347 (Newman dissent). According to Judge Newman, “when the issue of validity of claims has already been resolved in litigation, subsequent redetermination by the PTO is directly violative of the structure of government.” Id. at 1349. Because the Federal Circuit had finally resolved the issue of patent validity, with its 2009 affirmance of the district court’s judgment, the fact that the district court had to deal with damages issues did not make the validity judgment any less final because what remained “had no relation to any issue in reexamination; validity had been finally resolved in the courts.” Id. at 1355. In a six to four vote, the Federal Circuit denied Baxter’s petition for rehearing and rehearing en banc. Fresenius USA, Inc. v. Baxter Int’l, Inc., 733 F.3d 1369 (Fed. Cir. 2013).

Versata Software, Inc. v. SAP America, Inc.

Faced with a different chronology than the court in Fresenius, the Federal Circuit reached a different result in Versata Software, Inc. v. SAP America, Inc., 564 Fed.Appx. 600 (Fed. Cir. June 18, 2014). Versata obtained a judgment of infringement against SAP based upon a jury verdict, and SAP appealed. During the appeal, SAP filed a petition for Covered Business Method review of the Versata patent, and the PTAB initiated review. The Federal Circuit affirmed the judgment in favor of Versata but remanded to the district court to modify the permanent injunction it had issued. Versata Software, Inc. v. SAP America, Inc., 717 F.3d 1255 (Fed. Cir. 2013). Six weeks after the Federal Circuit’s decision, the PTAB found the patent to be invalid. Versata appealed. In the meantime, Versata withdrew its request for an injunction, which was the only part of the judgment not affirmed by the Federal Circuit.

SAP moved the district court to vacate or stay the judgment, in part, because of the PTAB’s finding that the Versata patent was invalid. The district court denied the motion because a final judgment had been issued in the case (and the CBM proceedings were on appeal and not final). The court reasoned:

To hold that later proceedings before the PTAB can render nugatory that entire [court] process, and the time and effort of all the judges and jurors who have evaluated the evidence and arguments would do a great disservice to the Seventh Amendment and the entire procedure put in place under Article III of the Constitution.

Versata Software, Inc. v. SAP America, Inc., 2014 WL 1600327 at *2 (E.D. Tex. April 21, 2014). The court distinguished Fresenius on the ground that Versata’s judgment “is final and there are no further issues to be resolved.” Id. In a very short per curiam decision, the Federal Circuit granted Versata’s motion to dismiss SAP’s appeal without citing Fresenius or any other cases. Versata, 564 Fed.Appx. 600.

The Federal Circuit decided the final installment of its what-is-final trilogy on July 25, 2014 in ePlus, Inc. v. Lawson Software, Inc., — F.3d –, 2014 WL 3685911 (Fed. Cir. July 25, 2014). In another split decision, the majority (again consisting of Chief Judge Prost and Judge Dyk) vacated a permanent injunction and contempt order following the PTO’s cancellation of the patent claim on which the injunction and contempt order had been based. As in the Fresenius and Versata cases, ePlus took a winding path to the Federal Circuit. At trial, ePlus prevailed on both infringement and validity, and the district court entered an injunction. The Federal Circuit reversed in part, holding only one of the claims of one of the asserted patents valid and infringed and remanded for the district court to reconsider the injunction. On remand, the district court modified the injunction and then found Lawson in contempt of the injunction. Lawson appealed both the injunction and contempt order. While that appeal was pending, the PTO concluded in a re-exam proceeding that the surviving claim was invalid, which the Federal Circuit affirmed in a separate appeal.

The Federal Circuit panel unanimously – without objection from the patent owner – first vacated the injunction, holding that the basis for the injunction – a valid patent claim – no longer existed in view of the PTO’s invalidation of the claim. Accordingly, under long-standing Federal jurisprudence, the injunction could not remain in place. ePlus, 2014 WL 3685911 at *5.

On the contempt question, the majority began its analysis by noting that courts have long held that civil contempt sanctions arising from the violation of a non-final injunction barring infringement of a patent should be set aside when the patent is subsequently found to be invalid. Id. at *6, citing Worden v. Searls, 121 U.S. 14, 26 (1887). The court then held that the Worden rule applied equally where “the injunction has been set aside as the result of the PTO proceeding rather than a court judgment.” ePlus, 2014 WL 3685911 at *7. Finally, relying extensively on Fresenius, the majority concluded that the injunction entered by the district court was not final at the time the PTO invalidated the claim at issue because following remand the court had issued a modified injunction, which had been appealed, and the PTO decision invalidating the patent had occurred before the appeal had been decided. Therefore, Lawson could be relieved from the contempt order. Id. at **7-8.

Judge O’Malley dissented from the portion of the majority’s decision holding that Lawson did not have to pay civil contempt sanctions. First, she argued that Fresenius did not apply to the ePlus case because the factual and procedural postures were different at the point in time when the PTO found the patent claims to be invalid. Id. at *12. Even if Fresenius were not distinguishable, however, Judge O’Malley found the application of that decision to the situation in ePlus troubling because “[t]he majority’s approach to finality will further displace the critical role of district courts in patent infringement suits.” Id. at *14. Specifically:

By extending Fresenius II to these materially different circumstances, the majority assumes that any determination made during an infringement case, even if that specific issue is never appealed, can be nullified by the action of an administrative agency as long as anything – even a fully discretionary “consideration” of an intact remedy – remains available.

Id. (emphasis in original). According to Judge O’Malley, the majority’s approach to finality “creates uncertainty for any future compensatory contempt awards” because the trial court always retain the equitable power to revise injunctions prospectively. Id. at *15.

Notwithstanding the strong dissents of Judge Newman (in Fresenius) and Judge O’Malley (in ePlus), practitioners must now consider the law of the Federal Circuit to be that as long as any part of a district court case remains to be decided, an intervening final decision by the PTO that invalidates the claims of an asserted patent will lead to the vacating of a court judgment in favor of the patent owner, regardless of how remote the open issues in the case are from the issue of the validity of the patent. We have likely not heard the last on this issue, however, as it would not surprise anyone if the Federal Circuit eventually decides to Bob has spent over 30 years litigating intellectual property and commercial disputes. With his experience as both a law firm partner serving as a first-chair litigator and a senior in-house counsel at a major US technology company managing patent litigation, Bob calls upon a broad and unique set of skills to resolve clients’ legal disputes. He not only has the expertise of a topflight litigator, but also an in-house perspective to better understand a client’s dispute-resolution goals and to maneuver a case in such a way as to achieve those goals.