The funding process through a venture capital investment is rather complicated. Once the idea presented in the pitch is chosen by investors, another very complicated step follows, as venture capitalists decide to valuate the company in order to appraise the value of the equity ownership held by them. This part of the deciding process must be fulfilled as investment plans are very risky due to the early stage of development of the company that needs funding to the innovative character of the products they want to impose on the market and to the fact that the market’s demands cannot be correctly evaluated in such short time. But, this valuation needs to be done in order to establish the percentage of shares investors will receive in return for the invested money. This is the only way in which they can calculate their final returns. Let’s not forget that this valuation is important for the demanding company as well as this is the moment in which their amount of shares is determined.
Stage 1 - Embryonic - No Product and little expense history
• No product revenue to date
• Limited expense history
• Have an idea and possibly some initial product development
• Incomplete management team
• Seed capital or first-round financing provided by friends and family, angels, or venture capital firms
• Securities issued sometimes common stock but more commonly preferred stock (Preferred virtually always convertible to common)
Stage 2 - Early development - Moderate development effort with partial proof of concept
• No product revenue (still)
• Substantive expense history, product development is under way, and business challenges are thought to be understood
• Second or third round of financing occurs during this stage
• Typical investors are venture capital firms, which may provide additional management or board of directors’ expertise
• Securities issued to those investors are preferred stock
Stage 3 - Later stage development - Product in beta testing
• Significant progress in product development
• Key development milestones met (e.g., hiring of a management team)
• Development is near completion (e.g., alpha and beta testing)
• No product revenue (still)
• Later rounds of financing occur
• Typical investors are venture capital firms and strategic business partners
• Securities issued to those investors are typically preferred stock
Stage 4 - Commercially Feasible - First revenues, operating losses
• Key development milestones met (e.g., first customer orders or first revenue shipments)
• Some product revenue, but still operating at a loss
• Usual for mezzanine rounds of financing
• Discussions start with investment banks for an initial public offering
Stage 5 - Financially Feasible - Break through to profitability
• Product revenue is achieved
• Breakthrough measures of financial success such as operating profitability or breakeven or positive cash flows
• Liquidity event of some sort, such as an IPO or a sale of the enterprise, could occur
• Securities issued typically all common stock, with any outstanding preferred converting to common upon an IPO (and or other liquidity events)
Stage 6 - Established - Meaningful history of revenues or profits
• Established financial history of profitable operations or generation of positive cash flows
• IPO or sale during this stage
In any private equity transaction, the biggest issue is going to be business valuation. In seed round financing, the issue of valuation often becomes even bigger, because normal metrics of valuation, such as earnings and revenue are non-existent. Entrepreneurs often value their company at what they believe it will become. Investors value the company at its current worth.
If, for instance, an entrepreneur made an offering of $1 million in securities representing 25% of the company post-transaction, the offering would value their company, before any significant development, at $3 million (pre-money). Could your idea and your commitment to seeing the idea through really be valued at $3 million?
Within the realm of startups, there are different levels of development prior to revenue: concept, proof of concept/product in development, prototype, product developed. An idea, no matter how great, is at the earliest level of development, concept. Most likely, it would be your commitment to seeing an idea through rather than the idea itself that would peak investor interest. If that commitment were sufficient to spark investor appeal at the concept stage, investors would likely seek an exponential return on investment.
Business valuation in venture capital transactions determines a present value of a future business. The method is called discounted cash flow (DCF) and discounts future earnings and residual business value upon the company's exit to a present value, based on a percentage that accounts for the interest rate the investors could get in a risk free situation plus a risk premium for the endeavor. The risk premium for a startup is high, because of the uncertainty involved and the high percentage of businesses that fail.
Venture capital firms and angel investors who tend to operate like VC firms might want 70+% ROI to account for the risk of investing in a pre-revenue, concept-only idea. The risk comes from the fact that the concept has not been proven to be feasible or useful, its development costs are uncertain, and the ability of the founders to develop it is unproven. There is also a threat that a more mature company could take the idea and develop it faster than the startup. The 70% ROI means that a five year plan should include a 14 fold return, requiring a $4 million (post-money) company to become a $56 million company in 5 years. If you approach the investors without any employees or management, or without substantial development, the premium could be even higher. Certain industries will also require a higher risk premium.
Even at the low end estimate (of 40% ROI), your $3 million idea will have to result in a company whose cash flow and residual value at the end of the five years is $21 million.
Not all angel investors will engage in a discounted cash flow analysis to value your business and/or may not require such a high rate of return. Some angels are looking to mutliply their investment by a certain number in a certain number of years. This is essentially a DCF with no defined ROI. There are even some real "angels" out there that will simply like an idea and then decide what they want to put into the company. The corresponding equity stake has little to do with any analysis of future earnings. However, most angels are going to take some look at the risk factors, acquisition prices for similar businesses, and profitability and revenue figures for those businesses, before they sink a large amount of personal capital into your venture.
Negotiating business values is often a disappointing endeavor for entrepreneurs doing their first venture capital transaction. There is some legitimate undervaluation that investors may propose to get a good deal. They are also expecting an inflated valuation, so the plan should reflect that. However, even the "fair" values use a risk premium that challenges the entrepreneur's ability to succeed. Be prepared to support your revenue projections and argue for a lower risk premium to increase valuation, but be prepared to accept a valuation that reflects the risk involved with startup capital if you decide to go the VC route.
You need to know these two terms.
Pre-money valuation: venture capital terminology for the valuation given to a company by a venture capital firm before it puts money into it. For example, a start-up is valued on a pre-money basis at $4 million. After $1 million is invested the company has a post-money valuation of $5 million with the venture capital firm owning 20%.
Post-money valuation: valuation placed on a firm immediately after receiving a round of funding. No negotiating item between entrepreneur and investor creates a wider gulf than this one. The two parties may agree on every other point but will have diametrically opposing views on what the startup is worth and how much equity the investor should receive in exchange for his capital.
To put it bluntly, placing a credible valuation on a startup is impossible. Privately held companies on the sales block are typically valued at a multiple of their historical ODCF (Owner's Discretionary Cash Flow). ODCF is the cash that can go into the owner's pocket after all operating costs are covered for the year. Obviously, since a startup lacks historical ODCF which is the basis for an objective valuation, any opinions expressed on valuation will be entirely subjective.
As a rule of thumb, this is what invariably happens when a startup is seeking seed capital. The entrepreneurs convince themselves based on discounting future cash flows that the company is worth today, say, $5 million. So, since they are looking to raise only $500,000 the investor providing that sum should be happy with 10% of the equity. Then when they start talking with a serious investor they discover that he expects 50 or 51% of the equity for his money. That's the magic number for most angel investors these days.
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David Hahn, CVA, ASA, MAFF, CCIM, CM&AA, MBA
CVA - Certified Business Valuation Analyst
ASA - Accredited Senior Appraiser
CM&AA - Certified Merger & Acquisition Advisor
CCIM - Certified Commercial Investment Member
MAFF - Master Analyst in Financial Forensics
CA State Certified RE Appraiser, License #AG009828
CA State Licensed RE Broker, License #00902122
Business Valuation, Commercial Real Estate Appraisal.
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