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 (http://www.softwareequity.com/) 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).