The Art of a Valuation (17 E-mails Later and a Few Rules of Thumb)I recently had an e-mail correspondence with a first-time entrepreneur about valuation. They requested pre-money of north of $100m, and I fell out of my seat. Luckily, our floors are carpeted, so it didn’t hurt much. But after many e-mails (note to self, I should have just picked up the phone) it became apparent that we weren’t on the same page, and the entrepreneur didn’t understand what I meant about valuation for investing purposes. So what is valuation? It’s simply what a company is worth before and after financing. Why is it important? Well, it impacts the cap table, which impacts what everyone involved owns, impacting how much one could potentially make one day, impacting one’s returns, impacting one’s motivation. I think you get the point - its impacts a heck of a lot. So now to define some important terms and provide some color into the mechanics. Pre-Money: This is the value of the company at the current moment, ahead of the close of a funding round. The math formulas we were taught (i.e. the science) in school don’t work here, as generally there is no revenue or substantial assets to base them on. Using financial formulas would lead to a valuation of $0 or close to it, so that doesn’t work for anyone. So if we cant determine a pre-money based on science, we need art. The bad news is that art is abstract, and in this case, a balancing act of the needs of the many parties involved. Here are some of them: • Ensuring the founders / team have enough ownership now and in the future to be incentivized correctly; if not, the likelihood for success reduces dramatically. • Ensuring the investors have the ownership level they need to properly generate the returns to support their investment thesis (there will be a future blog post on this). • Setting it to the correct level, which will help facilitate a future financing round that doesn’t set the company up for a downround. • What the ownership will look like for all parties after future rounds. As a rule of thumb, you generally should expect to give up between 20% - 45% of the company in each round of early financing, regardless of the amount raised. Now, there are outliers to the rule (i.e. Twitter/Facebook/your company) but these are exceptions, not the norm. Further, there are always other terms (i.e. liquidation preference) that also have impacts on returns, ownership, etc. Post-Money: This is the value of the company after the financing. This is equal to the pre-money valuation + total amount raised or the total number of shares in the company times the purchase price per share. Dilution: So why does this matter? Well, it determines how much everyone owns. To figure out dilution to the current owners (founders and any existing shareholders), divide the amount invested by the post money valuation and multiply by 100. Example: Amount Raising $2m Pre-Money Valuation: $4m Post-Money Valuation: $4m + $2m = $6m Ownership to Investors: ($2m / $6m) * 100 = 33.3% (this is the dilution to current owners) Ownership to Founders / Existing Owners: 100% - 33.3% = 66.6% An Important Note about Convertible Debt In a future post, I will explore more about convertible debt (both the pros and cons), but I wanted to quickly explain how it impacts the cap table. If you have convertible debt that is converting as part of this round, it needs to be included in the money raised and the post-money valuation, even though it's not new money. Using the above example, lets say the company had $1m in convertible debt, here is what the thing looks like. Amount Raising $2m Convertible Debt $1m Pre-Money Valuation: $4m Post-Money Valuation: $4m + $3m = $7m Ownership to Investors: ($3m / $7m) * 100 = 42.8% (this is also the dilution to existing owners Ownership to Founders / Existing Owners: 100% - 42.8% = 57.2% The important thing to look at here is where the breakout of the 42.8% goes. New money receives 28.5% of the company and convertible holders receive 14.3% of the company. (To make things easy, I have left out interest / discounts on convertible; though this only exacerbates the situation). Now, the new money $2m receives significantly less of the company due to the convertible debt (28.5% vs. 33.3%). The takeaway lesson here is to be careful about convertible debt and don’t take so much of it in that it impacts your ability to do a future round of financing. My rule of thumb is that existing convertible debt shouldn’t exceed 25% of the new money coming in so that it doesn’t have a huge impact on new money. We're looking forward to comments / questions / criticisms about this and all posts.

The Art of a Valuation (17 E-mails Later and a Few Rules of Thumb)

March 1st, 2010 by Jay Levy View Comments

I recently had an e-mail correspondence with a first-time entrepreneur about valuation. They requested pre-money of north of $100m, and I fell out of my seat. Luckily, our floors are carpeted, so it didn’t hurt much. But after many e-mails (note to self, I should have just picked up the phone) it became apparent that we weren’t on the same page, and the entrepreneur didn’t understand what I meant about valuation for investing purposes.

So what is valuation? It’s simply what a company is worth before and after financing.

Why is it important? Well, it impacts the cap table, which impacts what everyone involved owns, impacting how much one could potentially make one day, impacting one’s returns, impacting one’s motivation. I think you get the point – its impacts a heck of a lot.

So now to define some important terms and provide some color into the mechanics.

Pre-Money: This is the value of the company at the current moment, ahead of the close of a funding round.

The math formulas we were taught (i.e. the science) in school don’t work here, as generally there is no revenue or substantial assets to base them on. Using financial formulas would lead to a valuation of $0 or close to it, so that doesn’t work for anyone.

So if we cant determine a pre-money based on science, we need art. The bad news is that art is abstract, and in this case, a balancing act of the needs of the many parties involved. Here are some of them:

Ensuring the founders / team have enough ownership now and in the future to be incentivized correctly; if not, the likelihood for success reduces dramatically.
Ensuring the investors have the ownership level they need to properly generate the returns to support their investment thesis (there will be a future blog post on this).
Setting it to the correct level, which will help facilitate a future financing round that doesn’t set the company up for a downround.
What the ownership will look like for all parties after future rounds.

As a rule of thumb, you generally should expect to give up between 20% – 45% of the company in each round of early financing, regardless of the amount raised. Now, there are outliers to the rule (i.e. Twitter/Facebook/your company) but these are exceptions, not the norm. Further, there are always other terms (i.e. liquidation preference) that also have impacts on returns, ownership, etc.

Post-Money: This is the value of the company after the financing. This is equal to the pre-money valuation + total amount raised or the total number of shares in the company times the purchase price per share.

Dilution:

So why does this matter? Well, it determines how much everyone owns. To figure out dilution to the current owners (founders and any existing shareholders), divide the amount invested by the post money valuation and multiply by 100.

Example:
Amount Raising $2m
Pre-Money Valuation: $4m
Post-Money Valuation: $4m + $2m = $6m
Ownership to Investors: ($2m / $6m) * 100 = 33.3% (this is the dilution to current owners)
Ownership to Founders / Existing Owners: 100% – 33.3% = 66.6%

An Important Note about Convertible Debt

In a future post, I will explore more about convertible debt (both the pros and cons), but I wanted to quickly explain how it impacts the cap table. If you have convertible debt that is converting as part of this round, it needs to be included in the money raised and the post-money valuation, even though it’s not new money. Using the above example, lets say the company had $1m in convertible debt, here is what the thing looks like.

Amount Raising $2m
Convertible Debt $1m
Pre-Money Valuation: $4m
Post-Money Valuation: $4m + $3m = $7m
Ownership to Investors: ($3m / $7m) * 100 = 42.8% (this is also the dilution to existing owners
Ownership to Founders / Existing Owners: 100% – 42.8% = 57.2%

The important thing to look at here is where the breakout of the 42.8% goes. New money receives 28.5% of the company and convertible holders receive 14.3% of the company. (To make things easy, I have left out interest / discounts on convertible; though this only exacerbates the situation). Now, the new money $2m receives significantly less of the company due to the convertible debt (28.5% vs. 33.3%). The takeaway lesson here is to be careful about convertible debt and don’t take so much of it in that it impacts your ability to do a future round of financing. My rule of thumb is that existing convertible debt shouldn’t exceed 25% of the new money coming in so that it doesn’t have a huge impact on new money.

We’re looking forward to comments / questions / criticisms about this and all posts.

Jay Levy

For a startup with little or no revenue there arent to many math formulas to be used to get to as a valuation. As i mention most companies should plan on giving up 20% - 45% for each round of funding. What impacts the exact number are things like the team, overall concept, competitive environment, type of investors involved, other terms, etc. Your goal as an entrepreneur raising money should be to get the money from the best investors you can at a valuation that is fair and everyone is comfortable with.

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gilitred

Jay,Nice work putting things lound and clear.How about Valuation for a startup with little of no rev? is there any known formula or it's everybudy guess?I just spoke with a friend who did few startups and his take that it's pure a bargaining and in today market and atmosphere , a typcial investment will no exceed $4MM. please help

Larry - The deal never happened, the sense i got was the entrepreneur really felt he shouldnt have to give up much (i.e. less than 5%) of the company. On convertible it ranges from 10% - 40% with on average around 25%. Also there are different ways this can be handled, one is via a discount the other is via warrant coverage. Ill go into more detail in a future post.

rimalovski

Good post. Though the math is simple once people get it, the concept is foreign to most who have not been entrepreneurs/VCs before. You did a nice job laying it out clearly and concisely. I will bookmark for future the next investment opp I encounter a first timer. Share your pain on the PMV disconnect. Had a similar experience on a university spin-out ~2 years ago, where they were seeking a $2m raise for a prototype stage telecom software startup with 4 developers (mostly part time) and no CEO. I proposed a mid-low single digit pre, and they were shocked as they had a $20m pre in mind, based upon some quantitative analysis they had followed from some finance textbooks (e.g., DCF). I tried to help them see our position, introduced them to several law firms, etc. all to no avail. I then encouraged them to go talk to other investors and secure a better valuation. In the end, they elected to bootstrap while they tried to land their first paying telco customers. >2 years later they are still not funded.

Larry M

What happened to the deal? Did you educate the entrepreneur? Did it work out?I find it interesting that the entrepreneur wasn't better educated, especially with the abundance of blog postings focused on financing. I wouldn't expect everyone to understand convertible debt/warrants/liquidation pref etc., but the simple Round A to Round B should be common knowledge if you're seeking funding.Is there typically a discount for the convertible debt? Say 15-20% discount to the new money?

Your goal as an entrepreneur raising money should be to get the money from the best investors you can at a valuation that is fair and everyone is comfortable with.

Larry -

The deal never happened, the sense i got was the entrepreneur really felt he shouldnt have to give up much (i.e. less than 5%) of the company.

On convertible it ranges from 10% - 40% with on average around 25%. Also there are different ways this can be handled, one is via a discount the other is via warrant coverage. Ill go into more detail in a future post.

Share your pain on the PMV disconnect. Had a similar experience on a university spin-out ~2 years ago, where they were seeking a $2m raise for a prototype stage telecom software startup with 4 developers (mostly part time) and no CEO. I proposed a mid-low single digit pre, and they were shocked as they had a $20m pre in mind, based upon some quantitative analysis they had followed from some finance textbooks (e.g., DCF). I tried to help them see our position, introduced them to several law firms, etc. all to no avail. I then encouraged them to go talk to other investors and secure a better valuation. In the end, they elected to bootstrap while they tried to land their first paying telco customers. >2 years later they are still not funded.

What happened to the deal? Did you educate the entrepreneur? Did it work out?

I find it interesting that the entrepreneur wasn't better educated, especially with the abundance of blog postings focused on financing.
I wouldn't expect everyone to understand convertible debt/warrants/liquidation pref etc., but the simple Round A to Round B should be common knowledge if you're seeking funding.

Is there typically a discount for the convertible debt? Say 15-20% discount to the new money?

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