VALUATION - WHAT IS MY COMPANY WORTH?
(March, 2000)

• Introduction
• Before and After the Money
• A More Complicated Scenario
• How Much are You Worth?
• Conclusion

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Introduction

So, your business, like thousands of others, needs some extra money to continue growing, but what you don't know is how much of your company should be given up in exchange for that money? Of course, you want to give as little away as possible. Having said that, it is very important for you to understand that while the valuation of early stage companies is more art than science, there are some rules. The first rule is the "Golden Rule" -- "He who has the money makes the rules." If you can't live with this rule, then get a job with an established company because you are not going to like the fund raising game. Do not let this discourage you.

While you must accept the Golden Rule, it should not discourage you. The fact is -- if a potential investor is talking to you, you probably have something that interests him. While you may have to play the game by his rules, you will have some negotiating power.

Before and After the Money

To understand the basics of the valuation game, you must fully understand two terms: (1) "before the money" and (2) "after the money." Venture capitalists say things like, "We will invest $2.5 million based on a $10 million valuation." The founders might think that simple arithmetic dictates that the venture capitalist will then own 25% of the company. However, the venture capitalist believes that he will get 33% of the company. So why the ambiguity? The ambiguity arises because the parties failed to clarify whether the $10 million valuation was "before the money" or "after the money." You must clarify your terms early. "Before the money" refers to the value of the company before the venture capitalists' investment. "After the money" refers to the value after the investment. If the venture capitalists were saying that the $10 million dollars was "after the money," they were also saying that the "before the money" valuation was $7.5 million. As such, they should get 33 percent of the company. The arithmetic is actually quite simple. The "before the money" value plus the investment is equal to the "after the money" value. In other words, the "after the money" value minus the investment is equal to the "before the money" value. During a negotiation, do not be embarrassed to start playing with the before and after the money values and percentages with paper or a calculator.

A More Complicated Scenario

The first scenario was simple. A variation has the investment being broken into two rounds. I'll use simple numbers to make the illustration easier. Let's assume the venture capitalist will invest $5 million dollars based on a $10 million "after the money" valuation. If you did this in a single round, this would yield a 50% interest for the venture capitalist. If this was accomplished in two rounds of funding, however, it gets more complicated. To keep it as simple as possible, assume there will be an initial cash infusion of $2.5 million with another $2.5 million to follow when some agreed milestone have been met. It appears that after the first round, the venture capitalist would own 25% and after the second round, he would own the other 25%, thus yielding the same ownership as in the single round scenario.

The problem with this intuitive logic is that it is wrong. Why? Assume the founders of the company own 5 million shares. If the deal called for a single round of $5 million dollars for a $10 million dollar "after the money" valuation, the venture capitalist would get 5 million shares (assuming $1 per share) and own 50% of the company. With two rounds of funding, the arithmetic takes a twist. After investing that first $2.5 million, the venture capitalist will get 2.5 million shares at $1 per share. If we add these 2.5 million shares to the founder's 5 million shares, we have a company with 7.5 million outstanding shares. Since the venture capitalist owns 2.5 million of the 7.5 million, he owns 33%, not 25%. In this scenario, the venture capitalist ends up with 50% after the completion of the second round of financing.

The practical value to the venture capitalist is that he will get a bigger piece for his first investment. If he never completes the second round of financing, for whatever reason, he will still own 33%, instead of 25%. The fact is that these are two very simple examples of the arithmetic involved with investments. The schemes can get much more complicated than this. Unless somebody on your management team has the requisite financial sophistication and experience, you will have to look to your hired professionals to analyze the consequences of the various investment schemes that may be thrown your way.

How Much are You Worth?

In applying the Golden Rule, we know that it is immaterial what you think your company is worth -- it only matters what the people with the money think your company is worth. Nevertheless, never forget that not even the Golden Rule can force you to make a deal you hate. You can always walk away and try to find other investors. A venture capitalist will use various different formulas and subjective factors when trying to value your company, and each will yield a dramatically different result. For example, a venture capitalist might ask how many multiples of his investment can he expect to make from the time of the investment until the IPO (initial public offering). Other variations include an analysis of the annual ROI (annual return of investment), what percentage of the stock will the venture capitalist control with his investment and many others. Some of the subjective valuation factors (as if the formulas were not subjective enough) include: the general outlook for your industry, customer trends and tastes, your likely standing in your industry, your ability to use intellectual property laws to protect your idea, and the regulatory climate. So what does it all come down to? Your company is worth what you can agree you are worth.

Conclusion

Startups cannot be valuated on the basis of hard assets or cash flow, just potential. How strong is the management team? How good are your ideas? How far along is the company in taking your ideas and making them a reality? What advantages do you have over your competition? How long will you be able to maintain your advantage? These are only some of the questions potential investors ask and answer based on the information you have provided and their own research. In some ways, everything else is merely an attempt to quantify these questions. Develop strong answers to these questions and hopefully the value of your company will increase.

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