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Valuation

Valuation

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Published by: Najam on Jun 19, 2012
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06/19/2012

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Where capital and opportunity meet
Company Valuation
 A recent survey of managing partners of venture capital rms asked, “What is the most commonmistake entrepreneurs make as they try to raise money?” Part of the most common responsewas, “Not understanding how to properly determine the value of their company.”Determining the value of a start up company is extremely difcult, but there are some basicprinciples all fund-raising entrepreneurs should understand and some tools they should knowhow to use. Why is this important? If you were to survey professional investors, whether in thestock market, real estate, precious metals, or private companies, the secret to success, youmight nd the most common answer is “Buy low; sell high.” As the CEO of your company, itis your responsibility to make your company more valuable, to allow your investors (includingyourself) to prot from selling shares in the company. If you do not intend to raise money frominvestors, then you may not need to be concerned.
Key points to remember:
Value is subjective and differs by perspective. Even seemingly objective numbers aresubject to interpretation or negotiation. If you’ve had to deal with an insurance companyafter an auto accident or other loss of property, you probably learned the difference between“replacement” value, “book” value, “fair market” value, “depreciated” value, “assessed” value,etc. The check you received may not be what you expected. The value of your company maydepend on the value it represents to a potential investor or buyer.Ten percent of $50 million is worth more than 100 percent of nothing, or even $4 million.Bill Gates owns less than 10% of Microsoft and is one of few inventors who succeeded asentrepreneur who also succeeded as CEO of a large company.The goal of every company is to increase shareholder value. Every company starts off withthe same valuation: $0. The most valuable company, according to Fortune magazine in 2007,was Exxon Mobil at $425B. Your company will fall some place in between.Every percent of ownership given to new investors comes from existing shareholders.
Pre-Money Valuation Defned
Like insurance companies, entrepreneurs and investors have different denitions of “value.Forprivate companies seeking investment from outsiders, two of the most commonly used, andcommonly misunderstood, terms are “pre-money value” and “post-money value.While theyare denitely related, they are not the same. In fact pre-money value PLUS investment EQUALSpost-money value.
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Where capital and opportunity meet
If you own a piece of land worth $100,000 then spend $200,000 building a house on that land,in a simple world, the entire property is worth $300,000. What you started with, the land, is nowone-third the value of the whole asset. The new investment, the house, is worth two-thirds. Thisis similar to how a private equity investment may work. If your company is worth $100,000 thenyou raise $200,000 from investors, the company would be worth $300,000 after the investment ismade. You would own one-third of the company after the investors buy the other two-thirds withtheir $200,000. This $200,000 is the “money” in the terms “pre-money value” and “post-moneyvalue.”
Pre-money value: $100,000+ Investment (i.e. “money in”): $200,000= Post-money value: $300,000
Many home owners want to argue that, sure the tax assessor may appraise the total propertyat $300,000, but I could sell it for more than that! Given the real estate market in recent years,that’s probably true. But here’s the question – what if someone else spent the money to buildthe house on your land and you sold the property together; how would you split the proceeds?The simplest answer is to look at the value each contributed, assume the entire propertyappreciated or depreciated together, and share accordingly.Likewise, many entrepreneurs want to argue that their company is worth more than the $300,000in this example. Assuming they spend the $200,000 from the investors wisely, the companyshould be worth more than $300,000 … in due time. But, the point is to look at the company atthe time of the investment, which makes the math very simple: $100,000 + $200,000 = $300,000. Another mistake entrepreneurs often make is to use the pre-money valuation to determinethe ownership percentages. Allow me to use different hypothetical numbers than above forthis explanation. With these new numbers, the entrepreneur retains majority ownership. If acompany’s pre-money valuation is $1,000,000 and an investor puts in $500,000 cash, then howmuch does the investor own? Many people would say “half” because $500,000 is one-half of$1,000,000. The investor put in half as much value as the entrepreneur. This is wrong. Theinvestor will only own one-third of the company because the formula is Pre-money + Investment= Post-money. The post-money (i.e. the value after the money comes in) is $1,500,000 and$500,000 is only one-third of that. The investor would own 33%, not 50%. Another way tolook at it is Yours + Mine = Ours. We need to know much “you” and “I” own of “our” collectivecompany.
Negotiations with investors
There are dozens of terms you could haggle over when dealing with investors. Liquidationpreference, conversion rights, anti-dilution protections, etc. In many cases, no single item is
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Where capital and opportunity meet
more important or more hotly contested than the value of the company. It is akin to salarynegotiations – the investor wants the CEO to have enough incentive to work hard, but does notwant to overpay. For investors, companies’ valuations also are like prices of goods. When youbuy fruit at the store, you need to know how much you get for your money. Assuming you knowyou want to buy fruit and are hungry, price per pound is perhaps the only way you can literallycompare apples to oranges. The value of the company determines how much of the companythe investor buys with their investment. Prove this for yourself by changing the pre-moneyvaluation in the formula listed above, while keeping the investment amount constant.The irony about a start up company’s valuation is that it really matters most when a companyturns out to perform only modestly. Of course, no one at the negotiation table expects that to bethe outcome. Instead, they likely expect the company to be either a huge success, or go downin a blaze of glory. If the company does hit it big, then everyone should get very rich (or richer)in most cases. While the difference between 55% and 65% of $100M may have a large realvalue, the effect on one’s pocketbook or portfolio probably won’t be felt in the wake of gettinga windfall of $50M-plus. If the company is a failure, then you end up dividing a near-worthlessasset. But, if the company does “ok,” a few percentage points can mean the difference betweena net prot or loss on an investment, or between getting a decent payback on years of workingwithout a salary or having to explain to your family what you were doing all that time.In the end, the other issues in term sheets glossed over above are designed to protect aninvestor’s downside. Investors want to minimize their loss if things go wrong (which they usuallydo in this sort of high-risk investment) almost as much as they want to maximize their gain ontheir few winners. The division of a company (which is directly related to the valuation prior toinvestment) is what determines how much of an upside the investor can realize when things gowell, or very well.The survey of venture capitalist mentioned earlier found that there remains a major dividebetween entrepreneurs’ valuation of their companies and outside investors’ valuation. Whatdoes this disagreement mean? Should entrepreneurs value their companies lower? Should theystick to their guns until investors agree with them?Risks of OvervaluationFirst, you may not receive any investments if you ask for too high of a price. If you holdsteady with your price for too long, you may run out of operating cash and become sodesperate for investment that you have to eventually accept a valuation lower than you couldhave received at the start.Second, an unrealistic valuation is a sign of an inexperienced entrepreneur. Most investorsput more weight in the management team than any other aspect of a new business. If youstart off showing immaturity, then you stand a good chance of turning off potential investors,no matter how exciting your company itself is.Third, even if you do succeed in securing investment dollars (i.e. convincing someoneto invest in your company) you run a greater risk of dilution in later rounds. Subsequent
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