Valuation of Early-Stage Companies -- Part V – Negotiation

INTRODUCTION

The value of any company, whether it has revenue or not, is determined by negotiation between two or more willing parties based on a large number of factors.[1] For new venture opportunities that are pre-revenue, determining the value is challenging, as willing parties likely have dramatically different opinions of value. For an investor, the imperative is to balance perceived risk with their investment goals and desire to be “in the game.” For entrepreneurs, the need to secure investment to begin start-up operations is the driving force.

Naturally, investors seek to secure as much of the new venture’s equity as they can without sacrificing the motivation of the founders. Founders strive to retain enough equity to make the challenge worth the effort while retaining control of their new venture until such time that it makes sense for them to allow others to professionally manage the emergent company. Consequently, the amount of equity given up by founders to secure the needed investment is a central question for any new venture.

Negotiations are the next-to-last significant event to occur before funding (e.g., money in the bank) occurs. The last event is the signing of formal agreements.

Generally, negotiations favor the investor, as “he who owns the gold makes the rules” is as true today as it was millennia ago. This can be a discouraging process for an entrepreneur, especially in the beginning, when valuations are not what were hoped for or expected and seemingly onerous terms are presented from an investor. Furthermore, after much effort culminating in the development of the business and financial plans and supporting documentation, an entrepreneur is understandably very anxious to conclude the undertaking to secure funding. The anxiety associated with, and the duration of, the fund-raising process works to the favor of the investor. So what is a “smart entrepreneur to do?” The guidelines presented in this section should help.

NEGOTIATION GUIDELINES

Prior to meeting a potential investor and certainly before discussing valuation with a prospective investor, the entrepreneur should prepare to position the business opportunity for maximum value and also prepare to discuss key issues that ultimately affect the negotiated new venture value. Preparation is the key.

The following guidelines should help the entrepreneur prepare for, and conduct, the arduous but exciting adventure being undertaken. In the text below, a “professional investor” or “investor” can be an individual angel investor; however, it is presumed the investor will be either from an angel group or a venture capital firm.

1. Make your new venture attractive to an investor. The opportunity has to be of great interest to an investor, at least from the standpoint of return on investment. If the opportunity is also in an exciting market, all the better. If the product or service to be offered is new and innovative or offers some strong elements of uniqueness, then it is practically guaranteed that an investor will be interested, provided the management team is highly qualified and capable of executing the business plan. All of these favorable elements have to be brought out by the entrepreneurial leader and team. Though his/her vision, energy, and enthusiasm, the opportunity becomes even more desirable, hopefully not just to one investor but to multiple investors or their VC firms. By having robust marketing and sales strategies, well-done financial plan, and a persuasive business plan, the entrepreneur positions the opportunity as an attractive investment led by a professional and competent management team.
2. Establish the pre-money value of the new venture. Guidelines for valuation have been presented in Part IV of this series. An entrepreneur should have in mind the maximum credible value of the new venture opportunity based on the data of the business and financial plans. Investors will discount that number, even after the entrepreneur has arduously proven, at least in his/her mind, the pre-money valuation. Somewhere between the maximum credible value and the minimum acceptable value as determined by the entrepreneur is the valuation the entrepreneur will strive to achieve with the investor. These valuations are all pre-money. Success will be measured by the entrepreneur’s success in securing a pre-money valuation between these two limits.
3. Know how much investment you need. The required investment is derived from the financial analysis, in which the lower bound of plausible sales is used to derive the required investment. It must be remembered that it will take time to raise the next round of financing, and the company must operate during the time period that money is being raised. So as to not fall short, raise sufficient funds to meet objectives and span the time between “old” and “new” monies. Whatever amount is requested for funding will be scrutinized intently by new investors, and the transition to later-stage funding will be factored into the fund-raising amount so that the company is not caught short, presuming business goals are met, in the future.
4. Know how much equity you are willing to exchange for funding. Discussions of pre-money valuation, along with required investment, lead to a postmoney valuation, and investors will have their own offers regarding the amount of equity in the post-funded business they need to meet their fund goals. Pre-money valuation and postfunding investor equity are linked, of course, as explained in Part IV, and naturally depends on the amount of investment required as negotiated between you, the entrepreneur, and the investor. Entrepreneurs should be realistic about their expectations but also willing to be firm in the face of stress placed on them by investors, especially professional investors.
5. Be knowledgeable of the typical terms used by professional investors. Working with your corporate attorney, you’ll need to know the many terms of typical investment deals and have an opinion and position on each. Typical terms are discussed in discussed in my book. Generally, professional investors will have their way with many of the most important deal terms, but it is possible to adjust some of the terms in ways that the entrepreneur may desire. Have your positions staked out and be prepared to discuss in a give-and-take manner.
6. Develop your negotiation strategy and processes. While the CEO is expected to conduct the negotiations on behalf of the new venture, a knowledgeable CFO can be a good partner with the CEO and should be included in the negotiation team. Others should not be a part of the negotiation team, and certainly sensitive information should be confined to the CEO and CFO and the corporate attorney. Investors should know who will conduct negotiations and how, and this includes clarity on the role of the corporate attorney who advises the entrepreneur but does not negotiate any principle term. Corporate attorneys can certainly suggest alternative terms to facilitate the negotiation process, but they should not be decision makers. In later stages, it is not unusual for the attorneys on both sides to work out potential terms that will be approved or not by the principals to the investment agreement. Make sure you and your corporate attorney understand the ground rules. Experienced corporate attorneys are more likely to advise you on the appropriate ways to use their skills on your behalf.
7. Develop a professional investor target list. By checking with angel and venture capital organizations who maintain lists of their members along with descriptions of their areas of interest, preferred invested levels, etc., an entrepreneur can develop a ranked list of potential professional investors who meet his/her requirements. Consider starting with several firms toward the bottom of the ranked list so that some experience can be gained with the fund-raising process and questions from investors can be secured and further processed. After just a few of these lower-level contacts, you will have a firmer hand on the process, more confidence, and improved business and financial plans.
8. Do not “shop” your business plan. One of the worst approaches an entrepreneur can take is to broadcast or overexpose the business opportunity. No potential investor likes to think or know that you are “shopping” your business opportunity to a long list of potential investors. It is not considered good form, and it erodes the intrinsic value created by a resource (your opportunity) that is apparently in too great supply, so to speak. Treasure your opportunity and view it as something very valuable to be shared only with special people (the ones you would like as investor partners). Try not to have more than three professional investor “conversations” underway at any point in time. If your opportunity is as valuable as you think it is, the total number of professional investors and firms you will have to contact will not be too large (e.g., fewer than five to fifteen).
9. Seek professional investors you like and can trust. Presuming that most professional investors can meet the investment needs of your venture, at least for one stage and perhaps more, it will be a better experience if you chose investor(s) you like and have learned to trust (and this is a mutual quality). The entire experience of entrepreneurship will be much improved by working with people who share your same goals, principles, and morals. Strive to find just the right fit among the many professional investors available. As there is unlikely to be a nondisclosure agreement, be careful as to what is disclosed and reserve the company’s most vital confidential pieces of information until much later in the process, when trust has been secured and the potential for a deal is perceived to be very high—indeed, certain.

The following points are applicable to the negotiation process:

1. Talk with multiple professional investors. In order to extract the maximum valuation from the potential investors you are talking to, you must be meaningfully negotiating with at least two, and probably not more than three, investors, though the number is determined by the entrepreneur’s willingness to handle multiple conversations. If an investor senses either directly by asking you or indirectly through your words that you have only one opportunity to secure funding, then the advantage shifts to the investor. Don’t let that happen. Be engaged at all times with two or three potential investors who are serious and interested in your new venture. You have no requirement to disclose the number of parties you are talking to.
2. Don’t be the first to offer an opinion on valuation. Some artful dodging of the question from an investor puts the onus on the investor to offer an initial opinion, which no doubt will seem low. If the offer seems excessively low and below your minimum, you may counter with a noncounter; that is, don’t provide a valuation number and defer. This sends the message that the investor’s number is a nonstarter. The entrepreneur can opine that that number is too low for him/her to offer a counteroffer. Indeed, it may be well to move on to another subject for a while to see if the investor comes back with another thought. Only when the number is somewhat close to your minimum should you entertain a response, and the response should be your higher valuation. Hopefully, the investor you are dealing with is a reasonable person and would not make an insulting offer, but you will be tested, and better to elicit the highest investor-provided valuation opinion first. Always, make sure that the number is specified as pre-money.
3. Don’t be afraid to diplomatically pull back. At times, when the positions of the two parties seem far apart, an artful way to assess the investor’s degree of interest is to pull back just a little bit (e.g., half step). For instance, an entrepreneur could say, “Perhaps this is not the type of investment you are seeking?” The intent is two part—that is, on the one hand, you need to determine just how interested the investor may be, and if you sense that he/she is OK with your pullback, then perhaps that investor is not the right one. On the other hand, if the investor comes back expressing interest, you have a little bit more data that indicates a deal could be made, just not yet. The entrepreneur’s ideal position is one in which there is no great happiness or disappointment if the potential investor expresses an interest to further engage or to disengage. An entrepreneur may feel that potential investors will be lost, but with a little time and experience, the entrepreneur is more likely to gain the experience he/she needs and an investor more suitable for the new venture.
4. Don’t be too anxious. Anxiety can be sensed, and that anxiety affects presentations and discussions. Stay cool, realizing that the process of fund raising is long and consists of many parts and that you will likely need to talk with many people before achieving success. Professional investors understand the inherent stress within entrepreneurs during the fund-raising process. How you respond to the stress is used to assess your capability to be a CEO. Be mindful of your body language so as to not broadcast discomfort. Respond to queries with confidence and tranquility. This is about business, and though emotions are always under the surface, they should stay there except under very unusual circumstances.
5. Be mindful of your surroundings. When within the natural physical territory of a professional investor, be mindful that inadvertent glances and conversations outside the purview of your direct contact may be seen or heard by others within their organization. This “intelligence gathering” capability of the investor could inadvertently work against you, depending upon what is being communicated among your team members who may be with you. Also, be aware that an open speakerphone may transmit conversations between you and your team members to the rooms of others. Avoid discussions in the open, where voices may easily travel to others’ ears. Never assume conversations are confidential, even when they should be. It will be possible to conduct critical conversations within your corporate attorney’s office.
6. Use your corporate attorney adroitly. Do not use your corporate attorney to negotiate valuation—negotiation of valuation is between the CEO and the investor lead. However, having your attorney present during a discussion of valuation can be useful, for he/she can comment as appropriate on terms, and his advocacy can support your valuation opinions. During the terminal stages of negotiation, when legal language is involved, he/she can be an important supporter of the positions you would like to maintain, and often a corporate attorney can offer middle-ground positions to help both sides agree.
7. Have a backup plan. At all times, you need to have your “back door” prepared. For instance, a backup plan for not securing interest or investment from an investor would be the next investor on your list. The backup plan in the event that funding is taking longer than expected is an operations plan that controls spending or makes the available cash go longer. In essence, while you hope to be successful, you must also be prepared for a setback or delay and avoid at all costs the position of running out of cash, in which case investors will likely take advantage of your situation. This is easier said than done, but in practice, it means planning carefully by allowing nine to twelve months for the next-stage fund-raising effort (measured as the time from presentation of your new business plan to your first potential new investor) to get the money in the bank. Obviously, the more successful your business has become from using the prior round’s investment, the easier it will be to raise the next round. But don’t count on it. Stay extremely cautious and conservative.

The ideal ultimate goal, of course, is to arrive at the point where at least two to three professional investor firms are interested in your new venture opportunity and are in discussion with you to prepare the term sheet.  At that point you can strive to achieve the best pre-money valuation at the most favorable exchange of equity and, ideally, with a perfect investor partner.

Footnotes

[1] For a pre-revenue company, relevant factors are potential future earnings and increases in stock value, whereas an existing company would be valued on revenue, net profit, assets, liabilities, patents, fixed assets such as equipment and facilities, patents, etc.

***

Rocky Richard Arnold provides strategic corporate and capital acquisition advice to early-stage companies founded by entrepreneurs wishing to successfully commercialize high-value-creation opportunities, ideas, and/or technologies. More information about Rocky can be found at www.rockyrichardarnold.com. His book, The Smart Entrepreneur: The book investors don’t want you to read, is available for purchase on Amazon at http://tinyurl.com/pv248qq. Financial software for use by startups can be purchased on Amazon at http://www.amazon.com/gp/product/B00K2KPSI2. He posts articles about entrepreneurship on his blog at http://thesmartentrepreneur.blogspot.com. Connect with Rocky on Twitter @Rocky_R_Arnold; Facebook at www.facebook.com/rocky.r.arnold; Google+ at www.google.com/+RockyArnold01.

Valuation of Early-Stage Companies -- Part IV – Entrepreneurial Scorecard

INTRODUCTION

It should be appreciated by an entrepreneur that investors have to go through their internal processes before they can arrive at a decision to (1) become involved with the opportunity and its leaders, (2) have an opinion on pre-money valuation, and (3) determine the required investment. Investors typically arrive at a proposed valuation without fully disclosing the methods and processes they have used.

Nevertheless, entrepreneurs are well-served by doing their own assessment of new venture value before serious negotiations are considered. In this article, a method for an entrepreneurial computation of pre-money valuation is presented--it is based on four critical factors.

FACTORS AFFECTING PRE-MONEY VALUATION

Presuming that the opportunity is attractive to the investor, for whatever reason, and that marketing and sales plan (MSP), financial plan (FP), and business plan (BP) are reasonably thought out and in order, what the entrepreneur must consider are four quantitative factors central to valuation:

1. Discount rate based on the investor's goal return on cash.
2. Expected free cash flow (or net profit or EBITDA) at investor exit.
3. Terminal value based on the expected cash flow and a P/E ratio (or revenue multiplier)
4. Entrepreneurial Scorecard value (R). 

Discount Rate


The discount rate can be problematic, as investors will have their own notions about risk and return. Provided in Table 2 are computations of IRR for a range of return multiples and years. The darkened areas correspond to IRRs that are not practical for either the entrepreneur or the investor, leaving the bolded numbers and non-highlighted areas as the typical range that can find their way into calculations and discussions. All other factors being equal, lower IRRs are associated with opportunities perceived to have less risk, and higher IRRs go along with higher perceived risk.

Table 2 IRR for a Range of Investment Multiples and Years

Figure 1 shows the relationship among pre-money valuation, investment sought, and discount rate. An entrepreneur's knowledge (or least opinion) of pre-money valuation and required investment can be correlated to the discount rate that would satisfy those financial goals (e.g., investment and valuation). A bit of study of Figure 1 illustrates how the discount rate chosen by an investor dramatically affects founder equity.

For instance, if the entrepreneur estimated pre-money valuation at $3.5 million and the required investment is $2.0 million, the discount rate would be 40%. The underlying equation of the figure is simply:

Pre-money valuation = (1/Discount Rate – 1) × Investment Sought

Figure 1 Investment, Valuation, and Discount Rate

Expected Free Cash Flow

The expected free cash flow (or net profit or EBITDA) is secured from the company's integrated financial statements after proper account is made for sales projections, operating expenses, product cost of goods, etc. Generally, the free cash flow used corresponds to the presumed exit year for the investor(s).

Terminal Value

As a new venture will experience the largest amount of free cash flow in its “out-years,” the issue of terminal value and how it is calculated is very important. Over a five-year time period of interest[1] maintained by a professional investor, the fact that a funded venture may also have rapidly increasing rates of growth during the out-years also has a big influence on the terminal value of the enterprise.

As explained in Part III, there is a conceptually easy way to compute the terminal value of an enterprise: by taking the free cash flow (a.k.a. earnings) in the terminal year and multiplying by an assumed price-to-earnings (P/E) ratio. The assumed P/E ratio is based on comparables from public companies in the same or similar business and adjusted for various competitive and economic factors. For instance, if the free-cash-flow earnings of a new enterprise is projected at $800,000 per year in year five and the P/E for the companies that compete in the market and/or industry was 12, then the enterprise value is estimated at $9.6 million in year five. This scenario presumes the new enterprise becomes public.

Entrepreneurial Scorecard Value

With an established set of financial projections based on well-thought-out sales projections (see Part II of this series), the calculation of the NPV of a new venture is straightforward using the DCF method (Part III). The use of DCF and a supportable estimate of terminal value (at presumed investor exit) provides a defensible and credible valuation for the new venture IF a proper account is made for the developmental stage of the company. This is accomplished with the use of an entrepreneurial scorecard.

An entrepreneurial scorecard is a method an entrepreneur can use to adjust or estimate the value of a new venture based on an assessment of specific metrics that measure in some sense the degree to which the new venture has been developed.

A realistic pre-money value for a new venture can be computed from; for instance, the following simple relationship:

Realistic Pre-money value = maximum plausible NPV (Part III) × R

where R is a factor which accounts for all the important developmental metrics for an early-stage company as illustrated in Table 1 below.

Table 1 Entrepreneurial Scorecard

Thus, for example, if the entrepreneur scored the current status of the new venture at 68% (R = 0.68), with an NPV of $6.15 million, then the presumed realistic pre-money valuation would be 0.68 × $6 million, or $4.18 million.

This scorecard[2] identifies seven criteria for purposes of self-evaluation. The three columns in the center show three stages of development for a new venture—that is, pre-seed, seed, and start-up. A description for each stage is provided along with a range of numerical scores. The last column is for the entrepreneur to enter a score (independent of the developmental stage) reflective of his/her opinion about that criterion for the current state of the new venture or formed company. The score for each criterion is then totaled at the bottom of the form.

In using the entrepreneurial scorecard, the criteria need to be evaluated with intellectual honesty. The following guidance is provided.

1. Sales substantiation. As the new venture is presumed to be pre-revenue, sales substantiation is based on the quality of the MSP and the particulars of the strategic and tactical elements. A credible sales plan should at least describe the target markets with some precision, show a good understanding of the product benefits and unique selling proposition, and define the sales channels and tactical elements of the sales plan. For the start-up stage, the MSP must address all strategic and tactical elements with precision, and reductions from a maximum score would occur if there is no evidence of sales likelihood—as may be true if there is no focus group evaluation, no presales, and otherwise no anecdotal evidence of future sales.
2. Patent protection. An assignment of six points per granted patent is appropriate, up to a maximum of twelve points. Patent applications made would rate four points per application, up to a maximum of eight points. Provisional patent applications would be rated at two points per application, up to a maximum of four points. Fifteen points would be earned for an assembly of patent positions that could constitute an initial portfolio.
3. CEO leader. If the CEO or nominal current leader has no prior experience but has other significant skills (perhaps experience in the industry with high academic credentials) she/he would garner four points. For a very talented CEO with little experience but some experience with other start-ups, as many as eight points is allowed. The best situation is a CEO with a lot of experience in a senior leadership position (ten points) or one who has taken a company public or to investor exit successfully (fifteen points).
4. Executive team retention. One key person could correspond to the CEO, CMO, CSO, or CFO—whoever is presumed to be the visionary leader. Retention implies that the executive person is with the start-up already. As with the CEO ranking, executive leaders with more experience receive higher points. If the board of directors contains members of prominence and success, some points could be added for the board in addition to the points of the executive management team.
5. Product-market match. If the product and market match has no substantiation other than that of the founders’ opinions, then up to four points can be allocated. However, if there is some proof, as from focus groups, then up to eight points can be earned. If the product-market match is proven though focus groups, initial sales, and other evidence of a good match, then up to ten points can be earned.
6. Strategies, FP and BP. If the FP and BP are not complete or obviously flawed, then a maximum score of four points is allowed. A credible FP has a full set of integrated financial spreadsheets, and a credible BP is one that has all important factors at least identified and discussed. Credible plans are lacking only in the degree of precision that normally would be expected by a professional investor, but they would still be adequate for non-professional investors. An “excellent” score would be based on a totally integrated set of MSP, FP, and BPs.
7. Other risk factors. This category allows the entrepreneur to assess perceived risks with one or more factors: markets, product, technology, manufacturing, and sales channel. It would be expected that a new venture may have already formed ideas as to where there are issues that will hinder their forward progress and thus represent either current or future obstacles. It would be unusual to experience maximum scores for any stage of development.

SUMMARY

Valuing your new venture, at whatever stage, requires a disciplined approach and involves two factors under your control: Projections of expected free cash flow and the entrepreneurial scorecard. Two other important factors, the discount factor to be used and the terminal value, are used by investors to "adjust" their perceptions or risk and reward. The entrepreneur, you, must be prepared to not only provide data and opinions to investors, but also negotiate to achieve a fair pre-money valuation. More on the issue of negotiation in the next and final article (Part V).

Footnotes

[1] A five-year time frame has been chosen. Typical investor exits are five to eight years.

[2] This scorecard is solely the author’s.

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Rocky Richard Arnold provides strategic corporate and capital acquisition advice to early-stage companies founded by entrepreneurs wishing to successfully commercialize high-value-creation opportunities, ideas, and/or technologies. More information about Rocky can be found at www.rockyrichardarnold.com. His book, The Smart Entrepreneur: The book investors don’t want you to read, is available for purchase on Amazon at http://tinyurl.com/pv248qq. Financial software for use by startups can be purchased on Amazon at http://www.amazon.com/gp/product/B00K2KPSI2. He posts articles about entrepreneurship on his blog at http://thesmartentrepreneur.blogspot.com. Connect with Rocky on Twitter @Rocky_R_Arnold; Facebook at www.facebook.com/rocky.r.arnold; Google+ at www.google.com/+RockyArnold01.