Negotiating Valuation Strategy

Acing the Valuation Challenge

Ground Work is Essential For Any Valuation Discussion

Good news! you presented your idea, the investors love you and your product and think you and your company might be on to something. Now comes the difficult part – what is your company worth? which really translates into another question – how much money you are asking for and what % of your company you are willing to give in return.

In order to maximize your negotiation position, it is important to understand what your investor(s) is(are) valuing your business at. As noted in our Startup Valuation page, valuation of a company involves mixing science with art. Similarly, it is fair to say that an investor would likely establish a value in two ways – intuition and quantitatively. Understanding this, and preparing carefully for both ways is key to maximizing your ultimate main goal – justifying your desired valuation of the company prior to the financing round.

The question of gut feeling versus analysis is framed wrong. These are not independent, gut feel that does not rely on analysis, as a sanity check, as a verification; is likely to be very arbitrary and very likely to be wrong. Analysis that is not answering questions that are raised by somebody’s intuitive judgment that’s based on thousands of exposures to individuals thoughts and observations, is a sterile analysis. So the best of these things is as a synergy between intuition. And, intuition is not arbitrary. Intuition is a summation of many many experiences in the first place. But anyway, synergy between intuition and analysis. And that synergy is better than either intuition or analysis.

Andy Grove at SCVHA. (Published on Apr 19, 2016.)

Intuition

Venture capitalists criteria for evaluating investment opportunities focuses on three main areas:

  • uniqueness of opportunity
  • the expected returns
  • the strength of management

In evaluating management strength, many investors heavily rely on their “personal chemistry” with management and “gut feel”. While these are very subjective factors, there are more objective factors that are proven to increase perception of management strength by investors, and favorably influence their “intuition”. Some of these factors are:

  • the experience of the principal
  • the way the investment opportunity is presented
  • preparation level of the principal

We can and will work closely with you to prepare you to successfully hit these points to increase confidence in your business, and make sure the perceived value your investors will assign to your company will increase.

Qualitative

Hopefully, your investors have a good intuition about you and your company!

Now, they will also investigate the expected return on their investment to make sure it makes sense. They will use various valuation technics (to understand more on how investors will value your company, please read our Company Valuation and Strartup Valuation pages).

If you wish to maximize the value of your company, it is your job to understand these valuation methodologies, know which assumptions were applied and why, and be expected to articulate them to investors, and defend them with solid data and sound reasoning.

This is why we are here – to work with you on not only developing your internal valuation, but also strategically find the right places to advocate for inputs that will benefit your overall business valuation.

When you can intelligently counter your investors’ valuation of your business, you are more likely to success in bridging the expected gap between your desired valuation and the investors’ one.

“Pre Money” is Not Everything

Many entrepreneurs mistakenly believe that “pre-money” is the only important term they should be focused on in their valuation negotiation strategy. Yet, there two other key terms not always fully understood by entrepreneurs, that impact “true” price of an investment, and specifically the dilution of current shareholders:


1

Size of Option Pool

Investing in early stage companies means that the companies will undoubtedly need to hire additional management team members and sales and marketing and technical talent to build the business.  Issuance of stock options is one of the most common ways of soliciting the best talents. In anticipation of those hiring needs, many VCs will require that an increase of the option pool take place immediately prior to the investment round, typically such that the unallocated option pool will consist of 15%-25% of the fully diluted equity ownership. By doing so, the VCs are making sure that these new hires, that will happen after the investment round, will effectively not require further dilution from the VC. In other words, this “exercise” means that existing management team/founders have given up more of their ownership in order to go towards future hires. Effectively, this reduces the “Pre-Money” valuation of the company through the back door.

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price – the pre-money, the post-money, the option pool.


2

Type of Liquidation Preference

We have discussed briefly the various types of preferred stock here, and touched on the liquidation preference right. It is important to more that there are variations of liquidation preference structures and some structures are more “aggressive” toward the existing stockholders than others. Let’s review a simple example to illustrate why pre-money valuation is definitely not the only term to focus on:

Scenario A: a company raises $4M Series A Preferred at $6M Pre money valuation. The Series A Preferred is non participating convertible preferred. Following the investment the Series A owns 40% of the company.

Scenario B: a company raises $4M Series A Preferred at $8M Pre money valuation. The Series A Preferred is participating convertible preferred. Following the investment the Series A owns 33% of the company.

Presumably, scenario B is better for existing shareholders as it results in less dilution due to higher pre-money valuation. However less review closely the true effect of dilution that results from the liquidation preference right. We’ll assume the company receives an offer to be acquired for $20M:

Scenario A: being non-participating preferred, the series A stockholders will need to choose between receiving their liquidation preference of $4M, OR converting into common and participating with the common stockholders 40%-60%  (in favor of common). Since 40% of $20M is $8M, clearly the Serie A stockholders are better off converting their shares into common.

Scenario B: being participating preferred, the series A will be receiving BOTH their liquidation preference of $4M, AND converting into common and participating with the common stock 40%-60%  (in favor of common). In this case, the first $4M will go to the Series A shareholders, and the remaining $16M will now be split ratably between the Series A stockholders and Common stockholders such that the Series A stockholders will receive additional $6.4M (40% x $16M = $6.4M). In this scenario, total proceeds to Serie A stockholders is $3M + $6.4M = $9.4M.

We can see how liquidation preference impact greatly the amount of money left for other shareholders in he event of sale, and that a round with a lower “pre-money” is financial better to existing shareholders than a round with higher pre-money valuation.


Conclusion

There are many other elements of the deal that are just as important to understand beyond these important pricing terms.To learn more visit our Term Sheet Negotiation page.

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