The Art and Mystery of Start-Up Valuation by Jordan Green

Most pre-revenue entrepreneurs determine their company valuation through calculations of Discounted Cash Flow, Net Present Value, or comparisons with the early valuation of already successful companies.

Most experienced early-stage investors looking at a pre-revenue company start with a valuation of zero.

These two starting points are obviously far apart but, neither is the right answer. Valuation of an early-stage venture is a strategy for future success.

Valuation should be determined on two primary factors, future value growth and equity position and, ultimately, should be agreed in discussion. Existing cash investment and sacrifices by the founders are important but, their sum does not create a defensible valuation. Investors and founders are both betting on the future not the past.

An entrepreneur should prepare a valuation position and supporting rationale prior to engaging with investors. Setting this number in the right range sends a strong signal that the opportunity is worthwhile and that the founders know what they are doing. A credible number is always better than an ambit claim. An high valuation to concede in negotiations with investors may preclude having those negotiations. Too low a valuation may raise concerns about the founders’ business acumen but, is better than too high. What are too high and too low?

The honest answer is ‘it depends’ but, a fairly standard range for the first round of external investment in a pre-revenue or early revenue business seeking up to $1m is from $200,000 – $1,200,000 or, to put it another way, 20%-45% of post money equity.

Equity position is relative to the amount being invested and is dependent on the philosophies of the founders and investors. Generally, the first external investor (typical role of an Angel) will want a substantial minority position. Founders need to balance concerns about control with a respect for the investors’ money. Together, founders and investors should consider future demands on equity and ensure the valuation underpins that forward strategy.

Investment terms can effectively alter the valuation through preferences, options and conversion ratios. Traditionally, Australian Angels use ordinary shares to keep things simple and easy for founders. The emerging trend is for early-stage investors to use preferred shares that better reflect their financial risk by delivering a return of capital before converting preferred into ordinary shares to participate in distributions. Founders should be wary of investors seeking more onerous preferences and be confident of the value those investors will deliver.

Future value growth is an external measurement of performance. Most rapid growth companies seek to double their valuation at least every 12-18 months for the first 3 or 4 years. That performance encourages investors and acquirers to pay a premium presuming that growth will continue. Achieving that performance for a pre-revenue company valued at $5m, or $50m is much, much harder than for one valued at $1m.

Founders, particularly first time entrepreneurs, tend to worry a lot about control and fear that ceding a large equity position to investors may threaten the future of the venture. This is not entirely wrong but, it is usually blown out of proportion. Experienced, early-stage investors rarely want a simple majority of equity, especially in Australia with the adverse legal and taxation implications. An investor that intends to fill an executive role, or otherwise become a substantial contributor to execution may seek a majority position.

It is up to the entrepreneur to judge the expected value added by the investor to determine if the proposed equity position is reasonable.

For investors who intend to be proactive through a non-executive director, or similar role, it is reasonable they achieve that 20%-45% equity stake discussed above. Even those investors, if experienced, are likely to seek ‘negative control rights’ in their terms of investment. These empower the investors to stop the company doing something substantially different from the proposition they agreed to back. These rights usually cover new debt and equity, hire and fire of executives, business strategy and objectives, capital expenditure and changes to the governance and shareholder structures and procedures. Even a shareholder with a small equity position can, through terms of investment, have complete control. So, founders should think holistically about the control and not focus only on equity position.

Valuation is a complex topic and interdependent on terms of investment, investor involvement, future rounds of funding, projected revenues and profits, founder capability to execute, capital intensity of the venture and other concerns. Neither founders nor investors should rely on an accountant, lawyer, or corporate adviser to set the valuation. Early-stage investors are taking a risk on the entrepreneur who must articulate the valuation rationale and understand how to reach an agreement with investors. Investors should be able to articulate their valuation rationale and explain how they will add value to the business in a way that supports the valuation strategy.

Jordan Green is an internationally sought after thought leader in early-stage investing. Founder of Melbourne Angels [www.melbourneangels.net] and co-founder of the Australian Association of Angel Investors [www.aaai.net.au].