Both entrepreneurs and investors seem to often get confused with the various terms and math that go into determining valuation and the steps behind it. Valuing early stage companies, especially those heavily dependent on intellectual property and management talent, is extremely subjective. Consequently, valuation of these companies is subject to much speculation about the company’s future and goals. As a result, most of the valuation is determined by market forces rather than company fundamentals. When the market is strong, such as during the dot com bubble, valuations can reach nose bleed levels. When the market is weak, such as more recently, valuations can become depressed.
The math behind valuations isn’t as hard as it seems
The first round of financing for a company begins with its pre-money valuation, or the value of the company at the current time, prior to any investment or financing. Both the founding team and the company’s investors should bear in mind certain basic metrics by which to arrive at this pre-money valuation. First, it’s important to make sure that the founding team has enough ownership now and in the future to be rewarded appropriately. The investor wants a team that is fully invested in making this company as valuable as it can be. On the other side, the investors need to have enough ownership to allow them a chance to earn enough money to justify the risk of this very speculative investment. Setting the right levels for both the founders and the investors is essential at the pre-money stage because it sets the precedent for the future rounds of financing.
After the company and their investors agree upon a pre-money valuation and an investment has been made, we arrive at the post-money valuation. The post-money value can be calculated by:
Pre Money Valuation + Total Amount Raised (Equity Investment) = Post Money Valuation
It is also important to calculate price per share:
Pre Money Valuation/ # of Shares Outstanding = Price Per Share
Now, lets plug in some numbers to get a better picture:
- Pre Money Valuation= $1,200,000
- # of Shares Outstanding= 4,000,000
- Equity Investment= $300,000
-So our Post Money Valuation is $1,500,000 = $1,200,000 (Pre Money Valuation) + $300,000 (Equity Investment)
-Our Price Per Share is 30¢= $1,200,000 (Pre Money Valuation) / 4,000,000 (Shares Outstanding)
At this point, you determined how much dilution is happening, or how much of the company is being sold to outside investors. This can be calculated using the method shown below:
Total Amount Raised (Equity Investment) / Post Money Valuation * 100 = % of Investors equity in the company
100% – % of Investors equity in the company = % of Owners equity in the company
Now, lets plug in our actual numbers for both the company founders and their investors:
–Investors percentage stake is 20%= $300,000 (Amount Invested)/ $1,500,000 (Post Money Valuation) * 100
–Company founders percentage stake is 80%= 100% – 20% (Investors Stake)
As you can see, outside investments dilute the ownership stakes of the company’s founders, but it’s usually necessary to take the business to the next level. This is because founders don’t usually have the money to fund the business without selling equity to outside investors. As a rule of thumb, a company should be ready to give up between 20%- 45% of their company in each round of early financing. The company should attempt to keep this as close to the 20% dilution level as possible at each round. Too much dilution in any round, especially an early round of financing, can create bigger problems for a company down the road.
There are various types of financing that can be used raise equity. Two such methods are convertible notes and preferred shares. As the popularity of convertible notes, or a loan that can be converted into stock has recently increased, lets take a look at how it effects a company’s valuation.
- Equity Investment= $300,000
- Convertible debt= $100,000
- Pre Money evaluation= $1,200,000
-Because we have issued $100,000 of convertible debt, our Post Money Valuation is now $1,600,000 = $1,200,000 (Pre Money Valuation) + $300,000 (Equity Investment) + $100,000 (Convertible Debt)
Next, let’s look at how this impacts both the company founders and the investors stakes in the company:
–Investors percentage stake is now 25%= $400,000 (Amount Invested)/ $1,600,000 (New Post Money Valuation)
–Company founders percentage stake is now 75%= 100%- 25% (Investors New Stake)
Now, lets figure out the breakdown of the convertible debt and its owners. Upon conversion of the note to shares, the equity investors in the company now own 18.75% of the company ($300,000 / $1,600,000) and the convertible note holders now own 6.25% of the company. Evidently, the equity investors in the company suffer a decrease in their ownership as it went from 25% to 18.75%.
Hopefully, this brief analysis helped you to understand the ideas behind early stage company valuations and financing rounds. Remember to err on the side of caution because each round complicates the fund raising at the next round and all future rounds.