The Price

Create an effective valuation process

for entrepreneurs and investors

Topics

The Capital Life Cycle

• Concept Stage: An idea and maybe a vision

• Seed Stage: Business formation, prototype

• Startup: Pre-production development, market

evaluation, alpha test

• Early Stage: Pre-revenue, beta and market testing,

rounding out management team, initial sales

• Breakeven: Refine market and marketing,

accelerate sales, follow-on product definition

• Growth: Further sales growth, identifying potential

acquisitions/acquirers/IPO

Capital Life Cycle

Valuation Requires a Holistic View

The Valuation process and results affect the immediate and long-term prospects for the company, founders,

and investors

The Company: Sustainability

The Founders: % Ownership

The Investors: ROI

The Valuation process sets the tone of the relationship between entrepreneur and investors for months and

years ahead

The Interests of Entrepreneurs and

Investors are Naturally Aligned

• They have a common goal:

• Building an enterprise that produces:

• Value for customers

• Profits for the company

• Opportunity for employees

• Financial returns for entrepreneurs and investors

• It is everyone’s mutual best interest to share

information as openly and completely as possible

• A relationship rooted in common understanding and

mutual trust creates the framework for creating a

great venture and sharing in the rewards

The Reality of Valuation

1. Investors look for the potential to scale revenue rapidly from $30M to $100M to reach 5X-10X returns—a reasonable desire for the risk they take

2. To grow a startup business usually requires multiple rounds of investment

3. Therefore, the starting ownership percentage of the founder and any pre-revenue stage investor will likely be diluted over time

4. Dilution at exit can be expected to range from 25-70%, or more, based on the number and size of investment rounds and how the company performs

5. Understanding the mathematical effect of dilution helps an entrepreneur see an investor’s point of view and be more realistic about valuation

6. Investors have the money; entrepreneurs have the need

Constructing a Realistic Valuation:

Qualitative Advantages

• Founder is a serial entrepreneur

• Founding team and Advisory Board include

individuals known and respected in the industry

• Media recognition

• Milestones matched to capital requirements

Constructing a Realistic Valuation:

Quantitative Advantages

• A current cap table that is reasonable

• Intellectual property is protected and unique

• The market served is large and growing

• The future capital plan will provide funds for 18

to 24 months

• Early customers

• Paying customers

Vocabulary of Valuation

• Pre-Money Valuation: The value of a company

prior to investment

• Cash, patents, inventory, property, equipment, raw

materials, receivables, etc. net of liabilities

• New Investment: Capital raised during current

round

• Post-Money Valuation: Pre-Money Valuation +

new investment

Valuation Example: Series A Round

Assumption:

• Your company has a valuation of $1,000,000 and you are the only shareholder

• You sell 33% of your company to investors to raise $500,000 in a Series A round

Pre-Money Valuation: $1,000,000

New Investment: $500,000

Post-Money Valuation: $1,500,000

Resulting Valuation:

• You now own 66.67% of a company worth $1,500,000

• The new investors own 33.3%

• The Series A Post-Money Valuation becomes the new Pre-Money Valuation

Valuation Example: Series A Round

Assumption:

• Your company has paying customers, valued IP, and a valuation of $6,000,000

• Shareholders sell 33% of the company to raise $2,000,000 in a Series B round

Pre-Money Valuation: $6,000,000

New Investment: $2,000,000

Post-Money Valuation: $8,000,000

Resulting Valuation:

• You now own 44.5% of a company worth $8,000,000

• The Series A investors own 22.5%

• The new Series B investors own 33%

Dilution: A Dirty Word

• A reduction in value of common stock that occurs because additional shares are issued or convertible securities are converted into additional common shares

• The larger the number of shares, the lower the value of each share

• The value of pre-round stockholders shares will be worth less unless the value of the company grows

• Investors negotiate with the knowledge that most successful exits require multiple rounds of investment—meaning that their ownership percentage will be diluted over time

Down Round: Too-high Valuations

Cause Pain

• Down Rounds result when preceding valuation

was too high

• Previous investors’ share of the business is

diluted much more than normal

• The lesson:

Increasing valuation is very hard work

Most companies will require follow-on capital

Successful entrepreneurs set reasonable valuations

Sources of Capital

• You and Your Team: If you don’t invest in you, others will be less willing to write checks

• Family, Friends, Fools: Unadvisable unless they are in the business and can afford to lose every dime

• Angel Investors: They bring cash, industry experience, amazing contacts, and the willingness to mentor and help

• Venture Capital: They favor growth stage opportunities. Less than 2% invested in early stage

• Customers: If you have what they need, there’s the possibility of a strategic partnership

• Government: Depends on solution and stage. SBIR/STTR programs supply non-dilutive capital

• Banks: They look for positive cash flow first

Arriving at a Value

• The Reality in Early Stages: You are valuing a company that has no revenue, no track record, and few if any customers

• Asking investors to spend $500K-$1.5M based on scenarios

• Valuation ConsiderationsMarket Forces

Industry Experience

• Valuation ModelsExit Comparables—public and private

Net Present Value (NPV)—Discounted Cash Flows

Market Forces

• Most early stage investors seek deals in a close-in geography

• What are investor colleagues paying?

• How much competition is there for local capital?

• How hot is the particular technology/market segment?

• Are there local capital sources interested in your sector?

• Do angels in your region syndicate?

Exit Comparables

• Consider public and private exits

• Draw data from national sources• Subscription services such as VentureOne and Venture

Economics

• Dow Jones VentureSource(dowjones.com/privatemarkets/venturesource.asp)

• SEC filings—www.sec.gov/cgi-bin/srch-edgar

• Find competitors’ or comparable companies’ S-1 filings and deconstruct their financial history

• Talk to advisors, legal counsel, accounting

• Local angel groups have data on exits• Angel Resource Institute (ARI) Halo Report

(http://www.angelresourceinstitute.org/data/ACEF/DataProject/1H2012HaloReportFinal.pdf)

NPV of Discounted Cash Flows

• Requires several quarters of sales performance

• Application for companies in early to growth

stages

Deal Structure

• Deal simplicity and valuation are directly related

• If you want the money quickly, seek a simple structure

• Higher valuation, complex deal structures, result in more money going to lawyers

• Most private equity investments involve purchase of stock with specific conditions and protections

• Those conditions and protections are manifest as preferences

• Investors will get their money back first, with a preferred return before anyone else

Investment Return Analysis

• Investors expect ROI based on their investment risk

• Each stage of company development requires a certain type of investor

Founders’ and Management Team’s Payout

• Consider valuation in terms of absolute dollars

instead of as a percentage of company

ownership

• $3M payout invested at 4% in tax free bonds

generates $10,000 per month

• What does your company need to accomplish in

3 to 5 years to attract a buyer to make your

financial goals a reality?

Financial Structure

• As a rule, deal complexity is related to the

current status and history of accomplishment

• Private equity investment instruments have

evolved to protect the investor and offset risk

• Terms and conditions affect the structure of the

company and board, and management

responsibilities to the investors

Corporate Stock

• Common Stock: Generally voting, usually the first stock issued. Basic rights provided by state and federal law called “Blue Sky laws” govern offerings

• Preferred Stock: Ahead of common stock in liquidation, with specific privileges regarding voting, board representation, rights to documents, dividends, repayment period, forced sale of the company or offer of public securities. Can result in a minority owner effectively controlling the company

Startup Advantages of Preferred

Stock

• Will attract more sophisticated, experienced

investors

• Provides for a dual-priced stock structure

• Common stock can have a substantially lower

price than preferred

• The lower-priced common stock can be used for

employee stock incentive plan

• Over time, the price differential between the

classes must converge

Convertible Debt

• Fully secured by assets, including IP

• Convert to securities, often at same terms of the

subsequent investment round discounted

• Above market interest rate with interest

payments often deferred

• May be used as a bridge between rounds

• Best convertible debt terms don’t avoid

valuation

Venture Debt

• Small, regional, non-bank venture leaders invest in

early stage revenue-producing firms

• Intention is a debt position

• Often include warrant provisions

• May be secured by intellectual property, other

company assets, and personal guarantee by the

entrepreneur, but are not always fully collateralized

• Not convertible to equity but can include warrant

coverage

• Rates are typically 2X bank rates or more

Term Sheets

• Start with standard documents

• Anticipate future rounds

• Develop a basic business understanding of

common terms

• Engage an experienced attorney

Common Terms

• Share Price• Total Ownership • Board Structure & Membership• Liquidation Preference• Dividend Preference• Voting Rights• Class Approval for Specific Events• Anti-dilution protection• Conversion of Stock• Preemptive Rights (issuing treasury

shares in future)• Right of First Refusal (buy pro rata

share if other S/H sell)• Co-sale Rights (right to sell shares if

other S/H sell)• Registration Rights (possibly in

subscription agreement)• Demand Rights• Piggyback rights (best efforts)• No superior rights granted

• Follow-on and S-3 Registration Rights• Expenses of Registration• Indemnification of Selling Shareholders• Assignment of Registration Rights• Market Standoff/Lock-up provisions

(180 day)• Notice (in time to convert)• Information Rights (often precludes

information to others)• Annual Audited Statements• Monthly and quarterly P&L, Balance

Sheet, and Cash Flow• Annual operating plan budget • Other information reasonably

requested• Reasonable right of inspection• Key Personnel (who comprises key

personnel, insurance on same, employment terms, etc)

Tips for Negotiation

• Maintain flexibility and mutual respect.

• Keep in mind:

How each party will make money from the deal.

There will surely be a next round of financing

The exit strategy

• Seed stage companies can expect a pre-money valuation of $500K to $3M.

• When the deal closes, you will be in a relationship with your investors for years to come. Start off on the right foot!