How to achieve a solid early stage valuation


7 February 2017

Agreeing on a valuation is a key point to address in a term sheet and, as a result, questions around this cross our desks frequently.

It is also important to understand certain key factors which can influence valuation and what you can do to optimise these.

 

It’s not always scientific

Valuation of a very early stage company is inherently difficult.  Companies which are further along the development path will find this an easier exercise because they have more definitive valuation indicators to point to – assets, IP, recurring revenue, customer base etc.  For those of you aiming to raise VC funding, I’m sure co-sponsor SEP will have some helpful insights as to what they look for in potential investee companies, while accountants will be able to explain some of the traditional valuation methods and formulas which may be applied.

For companies at a very early stage, however, it can be hard to fix a value when there is little or no track record and financial performance is uncertain.

 

Understanding Valuation

Before you speak to investors, it is important to understand the difference between pre-money and post-money valuations.

Let’s say you need to raise 250k and believe that the company should be valued at £1.5m:

  • If £1.5m is a pre-money valuation, the calculation is £250,000/£1,750,000 x 100 = 14.29% equity to be offered;
  • Whereas if £1.5m is a post-money valuation, the calculation is £250,000/£1,500,000 x 100 = 16.67% equity to be offered.

Another important point to understand is whether the valuation has been agreed on the basis of the issued share capital or the fully diluted share capital.  The latter will include any share options or warrants etc which have been granted by the company.  An investor will usually want to agree on a valuation on the basis of the fully diluted share capital so that they are not immediately diluted by any existing option pool or warrants which may be in place.

 

Do your homework

Compare your company to other businesses at a similar stage in a similar field.  This will give you an indication as to the level investors will be prepared to invest at (and what your competition are offering).

Remember that geographical differences will apply e.g. it is understood that often early stage companies in the US manage to raise larger first round investments and at a higher valuation so they are not always a good example for comparison.

Some other factors which may influence valuation include:

  • Management team – founders with a proven track record may be able to secure a better early stage valuation than those with no experience in building successful high growth companies;
  • Industry – certain sectors experience periods of high interest and demand, for example, fintech and big data and analytics. If more investors are competing to invest in your company, this will drive up the price;
  • Market size – always consider the potential market size. The bigger the market, the higher the valuation which a company may be able to achieve;
  • Development – companies whose product/offering is at an advanced stage will be able to command higher valuations than those who are still at the ideas stage; and
  • Traction – any evidence of traction will help to de-risk the investment in the mind of an investor and help you to negotiate a higher valuation.

 

The best valuation doesn’t always = best investor

Just because one investor is offering you a better valuation, doesn’t automatically make them a better choice.  Consider the terms of the deal as a whole, rather than the valuation in isolation.

Remember that once they are shareholders in your company, you need to be able to work with the investors going forward.  Some will be able to help you more than others and some may have specific experience and contacts in your field which could be more valuable to you in the long run. You may know that certain investors would have the capacity/appetite to make further investments in the future, which is valuable given that you are likely to need to raise follow-on investment to build and scale the company.

Other investors may appear, on the face of it, to offer a higher valuation, but this might be coupled with a request for preference shares.  If the preferences being sought are aggressive, these could actually end up having a more damaging impact on valuation.

So, it is not just a case of who will offer you the best valuation.  The important question is who will help you build a successfully, scalable company with the best prospects for future growth/exit.

 

Flexibility

If you are very keen to work with a particular investor, but the valuation you are being offered is significantly below what you had hoped for, there may be ways to limit the impact of this.

Can you agree to take a smaller investment now so that a larger amount can be drawn down once the value has increased?

Alternatively, employee share options might offer a way of recovering some value.

 

Potential downsides of a high valuation

Believe it or not, there can be some downsides!

If a company is over-valued at an early stage, this increases the likelihood of future down rounds or flat rounds, which can be demotivating and disappointing for the management team and the investors alike.

Some investors may insist that the exercise price of any share options granted to employees be based on the last round investment price.  If that’s very high, the benefit for employees may be limited.

Other investors may be more relaxed about agreeing to a higher valuation, but on the basis that they have certain protections such as anti-dilution provisions and/or liquidation preferences (but please note such protections would not be available to SEIS/EIS investors, as any such provisions would cause them to lose their tax relief).

 

Conclusion

It is not surprising many people say that valuation of early stage companies is more of an art than science.  You will obviously have an idea of the valuation you hope to achieve, but try not to fixate only on the numbers as there are other important considerations at stake and you may need to listen to what the market is telling you.

Valuation is an area of negotiation and you might not get exactly what you want.  However, if you have done your homework, you should have a valuation range in mind which would be acceptable to you and which, coupled with the other terms of the deal, will help you to feel more comfortable with the numbers.

 

Free Legal Advice Service

Just a quick reminder that we are offering an advice service to all companies taking part in EIE17 to help make sure you are “investor ready”.  As part of that, we can offer each company up to an hour’s free consultation to talk through any issues you may be experiencing currently, or anything you might want to know ahead of speaking to investors at EIE.  We really do want to help make sure you get the very most from EIE and are in the best possible shape to attract investment.  If this could be useful, please don’t hesitate to get in touch laura.peachey@mbmcommercial.co.uk

 

 

About MBM Commercial

MBM Commercial is an award-winning commercial law firm that helps entrepreneurial businesses.  Many of our clients are businesses based throughout the UK, which are going through significant growth, either by investment, acquisition or by international expansion. We also offer US law capability to assist clients who are doing deals in the US, expanding into US markets or transacting with US businesses.

You can read about some of the deals we have been involved with recently here http://mbmcommercial.co.uk/News-Events/News/Ideals-update.html

 

 

By Laura Peachey, Associate, MBM Commercial

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