Lately, I’ve been speaking with startup founders who are asking me how much of their companies they should be handing over to investors in exchange for early-stage capital.
The simple answer: as little as possible.
But, seriously, determining the value of a technology startup is not simple. For mature businesses, with steady revenues and earnings, normally it’s just a matter of valuing them as a multiple of their earnings, say ten times. But it’s a lot harder to value an early-stage venture that may be years away from bringing in revenues. Often, start-ups are little more than a business plan and their founders’ hopes and dreams.
As a consequence, nothing creates a bigger gulf between founders and investors than the startup’s valuation. The two parties may agree on every other point but will have disparate views on what the business is worth and how much equity the investor should get in return for his money.
A Bay of Thermi client, who originally raised £2 million for his drug development startup at a £7 million valuation, told me that an angel investor offered to put money in at a £5 million valuation. If my client were to agree to the investment, it would represent a painful reduction in business value for him and his original investors. Moreover, it would mean accepting a hefty dilution in their equity.
In the past, I would have told the client to walk away and wait for a better offer to come along. After all, since raising its first round of financing, the company was meeting milestones and early stage trials of its drug treatment were proving successful – suggesting that a value north of £7 million might be justified.
However, in today’s capital environment, the wait for generous investors can be a long one. To put it bluntly, there is less early stage investment capital around these days, and what is available comes from increasingly tight-fisted angel and VC investors. So, the job of startups is to stay at the negotiating table and come up with creative ways of shaping deals that are acceptable to both sides.
Here are some ways to get things moving at the negotiating table:
Build a Defensible Valuation
Valuation, at the end of the day, is a matter of negotiation. Successful negotiation requires work to support a convincing case. The startup’s valuation – and the financial projections upon which it is built – should be based on hard facts that investors can believe in. It is awfully hard to sell your valuation to an investor who finds obvious “holes” in your plan and numbers.
It’s critical that startups build a realistic, defensible set of projections. Most importantly, if they want to get the valuation they are seeking they must have a well thought out and consistent story about why their plan will succeed
Clients have told me that the strength of the valuation model was the critical factor in their securing investment, and that the model, clearly presented, gave investors greater insights and visibility about the business opportunity, and greater confidence in its value. If you are looking for help with your valuation, do not hesitate to contact me.
Debt – Not Always To Be Feared
One way of bypassing the problem of valuation altogether is to borrow money from investors. Yes, borrow. After all, selling equity shares is not the only way to raise capital. Startups can think about debt – either straight debt or convertible debt. Most angel and VC investors are accustomed to putting money into startups through debt, so long as the startup is comfortable paying a hefty interest rate that reflects early-stage investment risk (anywhere from 7-20%) and holds the promise of producing positive cash flow in the not-too-distant future.
Making the debt “convertible” to equity gives the investors a share of the upside if the business gets acquired or goes public, and protects them from downside if the startup can’t generate enough cash flow to service its interest payment. Best of all, if the startup chooses to raise money later by by selling shares to VCs or other investors, more than likely, it will able to do so at a higher valuation than before.
CASH IS KING! Produce Some Revenue
Of course, the best way to gain strength in negotiations to is to show that your startup can make money. Nothing makes early stage investors happier than seeing signs of revenues coming in the door. Just the whiff of sales – be it in the form of a pilot deal or a trial contract – can give valuation a hefty boost.
Sign up clients as soon as you can to show prospective investors that they’ve got more than just a business plan and a dream.