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Pre Money Valuation

The valuation of your startup is key as it determines how much of the company you retain and the percentage ownership by the investor. At the outset it is important to remember that it will be much better to own a smaller percentage of a large success than a large percent of a startup that doesn't get off the ground.

This article addresses a few methods of early stage company valuations, but before proceeding further, here are the definitions of a few key terms:

Valuation - a general term describing how much your business is worth to an investor.

Pre-money valuation - the valuation of your startup prior to the VC actually investing capital in the business. This amount is negotiated between the VC and startup (usually with the assistance of counsel) and may be based on several factors.

Post-money valuation - this is the total amount of the pre-money valuation plus the actual investment made in the startup by the VC.

VC ownership percentage (or "cost of capital") - this percentage is the amount of the actual investment divided by the post-money valuation. The startup retains the balance. Over subsequent rounds of funding, which also include new valuation assessments, the startup's percentages are likely to "dilute".

Cap table (short for "capitalization table") - a summary spreadsheet reflecting the ownership by the various parties in this negotiation. Cap tables typically reflect pre- and post-money ownership for initial financing and forecasted subsequent rounds anticipated to achieve liquidity.

"Hair on the deal" - VC lingo describing undesirable factors surrounding early stage investors in the startup, typically by friends, family or angels. Often pre first-round "angel" or "family and friends" funding will attach a valuation on the startup that makes subsequent fundings undesirable to a VC. An alternative to avoid this problem is to seek "bridge" funding that takes the form of debt convertible to the first round, or "Series A" valuation terms, and may also include additional "warrants" in consideration for this early stage funding.

Term sheet - this is the document issued by the VC firm for startups they wish to fund. The term sheet includes much information, including proposed valuation and actual funding amounts. The help of experienced counsel will be good for understanding and negotiating the terms of the offer from the VC.

Variations in Value

Determining and discussing valuation is a delicate matter. Should your initial meeting with a VC go well, they may ask you this question toward the close of your meeting time. If a VC inquires about your "valuation," they are seeking to know if you are an informed entrepreneur about the relative value of your startup.

The term relative is key. Think of early stage startup valuations as similar to the relative "comps" on real estate. VC's are interested in determining a valuation that is comparable to other company fundings in your marketplace. Their underlying goal is to negotiate the most favorable ownership percentage for the investment capital they intend to place in the venture. Try not to be coy, but avoid answering with a specific number if possible. The VC is most likely interested in your thought process used to arrive at a valuation over a specific number. In many cases you might suggest a range, for instance, a $6-7m pre-money valuation on a $3m investment for a post-money of $9-10m. In any case, flexibility is the key message you want to convey -- along with the fact that your primary interest is launching the startup about which you are passionate, and while changing the world through this startup you also intend to make a great deal of money for yourself and for the investor. The ideal scenario is that both parties exit the negotiation believing that the deal is fair, although they would have both liked to have received more value on their side of the deal.

How to Determine Your Startup's Valuation

There are several ways to determine valuation for your startup. Know that with most of these methods may be difficult to base on objective facts. At the end of the day you may need to rely on the fairness of your investor to propose a valuation that is consistent with other known "comps" and also consistent with other relative valuations in his/her existing portfolio.

A no-cost method to research and potentially establish valuation is by searching for similar companies that have recently received funding via online information sites. While the amount of funding may be readily available, the pre-money valuation may not be. Another method is to use a professional valuation firm.

Another, possibly more justifiable method is to use a professional valuation firm like Venture One. This firm offers a "Comparable Valuations Report" for a fee of $1,295.00 that specifically addresses your company's market space and locates comparable business fundings and valuations that you may use in your negotiations with a VC firm. Having said that, it is not advisable to enter a term sheet negotiation by waving a Venture One report in front of a VC and stating that this is the valuation you expect. Rather you should use this tool as backup to substantiate your position as the negotiations unfold.

On a final note, traditional methods of deriving a startup company's valuation through discounted cash flow (DCF) models, or assigning value to individual key contributors or forecasted sales and multiplying by a factor are not highly weighted, or may even be dismissed by the VC. However, check with your legal counsel about the value of assessing the impact on valuation for the intellectual property owned and developed by the startup.

By Technology Toolbox, Inc.



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