Why Valuation Matters
Centuro Global, 16 September, 2019
“What is your valuation?”
“£100,000 for 10%?”
The above seems like a fabricated scenario made for Dragons Den or Shark Tank, but at some stage, every investor will want to know: “what is your valuation?”
Often one of the most daunting questions that a VC or angel investor can impose on you is around valuation and the distribution of your equity. Without wanting to get tangled up in trying to cover behavioural economic signalling, it’s best to regard answering this correctly as more of an art than a science. At any investment stage, when an investor is asking for your valuation they are looking for many things. Principally, they want to gauge how attractive the deal on your startup’s equity is - they can then make any further decisions anchored to this number.
There is a lot to look at when it comes to tackling your valuation. You’ll hear terms such as ‘pre-money, post-money, EBITDA multiple’ thrown around and it’s easy to get lost in the jargon (there’s a handy Jargon Glossary at the end of the article in case you run into any new terms whilst reading). What really matters is how your stated valuation affects the investment deal for both you, and the interested party.
Every interaction with an investor will act as a signal. The way you dress, pitch, your tone of voice and your enthusiasm are all factors that are hard to control. Believe it or not, we’re seeing data that suggests even being enthusiastic in pitches could actually hurt your chances of success! The point is that interactions can be erratic, and it’s near impossible to predict their effects on individuals.
Nonetheless, there is no need to panic! Your valuation is one thing that is totally in your control.
Until you have your first lump of capital invested, you are entirely free to move your valuation to suit your aims & business ambitions.
Sure, we’re framing this potentially daunting autonomy as being a good thing, but if you can’t get excited by risk, then maybe fundraising isn’t for you after all...
So, Why Does It Matter What Valuation I Say?
How does what I say affect the deal and what are these behavioural economic signals I’m sending?
If you state your valuation too high, you could seem delusional or price future investors out of the deal. Too low and you might imply a lack of faith in your idea and team or, even worse, sell your equity too cheaply and as a founding team be stuck with a minority stake in a booming business one day.
You’re sending an important signal and you must use this as a tool to your advantage. Signalling isn’t something that many accelerators or incubators will adequately teach you. Being lucky enough to get introduced to investors is one thing, but knowing how to manoeuvre that room once you’re in it is a whole new game.
As a founder, equity in your attractive business is your one pivotal asset and will be a central factor in any investment negotiation. Any deal-making is based on tradables as seen below:
P1: I trade X for Y
P2: What if we traded my Y for your X and your Z
P1: We can make it work if we trade my X and Z for your Y and W. Deal?
The letters in the above negotiation are tradable; each one adds more value to the deal and eventually leads to an agreement that is mutually beneficial to both parties (at least that’s the aim). There are many tradables in an investment deal (board seats, liquidation preferences, shareholder rights, pre-emption rights, drag-along rights etc.) and you should become familiar with these terms before embarking on any deals. While we’re not fans of jargon, sometimes it does pay to be in the know. Check out our glossary below where you can find definitions to all of these terms and more.
In almost all early-stage financing rounds what matters most is what the investor ‘gets’ for what they put in.
In effect, your stated valuation is your opening position and (as any game theorist or expert negotiator will tell you) this sets the stage for the entire rest of the deal.
How Do I ‘Use’ My Valuation?
The valuation you state first, i.e. the one that is in your pitch deck, isn’t necessarily going to be your final agreed figure. As a founder, it’s vital to know the equity percentage that you want to end up at and it is prudent to have an upper and lower bound as to what you will accept.
Once you know and understand your personal (or team’s) percentages, then you are at an advantage as you can enter any negotiation or pitch with clear parameters of what you will accept and clear parameters of what you will walk away from.
After you’ve settled on ideal outcomes, you can focus on what information you can deliver with your valuation.
In most cases (like any negotiation) it is best to open at a high asking price, as it’s likely you’ll see efforts to bring the valuation downwards, so it’s good to leave room to ‘cooperate’. Additionally, opening with a reasonably high valuation tends to signal confidence.
Since you’re able to be flexible from pitch to pitch about your valuation, you can fluctuate your valuation number easily depending on whom you are pitching to. For example, when meeting professional VC investors with established funds, a £1m+ valuation at seed stage is not untenable (in fact, VC’s won’t really get excited about anything lower than this). In comparison, an angel investor certainly could be scared off by such a high valuation. Tailor your valuation to what works for you, and what you expect to work for the specific investors you’re targeting.
On angel platforms (e.g. https://www.syndicateroom.com/) or equity crowd funders (e.g. https://www.seedrs.com/) it’s often prudent to set your valuation low to encourage rapid micro-investments. As you gain momentum and reach your milestones you could end up raising considerably more than your initial ask at a much higher valuation (although watchout for down rounds).
Above all, try to simply look at valuation (and investment generally) as a tool to grow and accelerate your startup. It isn’t just a signalling method and it certainly isn’t a vanity metric, it’s a real number that will affect your startup for years to come. A massive valuation is guaranteed to make headlines, but it’s certainly not guaranteed to bring successful growth.
Finally, Is Valuation Everything?
As discussed above, there are numerous factors in play during an investment deal.
For example, take these two deals:
- A: £400,000 for 20% equity
- B: £200,000 for 10% equity
Both of these deals would give the startup a pretty tantalising pre-money valuation of £2 million. However, deal A gives the startup far more rope in terms of working capital for a sustained burn rate than deal B, at the cost of surrendering more equity. Only you can decide which is better - it’s when you’re presented with decisions like these that you’ll be grateful for the mentors and team around you.
Ultimately, a stranger could invest £100 into your startup for 0.00001% equity and you would technically have an instant ‘unicorn’ (£1billion+ valuation). In this case, your valuation would be a dangerously misleading vanity metric, and certainly unimportant for you and your business.
A Complex Problem
If you’re dedicated and talented enough to fundraise, your valuation/s will be one of the most prominent factors in your career. It’s fraught with problems and since it’s often little more than an educated guess, it makes sense to get the right help in early before you start making commitments and receiving capital.
At Centuro Global, we assist businesses in getting the right advisory support from our unique network of professionals.
Our team comprises industry experts within the legal, finance, technology and marketing sectors. We have led companies, advised major brands and contributed to the growth and success of numerous small to medium and large businesses around the world.
Valuations are tricky. It is definitely an art not a science and, put simply, it can be a disaster if you get it wrong. However, as the best entrepreneurs have shown over time, your valuation can equally be a significant asset when you get it right.
Pre-Money & Post-Money Valuation - The value of private companies is very subjective and usually comes down to negotiation.
Pre-money valuation is the value you place on your company before going out to find investment.
Post-money valuation is simply the pre-money valuation plus the investment.
The higher the valuation is, the less dilution there will be as the company will need to issue fewer shares for any capital raised. However, if the valuation is too high it will be off-putting for potential investors. As always, balance is key – don’t be too greedy but don’t sell too cheaply either!
EBITDA Multiple -This financial ratio compares a company’s Enterprise Value to its annual EBITDA.
The Enterprise Value considers the startup’s entire market. For example, all ownership interests and asset claims from both debt and equity are included.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a metric used to evaluate a company’s operating performance.
Put simply, a low EBITDA ratio value indicates that the company could be undervalued, and a high EBITDA value suggests that there may well be an overvaluation. Importantly, it’s not uncommon for prospective buyers and investors to push for a lower valuation to get more ‘bang for their buck’.
Pre-Emption Rights - These can be set-up to give a contractual right for existing shareholders to maintain their proportion of ownership of the company. Put simply, they do so by acquiring their proportional share of any additional stock issuances (e.g. if the company goes public). This right ensures that a shareholder's ownership interest is not diluted through the issuance of more shares.
Also known as subscription rights or subscription privileges, these can be really important in negotiations as they allow a shareholder to be able to protect themselves from having their shares devalued over time. Equally, they can prevent selling or transferring shares to another party whom they may not wish to be in business with, thus potentially blocking future deals.
Down Round - Generally viewed as a very negative way to raise capital for founders; a “down round” is when a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing. Investors will often cement protections against down rounds. They are typically issued new shares to ensure their stake in the company isn’t diluted by new investors acquiring equity. However, that has to come out of someone else's proportional stake - typically founders.
Additionally, down-rounds can be seen as a backwards step for a company as the valuation shrinks. This is bad for a number of likely obvious reasons and is likely to hinder future investment opportunities and damage employee morale.
Drag Along Rights -An agreement that enables a majority shareholder to effectively force a minority shareholder to join in the sale of a company. A key caveat is that the majority owner doing the ‘dragging’ must give the minority shareholder the same price, terms, and conditions as any other seller. Something to watch out for as it can suggest an investor’s exit strategy doesn’t align with yours.
Tag Along Rights -Effectively the opposite to Drag Along Rights, whilst not mentioned in the article, are very important for some investment deals. Also known as 'co-sale rights', they occur when a majority shareholder sells their shares; a tag along right will entitle the minority shareholder to participate in the sale at the same time for the same price for the shares. These rights are meant to protect minority holders from being ‘left in the cold’ after a sale of large proportions of the equity that don’t involve them.