Article about a company from startup to IPO

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ENTP325-Spring2018-Week4.pptx

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ENTP 325 Early Stage Venture Financing Week #4

This week

Tuesday

Determining early stage valuations

Thursday

Negotiating with investors: Shark Tank case studies

Sunday

Quiz #2 (focus on crowdfunding, valuation and cap tables)

Cap tables introduction

Team exercise using the Startup Valuation Calculator

Equity crowdfunding update (May 2016 to May 2017)

Crowdfund Insider reports that in January 2018, equity crowdfunding offerings topped $100 million in capital raised.

The $100 million was raised via 731 campaigns.

Approximately 101,000 individuals invested in a campaign with an average $992 per investment.

Companies raised an average of $360,691 per campaign.

Nearly 50 percent of firms were located in California, Florida, or Texas

A total of 326 companies

Approximately 33 percent were mobile app/internet services companies;

Approximately 12 percent were consumer gadget companies;

Approximately 60 percent were in business one year or less

Determining early stage valuations

or….what is my startup worth?

What is Valuation?

Valuation reflects the entrepreneur’s determination of the acceptable amount of ownership that may be given in return for the investment, and the investor’s determination of the risks and rewards of the investment.

Investment deals often focus on the “pre-money” valuation of the company.

Pre-money valuation is the estimated value of the company as it stands prior to any purchase of equity.

The pre-money valuation of the company, combined with the amount of capital accepted by the company, determines the amount of equity ownership sold in exchange for capital.

The resulting valuation after the investment of capital is called the “post-money” valuation.

For example, in a company with a pre-money value of $5 million, a $5 million investment would buy a 50% ownership stake in the company.

Pre-money valuation

Investment money

Post-money valuation

What you’re worth before investment

What you’re worth after investment

Investment money

Post-money valuation

% equity given up

Valuation methodologies

Valuation methodologies differ by the stage of investment and the availability of quantitative and qualitative data.

Formal methods include:

409A – A formal report that is produced by a certified professional that uses multiple mathematical methods to value a company’s various classes of stock.

Discounted Cash Flow (DCF) – Uses future cash flow projections and discounts them to a present value by using an assumed cost of capital.

Multiple of Revenue or EBITDA – Valuations are sometimes set or influenced based on a multiple of the target company’s annual revenue or EBITDA earnings.

Seed Valuation Ranges

Y Combinator (accelerator) buys about 6% of a company for $15K-$20K. So the post-money valuation of their investments is $250K-$333K.

If you sell 20% of your company at a $2.5M post-money, you raise $500K. That’s about the maximum for a seed round.

But don’t fixate on valuation. Low valuations aren’t bad if you keep the dilution down too. 6% dilution is very low if the company makes a lot of progress with $15K-$20K.

Consider two scenarios – Dropbox vs. Instagram

Drew Houston went to Y-Combinator, where he received about $20K in exchange for 5% of Dropbox.

Valuation $400K

Kevin Systrom went to Baseline Ventures and received $500k in exchange for about 20% of Brbn (predecessor of Instagram).

Valuation $2.5M

Data

https://angel.co/valuations

Challenges with early stage valuations

The high degree of uncertainty inherent in seed and early-stage investments translates into low pre-money valuations.

Failure rates of startup companies are high, so investors must be compensated for placing their capital at such risk.

Valuations at the “seed stage” are generally driven by factors that by their nature are subjective.

Subjective valuation methods

Traction

Expressions of interest

Beta tests

Conditional orders

Product

Intellectual property

Design spec

Working prototype

Beta test

App store

Industry “hotness”

External validation

Press articles

Beta customers

Incubator/accelerator

Team

Founder credentials

Advisors

Investors with credentials

Team commitment

Comparable companies

Value drivers are used to value startups which often have little or no earning

For an internet startup, value-drivers could be market share, page views and number of subscribers.

Example: take the ratio of market value and value driver of the market leader (example: market value of each percentage point of market share) and multiply that by the target firm’s value driver.

Problem with this approach is many of these firms never show any earning despite showing huge market valuation.

Plus there is substantial risk involved

Risk areas: Value is the inverse of risk. The more layers of risk your company has, the lower valuation you get.

Opportunity Size (Total Addressable Market, direction of market)

Team (composition, execution experience, subject matter expertise, professional network)

Development (sweat equity, skin-in-game, milestones completed)

Competitive Advantage (approach vs. pricing vs. technology vs. network-effect)

Traction (eyeballs, customers, revenue, earnings)

Distribution (repeatable processes, recurring earnings)

New founders may think that startup valuations work like this (the Shark Tank method):

I figure out what the value of my existing company is

I figure out how much money I need

I give the % away equal to: money needed/(valuation + money needed)

In reality, valuation is a process of reducing layers of risk.

So, it looks more like this for angel/seed round:

Founder convinces investors that they are investor-ready

Founder convinces investors they need $X

Investors ask for 15% to 25% post-money

Post-money valuation ends up being calculated

(e.g. $1.5M investment/20% stake = $7.5M post-money)

Notice that here we don’t have to worry about determining pre-money valuation

Investment received

% equity given

Post-money valuation

What you’re worth after investment

Setting value based on how much money you need

Figure out how much money you need to grow to a point where you will show significant growth and raise the next round of investment.

Let’s say that number is $100,000, to last you 18 months.

Your investor does not have a lot of incentive to negotiate you down from this number.

Why? Because you showed that this is the minimum amount you need to grow to the next stage.

Now figure out how much of the company to give to the investor

It could not be anything more than 50% because that will leave you, the founder, with little incentive to work hard.

Also, it could not be 40% because that will leave very little equity for investors in your next round.

30% would be reasonable if you are getting a large chunk of seed money.

In this case you are looking for only $100,000, a relatively small amount.

So you will probably give away 5-20% of the company, depending on your valuation.

Setting value based on how much money you need

As you see, $100,000 is set in stone. 5%-20% equity is also set.

That puts the (pre-money) valuation somewhere between $500,000 (if you give away 20% of the company for $100,000) and $2 Million (if you give away 5% of the company for $100,000).

Where in that range will it be?

That will depend on how other investors value similar companies.

How well you can convince the investor that you really will grow fast.

Other subjective factors

Other approaches

Venture Capital method

Dave Berkus method

Scorecard method

Risk factor summarization method

Venture Capital Method

This tool requires the estimation of the eventual selling price of the company, which is then divided by the investors’ anticipated ROI to arrive at a current valuation.

Return on Investment (ROI) = Terminal (Harvest) Value ÷ Post-money Valuation

In the case of one investment round, no subsequent investment and therefore no dilution) then:

Post-money Valuation = Terminal Value ÷ Anticipated ROI

Dave Berkus Method

Attributes a range of dollar values to the progress startup entrepreneurs have made in their commercialization activities, the sum of which becomes the valuation of the company (pre-money valuation)

If Exists: Add to Company Value up to:

1. Sound Idea (basic value, product risk) $1/2 million

2. Prototype (reducing technology risk) $1/2 million

3. Quality Management Team (reducing execution risk) $1/2 million

4. Strategic relationships (reducing market risk and competitive risk) $1/2 million

5. Product Rollout or Sales (reducing financial or production risk) $1/2 million

Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million)

Scorecard valuation method

This method adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company.

Multiplying the Sum of Factors (1.075) times the average pre-money valuation of $1.5 million we arrive at a pre-money valuation for the target company of about $1.6 million

Risk Factor Summation Method

This method compares 12 characteristics of the target company to what might be expected in a fundable seed/startup company

Risk areas:

Management

Stage of the business

Legislation/Political risk

Manufacturing risk

Sales and marketing risk

Funding/capital raising risk

Competition risk

Technology risk

Litigation risk

International risk

Reputation risk

Potential lucrative exit

Each risk is assessed, as follows:

+2 Very positive for growing the company

+1 Positive

0 Neutral

-1 Negative for growing the company

-2 Very negative

The average pre-money valuation of pre-revenue companies is then adjusted

Positively by $250K for every +1 (+$500K for a +2)

Negatively by $250K for every -1 (-$500K for a -2).

Example: assume the average pre-money valuation of pre-revenue companies is $2.0M

If your judgment of the twelve factors above has five neutral assessments (five zeros), five +1’s, one -1 and one -2 (a net of two +1’s), then add $500K to the average valuation of $2.0 million, arriving at a $2.5 million pre-money valuation.

Control and fairness test

Terms often matter more than the valuation

For a higher valuation, you may be giving up some control, like a board seat.

Why do people push super high valuations?

It’s one of the few moments in your company’s history where you can get a stamp of validation.

Just like good grades or good schools help drive your self-worth, a great valuation can do that too.

It’s something you can tell others or use to compare.

So, the bigger the stamp, the more likely you’re seemingly doing well.

Don’t be tempted by this.

Downrounds

Don’t risk a down round

A down round happens when the valuation of your next round is less than your current round.

No one comes away from that undamaged.

That can happen when people are too aggressive about their valuation in that first round.

Keep your next round of funding in mind