VALUATION

Determining an appropriate valuation for your company can be challenging. The first task is to convince the investor that your company should warrant investment at all. This is accomplished by creating interest in the potential opportunity, which is why an outstanding elevator pitch, introductory PowerPoint and executive summary are so important. The second task is to convince the investor that the proposed terms of the investment offer an attractive potential return, given the risk factors.

If a company initially suggests a pre-money valuation much too high—or too low—it raises questions for an investor about whether the company has done its homework regarding valuations for early stage companies of its type (or has done its homework about anything, for that matter) and whether there can ever be a meeting of the minds. In our opinion, it is better for a company to go for a valuation that is “in the ballpark” than strike out in the first at-bat trying to swing for the fences. Typically, we look for pre-money valuations well below $3 million. It takes unusual situations (e.g., a company with substantial existing revenues, patents in place and demonstrated growth) to get us to consider a pre-money valuation higher than $3 million.

Even the most enlightened and flexible CEO will inevitably look at the opportunity to fund his company in a different light than will the people writing the checks. Investors will be very aware of how difficult it can be to get a product to market, gain strong customer traction and build revenue and ultimately profitability. Since more early stage companies fail than succeed in executing their business plans, most investors know that product development risk is usually higher, capital requirements more substantial, market acceptance slower, management team-building more unpredictable and exits more delayed than most CEO’s project.

These challenges are why entrepreneurs should not expect investors to get too excited about their ROI projections based on a five-year scenario fraught with uncertainties, especially if the company is a recently formed, two person, pre-revenue organization with little funding to date and major future capital needs. Certainly don’t think that a 20% return is acceptable, as the potential investors are probably thinking that, given the risks, they need to see the possibility of a 20x return!

FULL-DILUTION

In determining valuation we take into account the effect of all commitments to issue shares, which is called the “fully-diluted” number of shares. More specifically, the fully-diluted number of shares includes all shares that you would issue if all unconditional and contingent commitments to issue shares were to be given effect (e.g. exercise of options and warrants, conversion of preferred shares, exchange of debt for equity, etc.). Moreover, we expect a reasonable number of shares to be already reserved (and counted as part of full-dilution) for filling out the key management slots and for other employee stock options.

PRE-MONEY VALUATION BASED ON PRICE PER SHARE

The pre-money valuation, simply put, is the value you put on your company before getting the capital you seek. To compute: multiply the fully-diluted shares immediately prior to the proposed financing (e.g. 2 million fully-diluted shares) by the price per share of the proposed financing (e.g. $1/share) to yield the pre-money valuation ($2 million, in this example). If you add the proposed financing amount (e.g. $500K) to the pre-money valuation you get the post-money valuation ($2.5 million in this example).

PRE-MONEY VALUATION BASED ON % OFFERED

Some entrepreneurs are more used to thinking in terms of offering some percent (e.g. 20%) of their company for some amount of financing (e.g. $500K). Numerically, divide the proposed financing ($500K) by the offered percentage (20%) to get the post-money valuation ($2.5 million), and then subtract the money you are raising from the post-money valuation to get the pre-money valuation ($2.5 million – $500k = $2 million). Both methods of computing a pre-money valuation are equally valid and, as expected, yield identical results.

LATER-ROUND DILUTION

It is important to keep in mind that early stage investors will likely have their equity interest in your company diluted (made smaller) by later investors. For example, if Ignition Point members invest $500,000 at a pre-money valuation of $1 million (and thus end up owning 33% of the company), and then a venture capital firm invests $5 million the following year at a pre-money valuation of $5 million, the original Ignition Point investors will now own only half as much of the company, even though the company value has increased more than three-fold. As a result, because of the early stage at which we invest, you should know that Ignition Point typically receives 25-50% of the company’s fully diluted equity in exchange for our investment.