What is the right Valuation for my startup?? How much money should I raise??
One of the most common questions I get from founders is, “How much of my company should I give away?” and my automatic answer is “None!!”. Equity in your company is a precious and finite resource, you never give it away. I recommend that you always consider that you are selling your equity, or even better, that you are spending it to buy something valuable that you absolutely need.
The question of valuation remains contentious because so many different people have different views based on their own experience and, usually, they are most influenced by bad experiences. The one truth is that value is in the eyes of the beholder so, your company is worth what the investors are willing to pay.
If you have already identified the investors you most want and they don’t like the valuation, you should consider carefully if you really want the investors who do like the valuation. At seed and start-up rounds the investors you choose to invite in as shareholders can be critical to the success of your business. Make sure you trust them to be the shareholders you want to have.
If we accept that we are discussing seed or start-up rounds for what are expected to be high-value-growth ventures, then there are some simple parameters to consider. These are based on the conventional approach of experienced start-up investors in Western countries. What that means is that first we must acknowledge the assumptions most of those investors will be using:
- The round should purchase between 10% & 35% of the company
- The company should be able to maintain, at a minimum, a doubling of its valuation every twelve months for at least the next five years (some argue this rate is higher in Silicon Valley)
- Nobody wants to experience a down round
- Investors are seeking a target return of 10 times their investment in 4-6 years
As illustrated below, getting the valuation right is about building a strategy for future success. For the first round of external investment, typically Angel investors, valuation is not driven by the funds invested so far, the sacrifice of salary by founders who left well-paid jobs, the time, blood, sweat and tears that has gone into getting the company to this point. All those things are very relevant but, not arithmetically meaningful.
Valuation is about putting the company on the path to an attractive exit in which the founders do extraordinarily well, the Angel investors do very well and later round investors all get their expected returns.
Valuation is not about control, which happens in the terms of the shares purchased rather than in the volume, since experienced early-stage investors rarely want a simple majority ownership.
The seesaw for the founders is often about how much money to raise versus the pre-money valuation to use. The right amount of money to raise is usually the amount required to achieve the next inflection point in perceived value of the company. That might be a product launch, a single customer contract, a trigger volume of customers, a benchmark level of revenue, a revenue run rate, or a regulatory approval. Any and all of these, as well as others, can be the basis for the world saying, “Wow!!! That company is really going places, fast!!”.
“We need to achieve milestone X. To get there, we need Y people, and we need Z capital. We believe it will take us W months to get there.” Alex Iskold, TechStars
So the money raised should be what is required to hire the people, engage the contractors, buy the equipment and services, fund the marketing, pay the overheads and a modest safety margin given that things usually cost more and take longer than expected. How much runway does that mean the money should buy?
As with all these considerations, it all depends. It depends on the business model, the type of customer, the market sector, the market geography, the regulatory environment and all the other things you will have considered when working through the business model canvas to develop your business plan.
Don’t have a business plan?
How do you expect to be able to validate, substantiate and communicate your vision for success?
The real value of a business plan is in the planning!!
Rule of thumb, a seed or start-up round should be enough for at least one year and not be expected to cover more than two years. You don’t have to raise more money. If your business model doesn’t require more capital to at least double the value of the business in the next twelve months (or less) then your existing investors will probably prefer that you don’t raise more capital. You and they will be taking dilution that isn’t required.
If you do expect to raise more money, since raising money always takes time, you should be planning to start raising the next round 3-6 months before your current runway expires. There is little worse than being in the market for investment when you are desperate for funds.
Let’s consider a company developing a software-based solution that will run in the cloud, be sold on a subscription basis and requires content, as well as platform development. The core innovation here is in product/service design rather than original technology or even business model innovation.
The founders have managed to create a working prototype which has been demonstrated to early-adopters in the target customer base with very positive response. There are no recurring revenue streams activated yet but, first customers are ready and willing to come on board with an agreed pricing model that recognises the content and features will be incomplete. The company needs enough money to hire and contract some development expertise (platform and content), to hire some marketing and sales resources, to fund travel and to address some administrative basics including insurance, payment systems and an employee equity participation programme.
Initially the founders have decided they need to raise $2m on a $10m pre-money valuation which means they will sell 16.66% of the company.
When they approach their local Angel group the founders are advised to drop the raise to $500k on a pre-money of $2m, thus selling 20% of the company. This is in line with the norm where each new round of start-up funding buys approximately 20% of the company.
The Angels are eager to help the founders avoid excessive dilution while increasing the chances of success by reaching key valuation inflection points more effectively. These Angels are more than willing and able to provide ongoing financial support and will welcome the higher valuations of subsequent rounds that result from successful execution by the founders. So, the founders take the advice, raise $500k for a 12 month runway to realise recurring revenues that reach $50k/mth at the end of 12 months, an equivalent run-rate of $600k/yr. While this is a relatively low revenue figure it is accompanied by stabilisation of the technology platform, first generation content and a sustainable content development model, validation of the pricing and refinement of the value proposition that drives customer acquisition. That’s a very busy 12 months!
9 months into the first year the company is doing well and on track to meet all its targets. The founders come back to the investors for their support in raising a $1m round on a $4m pre-money valuation. So, a 2 times uplift in value to sell a further 20% of the equity. In month 10 all the original Angel investors double-down and commit to $500k of this next round. They also offer to syndicate this opportunity with their friends in other Angel groups to invest on the same terms. The founders agree and they arrange to present their opportunity to three other Angel groups in month 11.
The company is projecting the $1m round will fund a further 12 month runway at the end of which the company will have achieved a $5m/yr revenue run-rate, be past breakeven in its cash flow, have opened at least one international market and completed hiring the core executive, development and sales teams. Another very busy 12 months and at the end of that time the company will be well positioned to continue to grow rapidly without further investment, thus avoiding further dilution for the founders and all of the shareholders. All concerned agree that on-target performance could reasonably support a valuation uplift at the end of month 24 to $12-15m.
The incumbent Angels share their due diligence with their friends in the other Angel groups together with the agreed terms sheet that describes the terms of investment. From those other Angel groups the founders receive $700k of interest so, their Board has to decide whether or not to take the over-subscription of funding. They go back to their incumbent Angel shareholders for advice.
In negotiation with the incumbent and new Angel investors the founders agree to take the full $1.2m on offer at a pre-money valuation of $5m, thus, selling only 16.66%. The investors agree on the condition that if the company fails to meet its 12 month targets for revenue run-rate, breakeven, staffing and content development there will be an automatic adjustment that effectively changes the pre-money valuation of this round to $4.8m, raising the equity purchased to 20%.
I’m not a huge fan of these sorts of arrangements for a variety of reasons but, provided they are well specified with objective triggers for milestones, they can provide a very good option for all parties. Assuming things go according to plan the founders continue with 63% ownership of the company and, if things go significantly off-track the founders continue with 60% ownership. The good version doesn’t require anyone to take any further dilution and the company is executing on its planned growth to realise $50m in profitable revenues in year 4. The disappointing version is a minor shift in dilution for the founders to reward the investors for their support and still has the company substantially on track. However, failing to meet revenue and/or breakeven may mean the company needs another round of funding and it is very likely that the founders have lost the confidence of many of the current shareholders.
In month 20, the founders decide to raise a third round of funding and are seeking $2m on a pre-money of $12m, selling 14.3% of the equity. The existing Angels encourage the founders to find new sources of capital before they will commit to participating in the round. The founders find a high-net-worth individual who isn’t much of a start-up investor but, likes the business and believes that the current set-back is only temporary. However, she believes that she has to play hardball, as she would in her other investment activities so, she tells the founders she will invest all of the $2m on a pre-money valuation of $4m, buying 50% of the company! This is a down-round, an investment valuation lower than the previous round!!
As part of their terms of investment the Angels had secured a requirement to approve any new issue or sale of equity or debt to fund the company. When they hear the proposal they refuse approval for a deal that would significantly disadvantage the founders and all other shareholders. They seek the opportunity to discuss the situation with the new prospective investor and they help her understand the different nature of start-up investing. Together with the founders, there is an open round table to discuss the future of the business and the new investor agrees to provide $1.7m while the Angels, among themselves, source the other $300k and this round will be on a pre-money valuation of $8m buying 20% of the company.
Now the founders are down to 40% ownership but, no-one has suffered a down-round and there is plenty of upside for everyone if the company can get back on track to meet or exceed its four year performance targets.
Note that this model only works for start-up rounds since clearly, five rounds at 20% and the founders have zero equity in their own company. That is never a good outcome!
So while you might expect seed and start-up rounds to follow the 20% rule that should end at Series A. Once you enter the larger rounds of later stage venture capital the valuations will soar and the dilution model will change. This is one reason why the larger venture rounds, say $10m or more, support valuations in the order of $100m. No-one is really saying that the fundamentals of the company arithmetically support the $100m valuation. What they are saying is that in order to make room for the new investment and to avoid it buying too much of the company, the valuation is modelled accordingly. However, this is only possible if the valuations on prior rounds have been restrained to build to this point, otherwise, excessive valuations of earlier rounds will either prevent these later round investments, or drive the pain of a down round for all shareholders.
A down round may be only a temporary reset but, it is likely to substantially increase the time to exit even if the company can continue on its doubling of valuation every 12 months. To be clear, the issue of a down round can dog a company for some time and it has one, very likely outcome that is driven by human nature. Once the down round is part of the history of the company new staff, customers, suppliers, channel partners and investors will all want to know what went wrong and why they should be confident it won’t happen again and damage them. No matter the actual reason for the down round there is really only one answer that satisfies – we’ve changed the people! So, the most likely result of a down round is that the executive team (typically the founders at that point) are replaced.
So to answer the questions in the title, the right valuation is the one that sells about 20% of your equity to enable a doubling of valuation every twelve months and is least likely to promote a down round. The money you raise should be sufficient to fund operations for between 12 and 24 months while achieving a doubling of valuation every 12 months as driven by milestone achievements that support objective inflection points in value.
On the one hand the arithmetic is quite straightforward, on the other hand the conversation about value inflection points can be quite challenging. I have written more about that and the other investment terms that can impact milestones.
About the author:
Jordan Green is an internationally sought after thought leader in early-stage investing, adviser to governments developing Angel ecosystems, serial founder and entrepreneur, successful VC and, speaker and commentator on the innovation economy. He is Founder & President of Melbourne Angels, co-founder, Fellow and Chairman Emeritus of the Australian Association of Angel Investors, Trustee of the Angel Resource Institute, Chairman of the Asian Business Angel Forum, Chairman of the Victorian Committee for the Pearcey Foundation and adviser to start-ups, growth companies and investors. Jordan was a guest speaker and a judge at Startup Gippsland Showcase event in 2019.
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