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Start-up Valuation; fantasy and reality

Control (in the sense of majority stock ownership) does not seem to be the controlling factor. As a practical matter, the "golden rule" applies: he who has the gold rules. Companies need capital and those who provide them with the necessary capital set the rules even if the venture capitalists don't have a majority of the stock after the first round. There will be a second round and the entrepreneur needs the venture capitalists on board. Venture deals are done with preferred stock in Silicon Valley. The liquidation preference allows the company to sell its common stock to its employees at a discount from the the price paid by the venture capitalist for the preferred stock. The liquidation preference allows the VCs to argue for a bigger cut of acquisition consideration if the company is sold. Everybody benefits. The SEC is getting tough on the "cheap stock" issue for the Internet start-ups, however. We are counseling that companies get more appraisals of common stock to justify their pricing.

Jacqueline A. Daunt
Corporate partner at Fenwick & West L.L.P., in Palo Alto, CA representing domestic and international high-technology clients in venture financings, acquisitions, partnering and licensing transactions

The issue of valuation is fundamental to the fundraising process, of course, in that valuation will be determinative of how much equity of the company has to be sold to achieve a particular level of capital. Whether a company is prepared to sell "control" to investors, or is indeed able to retain for its founders a majority stake in the company, will be tied directly to valuation. Whether investors are acquiring a majority or minority interest in a company will dictate the appropriateness of a number of terms and conditions, such as voting arrangements for directorships, tag-along or co-sale rights, protective provisions or covenants requiring special class voting for organic (sale of company, etc.) changes as well as other material actions or transactions by a company, among a host of other considerations.

Martin H. Levenglick
Partner at New York's O'Sullivan Graev & Karabell L.L.P., representing companies and investors, particularly in information technology, online and new media fields in venture capital, corporate finance and mergers-and-acquisitions transactions

Pre-Money & Post-Money Valuation
First, a word on valuation. Let's talk what's called post-money valuation. Post money valuation is a pretty straightforward calculation. I pay $1 million for 10% of the company. Thus, the post-money valuation that I have placed on the company is $10 million. It's called post-money because it reflects the value of the company right after the funding round closes. Up to that point, the valuation will fluctuate with negotiations. Most startups tend to get seed or first round valuations of between $2 million and $5 million, Internet startups may get $10 million valuations, and an idea with a prototype and strong management team may get a $20 million valuation.

Regarding capital structure and stock ownership, I am familiar with two models of apportioning ownership.

MODEL 1
The company is incorporated with authorized 100 shares. Each of the 4 founders gets 5 shares, 10 shares are reserved for employees, and 70 shares are reserved for VCs. If I get a $10 million first round valuation and sell off 10% of the company for $1 million, then VC1 gets 10 shares for his million. If I get a $20 million second round valuation and raise $2 million, then the VC2 gets 10 shares. If I get a $100 million third round valuation and raise $20 million, then VC3 gets 20 shares. One thing to remember is that generally more than one VC will participate in a round and your first round investors will often kick in money in later rounds to up their holdings. I then go public and sell 10 shares to the public.

MODEL 2 - DILUTION
The company is founded by 4 founders, each of whom will share equally in the company. Thus, with 100 authorized shares, each founder owns 25 shares and thus 25%. We then raise $1 million in the first round and get a $10 million valuation. To cover this, we authorize 11 more shares for VC1. At the end of the round, the ownership looks like this:

111 shares outstanding (25+25+25+25+11=111)

F1 - 25 shares and 23% of the company
F2 - 25 shares and 23% of the company
F3 - 25 shares and 23% of the company
F4 - 25 shares and 23% of the company
VC1 - 11 shares and 10% of the company

At the end of the round, each of the founders has thus been diluted.

In the second round, we raise $2 million and get a $20 million valuation. Here's where it gets a little tricky. We authorize 12 shares to give VC2 an ending control of 10% of the company. The ownership now looks like this:

123 shares outstanding (25+25+25+25+11+12=123)

F1 - 25 shares and 20% of the company
F2 - 25 shares and 20% of the company
F3 - 25 shares and 20% of the company
F4 - 25 shares and 20% of the company
VC1 - 11 shares and 9% of the company
VC2 - 12 shares and 10% of the company

This assumes that VC1 has no anti-dilution clause. If they did, then they would be issued 1 more share to preserve their 10% ownership.

This question relates to a start-up which has venture capital financing aspirations. While there are many potential sources of funding, they aren't all equal and they will each have different perspectives on what constitutes value.

With the VC premise, then that already defines the Angel group you'd be seeking. These would be sophisticated individuals who have been successful entrepreneurs who have had angel and VC funding, or individuals who are sophisticated and experienced investors in such companies. To do anything else might "poison the pond" with regard to attracting VC funding in subsequent rounds.

That said, to a large degree VC valuation issues can be reduced to arithmetic. In today's market, if a business start-up is ultimately VC bait, then the rule of thumb is that the starting value is about $3 million. That then will be adjusted by many factors with which you are all familiar.

Why $3 million? Well, it can't be much less because VC's want to put significant dollars to work, so even early stage rounds will be in the $5-10 million range in many cases. The dilutive impact of that level of financing reduces founders/management's incentives below a reasonable threshold.

Why not $10 million? Well, again the flood of VC money comes into play. If VC's want to put large chunks at work at a time, and want to have share price appreciation between rounds, with an IPO as an exit possibility, then $10 million gets a little rich. Think about it $10 million pre-financing value plus $2 million angel round is $12 million post-money. Try to get 2X between rounds and VC comes in with $6 million, yielding $30 million post-money. Another 2X and a $10 million investment in the next round gets us to $70 million post, and that last round investor will want at least a 3X and probably 5X return on an IPO, requiring a market cap at IPO of somewhere in the range of $210 - 350 million. Not too many companies blast out of the gates at that level.

As a practical matter, your "models" are equivalent. Equity is based upon shares outstanding (plus options, if you're talking about fully diluted, which you should). So Model 1 would reflect the same dilution.

Two problems.
First, unless it's a very rare founder team, the "four musketeers" approach of "one for all and all for one, so we'll divvy up the equity pie equally", is often a recipe for failure. For more on this take a look at "25 Entrepreneurial Death Traps" by Fred Beste of Mid-Atlantic Ventures.

Second, unless you were just making the math easy, the division of equity among the founders, management, and multiple rounds of VC are nowhere close to realistic. If those are your expectations, you will be very disappointed.

L. Frank Demmler
The Gerald E. McGinnis Adjunct Professor of Entrepreneurship
The Donald H. Jones Center for Entrepreneurship
Graduate School of Industrial Administration
Carnegie Mellon University
e-mail: fd0n@andrew.cmu.edu

and

Ben Franklin Technology Center of Western Pennsylvania
Phone: (412) 681-1520 ext. 410
Fax: (412) 681-2625
e-mail: fdemmler@bftc.org

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