The
Valuation Question has a Simple Answer
A
popular topic among startups and investors is that of valuation. What's my baby
worth? How much equity has to be given up to attract investors?
We
often hear the term, "pre-money valuation". This refers to the value
placed on a business prior to the injection of new capital. Although this is a
negotiated figure, company founders jump through hoops trying to justify the
value based on various approaches. Startups will little more than an idea have
greater difficulty justifying a given value than a company with a little history
and a bit of a track record.
Some
of the common approaches to valuation are the discounted cash flow method (i.e.
basic engineering economics to produce a present value for pro-forma cash
flows), replacement cost method, market value based on comparable deals,
tangible asset value, or various multiples applied to either trailing or leading
revenues or earnings.
Whereas
such approaches may be useful to investors or entrepreneurs in justifying their
negotiating stance to the other party, I'm not convinced that there is much
merit in any of these methods, especially at the nascent stages.
One
could argue that in most cases, the pre-money value is zero, or close to it.
Why? Without capital, the business will not grow and is worthless. Hence, a more
practical approach would be to recognize the fact that without the idea, the
people, and the
capital the business won't fly.
It
may be more productive to look at who is contributing what to the business and
then agree on a mutually acceptable division of the pie based on these relative
contributions.
When
arguing for the size of their share, investors must realize that the founders
must not feel squeezed or taken advantage of. It takes the total commitment of
the entrepreneurs to make the deal work. And when it does, the investment
returns will be so many multiples that it isn't worth quibbling over a few
percentage points going in.
There's
lots of evidence to suggest that the team, not the technology or the business
plan is what counts. The majority of B.C.'s leading technology ventures, e.g.
Creo Products, Pivotal Corp, QLT, and Ballard are all successful today in areas
that they did not originally identify. Most are not even close to doing what
they spelled out in their first business plans!
The
point here is that a determination of value is usually based on the wrong
aspects of the business (i.e. the technology and the forecasts). It's the team
behind a company that ultimately drives the value. And, that's tough to
quantify.
In
the public markets, Canadian stock exchanges like the CDNX and its progenitors,
the VSE and ASE, have unduly fussed with the valuation question and have
required companies to hire high-priced experts to produce independent opinions
on value so as to protect the investing public.
This
can actually hurt a company insofar as the valuations are always on the
conservative side. No one wants to be sued for hyperbole. More often than not
(e.g. as seen in recent IPOs like Creo, Pivotal, and Sierra Wireless) public
offerings are priced well under the market's appetite which means that, although
investors are happy, maybe a little too much was left on the table.
And,
if you're worried about hyper-values, don't be. Look at it as investors'
confidence in the management team to meet expectations. Even though a company's
treasury is not affected by a rising stock price, it does allow a company to
raise equity at lesser dilutions or make acquisitions with its own paper.
The
way I see it, early stage valuations are best addressed by looking at the
"post-money" scenario as determined by all participants' contributions
and commitments, especially the commitment of the entrepreneurial team.
Copyright, 2000.