KEY ISSUES

CALCULATING PRE-MONEY VALUATION

Pre-money valuations are mostly grounded in opinion, not fact. The quality of the technology, business model, and management team affect the investor's estimates of risk and future valuation, from which the investor back-calculates a pre-money valuation for the current round. Estimates are often so adjustable that, regardless of data, almost any number may be justifiable. Consequently, it all comes down to negotiation and leverage merely rationalized with subjective math.

For example, an investor who wants to invest $3M will calculate how much the investment should be worth in five years in order to justify the risk. For a low-risk company, the investor may be happy with a four-fold return ($12M). If it is a high-risk proposition, the investor may feel that only a 10-fold return ($30M) would justify the risk. If the investor wants a ten-fold return ($30M), then he will calculate how much of the company he would need to own now so he has $30M worth of equity in five years. If the investor estimates that the entire company could be worth $150M in five years based on the value of comparable companies, he would have to own 20% of the company five years from now to make $30M. Because each round of financing dilutes the equity stake of all previous investors, these calculations can be somewhat complex. For example, the company's financing activity in the coming five years will dilute current shareholders 2fold, then our investor must own 40% of the company now in order to own 20% of the company 5 years from now. He will therefore value $3M as equivalent to 40% of the company, and the other 60% will have an intrinsic value of $4.5M. In this case, $4.5M would be the investor's estimate of the company's current pre-money valuation. But if another credible investor offers to invest at a $6M pre-money, the first investor might agree to match or beat the offer, if only because the other party's interest serves as external validation of the startup.

If a prospective investor feels a company is solid and that the entrepreneurs could easily raise money elsewhere, a five-fold return on $3M over five years may justify the risk he feels he would be taking. Such a strong startup might have a projected valuation of $300M in five years. The investor would only need to own 5% of the company in five years to recover $15M and would have to own 10% today (assuming 2-fold dilution due to future rounds of financing). If 10% of the company is worth $3M, then the other 90% is worth $27M, a very attractive pre-money valuation for the founders.

However, some startups are of such a low quality that when the investor calculates how much equity it would take to make the investment worthwhile, the result is very high, maybe 90% or more. The founders and employees may be left with too little equity to remain motivated. Investing at a higher valuation might leave the entrepreneurs and employees with more equity and happier, but the investor might not earn an attractive return on his investment.

Share price is calculated from the valuation and number of shares outstanding at the time of the financing. If the founders have issued one million shares to themselves prior to financing and an investor gives them $3M for 50% of the company, then the investor will be issued one million new shares (the founders do not transfer their own shares to the investor because they are not the ones receiving the money). The company now has a total worth of $6M with 2 million shares outstanding valued at $3/share.

DISCUSSING VALUATION

Investors are often straightforward in asking "What valuation do you have in mind?" Rather than set a starting point for negotiations, this question may be intended to discern whether the entrepreneur's expectations are realistic. If the response is astronomically high, the entrepreneur will appear naïve or delusional. Time is on the investor's side; after being rejected by enough investors, the entrepreneur will lower the valuation until it falls into investors' negotiating range.

Entrepreneurs should identify solid comparables that justify the valuations they ask for. Consider the environment in which those companies raised their rounds; financings done in 2000 are unreasonable comparables because most valuations were uncharacteristically high. If investors turn down a deal because of valuation, the entrepreneur should take the time to find out why the investors think their particular estimate is reasonable. The goal is to prepare for the next investor meeting.

Some investors value all seed-stage startups at under $2M, regardless of the concept, IP, etc. Investors may expect these companies to raise a small amount of capital ($1M or less) and prove that they deserve more money. If a biotech company justifiably needs $7M, a reasonable valuation might be between $5M and $12M. If you try to raise less money, the valuation might drop. If you can prove you need to raise more than $7M, the valuation might increase. It's not an exact science; at the end of the day, many early-stage biotech investors simply want to own 40%-60% of the company.

CASH AND SECOND CHANCES

Disappointing clinical results or other bad news can put a company in a position of weakness from which to negotiate additional financing. Raising money in a down round (i.e. at a lower valuation than the previous round) damages current shareholders through excessive dilution and hurts the reputation of the company by essentially announcing its failure to the world (since financing events draw the investment community's attention). Having a strong cash reserve allows a company to weather disappointments with minimal effect on current shareholders.

The shares of public companies trade daily. Therefore, the real-time effects of a public company's successes and failures on investor sentiment are constantly reflected by the share price. The share price of private companies, however, remains static between financing because shareholders are restricted from trading their shares. Therefore, if a private company falters, this mistake need not drive the share price down as long as the company can recover before it needs to raise additional fund.

TAKE THE MONEY

A company should raise as much money as possible when it can, not just when it needs it, because you never know when the opportunity to raise capital will come along. Investors, after all, can be fickle. One day they offer more money than you ask for and the next they may not offer any capital at all.

Management should select investors from the start who will be able and willing to invest in future financings. In bad times, these investors will be more likely to let the company raised money in a down round since they will also have the means to buy shares at the lower price. Most VCs that participate in one round of financing will allocate additional capital for investing in subsequent rounds. Angel investors or small funds, however, may not take such a disciplined approach.

If investors exercise undue control either through negative covenants or board representation, they may prevent a financing from going through or may limit the amount of money the company may raise in a round. They may prefer that the company raise a little money now and then raise more after achieving milestones that may justify a higher valuation, thereby minimizing dilution. The burden of executing these multiple financings, of course, falls to management and may impede progress, particularly if the financing climate turns cold.

RENEGOTIATING FINANCING AGREEMENTS

While investors may negotiate all sorts of protection into their contracts, including aggressive anti-dilution provisions and board seats, once signed these contracts are not set in stone. During negotiation of a new financing round, the prospective investors may demand that all previous contracts be renegotiated before investing in the company. For example, new investors contemplating investing in a down round may demand that old investors forfeit their anti-dilution rights. The entrepreneur must then secure the signatures of all or a majority of the old investors (according to the agreement) indicating that they forfeit their rights. If a few shareholders would rather sabotage the financing than let the new investors have their way, they certainly have the power to do so.

The best way to avoid having prospective investors dictate financing terms is to negotiate from a position of strength, when the company is not desperate for capital and several funds are competing to invest.

CONVERTIBLE DEBT

An angel investor who agrees to provide $100,000 in seed capital may not want to decide how much the investment is worth. Instead, the angel can provide the capital in the form of a loan that will convert to stock at the valuation established at the next round of financing. If a VC sets the share price of the next round at $5, the angel will receive 20,000 shares.

However, by investing at an earlier stage, the angel has assumed greater risk than the VC. The angel should be compensated more generously and may stipulate that the $100,000 loan convert at a 20% discount to the valuation established at the next round. If the share price at the next round is set at $5, then the angel's $100,000 is converted at $4/share to 25,000 shares. In this case, the angel receives 5,000 more shares than without a discount. If an angel requests an overly aggressive discount, subsequent investors may not appreciate having to split the pie unfairly and may be discouraged from investing.

Until it is converted into stock, the loan will appear as debt on the balance sheet. When negotiating convertible debt financing, verify that the loan does not need to be repaid if the company fails to close a next round. Instead, the agreement should stipulate a default valuation at which the loan will convert into preferred shares after a certain period of time. Though default conversion will favor the angel investor, it will, at least, remove the outstanding debt from the balance sheet.