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So as we said earlier, the alternative to doing a convertible debt financing which is in some ways really the more traditional way that Start up companies get financed, is actually having a priced equity route. start up company will have discussion and negotiation with the venture capital investor as to what the valuation of the company is and what the price per share that they’re going issue equity for is.
We’re going to talk at a high level at really the key terms of the preferred stock investment to start a company are. I usually like to to categorize the key terms preferred stock financing into five different buckets.
One is the valuation issue that we’ve been touching upon a little bit in this video, another is the control of the investor over the business. Another one is the the ability of investors to monitor their investment over time. A fourth category is the investor’s ability to maintain or increase their ownership over time.
Last, but certainly not least, the last category that we will talk briefly about is liquidity. Investors don’t want to invest in startup companies and have their investment dealing with forever. They want to know that there is a hopefully a pot of gold the end of the rainbow and they’ll be able to sell their their position the company at some point in time, so how can investors determine how and when the company ultimately has an exit event.
So starting with the pricing and economics of the deal, here we are starting out as an investor, excuse me, as a founder or entrepreneur in a company. You own 100% of the business either yourself or with your cofounders and now you’re talking with an investor about potentially investing in the company, and as a result you have to give up some ownership and control of the business.
The way you determine how much control and ownership of the business you give up is by having discussion about valuation how we want to price the deal we hear often times or entrepreneurs hear the term pre-money valuation a lot. Pre-money valuation is effectively the valuation that’s being ascribed to the business before the investor invests in the business. So starting today what is the inherent value of your business before any new investment capital comes in the company.
In its simplest form, pre-money valuation determines the amount of the company that’s going to be allocated to the investor in return for his or her investment capital. For early-stage companies that are raising investment capital, I find the valuation really hinges more on growth potential.
Again, an early stage company may have no users may have no casters may not even have a product that they’re able to sell you so with the pre-money valuation again as a hinge more on what’s the potential for growth, not the actual inherent value of the company today companies that are looking to raise their first round of financing will oftentimes back into their evaluation.
What do I mean by back into their valuation? Wealth as I said a couple of times in this video a companies need to think about how much money they want to raise how much money they need to really grow over the next 12 to 24 months and hopefully get to inflection point where they shown substantial growth or substantial prospects for further growth that’s going to convince investors to hopefully invest another round of financing in the company. So once the company is establish what that number is could be $250,000, could be $1 million could be somewhere in between.
Once that amount of money and its desire to be raised has been established, what I mean by backing into the valuation is you need to think about based on how much money you’re seeking to raise and how much of the company are willing to give away/ It’s pretty easy to put some stakes around the boundaries of that percentage would be.
Certainly I would never advise the company to in an early-stage financing giveaway 50% or more of the company because that’s going grossly disincentivize you as an entrepreneur founder from being excited about working 18 hours a day and weekends to grow this business and increase value because you don’t even own half the business anymore. Why on day one would you want to have an outside investor having a majority stake in your company? So can’t be 50%. 40% is probably too high an allocation also because that’s not to leave a lot of room for future financing rounds where you as a founder to get diluted even more. So 50% is too much, 40% is too much.
I typically see the amount of money that is being invested by investors and early-stage results in an ownership stake is somewhere between five and 30% of the business enterprise. So you can pretty easily figure out what your valuation is based on the amount of money being invested and what percentage of the companies being allocated to that investor.
Factors Determining Pre-Money Valuation
What are the factors though that determine what your pre-money valuation are? The first one certainly is attraction and customer validation the whole point of a business is to attract users and customers, so if you as a a business even in early stage already have some users and customers, perhaps paying users and customers that’s going to impact the pre-money valuation discussion in your favor.
Another one is going to be the reputation of the founder team. If you’re Mark Zuckerburg, and you decide not work at Facebook anymore and want to start a new business, I’m fairly confident that whatever business he starts he’s going to get a very good pre-money valuation just because of his reputation and his past success for growing businesses in the past.
So if you have an all-star hotshot founder team with some folks that have had successes in the past, chances are you’re going to have a bump your pre-money valuation because of that reputation. Whereas if you’re a first time entrepreneur, you may be a budding Mark Zuckerberg in the waiting, but you have to prove yourself probably won’t get the the benefit of the take-up and pre-money valuation as of your lack of a track record.
Another important component that goes into the pre-money valuation discussion is revenues. this of course goes a bit part and parcel with a customer validation issue we talked about previously, but if you’re a startup company and you’ve already got customers that are willing to pony up their hard-earned cash to buy your product, that’s a pretty good sign that you maybe have a viable business that investors can be comfortable investing in.
Interestingly depending on what type of business you are revenues can either hurt you or harm you.I find that for upbeat of the startup revenues are very very helpful to show that.
Interestingly if you’re a consumer products company and you have revenues, in a perverse way that almost hurt your free money valuation because if you have revenues as a consumer product company that means that someone has to pay for your product and by virtue of some having to pay for your product, that might mean that your growth path is not going to be is accelerated because of course there’s the impediment for someone actually having reaching the wallet and pay for your product. so revenues are important but can vary based on what type of product your business is selling.
How Hot is Your Industry?
And then the last component that all say that goes into the art versus science of how you come up with your pre-money valuation is how hot your industry is. Every year we typically see certain industries that for better for worse become the flavor of the month in terms of industry that investors like to flock to. Recently in 2016, I’m seeing big data companies, analytics companies, oreven financial technology companies being really really hot sectors that have got fairly robust pre-money valuations, but that can change and I’m sure will be some new sector that is hot next year. so they can be whatever sector that you’re in this if investors perceive it as being a hot sector with more robust valuations, that’s going to beat to your benefit that when you’re having that negotiation discussion with preferred stock investors.
Why Entrepreneurs Focus on Pre-Money
One final point I’ll say about pre-money valuation because a lot of entrepreneurs really focus on pre-money and rightfully so. It’s an important conversation to have. It’s going to have a significant impact on how much pollution you suffers a founder early stage but a high pre-money valuation can be a blessing and a curse. Of course it’s a blessing because the higher the pre-money valuation, the lower percentage of your company that you’re giving away to investors at an early stage. It can also be curse, though because if you’re a company is able to earlier that’s probably have to raise additional financing the year 18 months 24 months from now.
If you started with a very high pre-money valuation perhaps you haven’t done as good a job as you anticipated in leveraging that early capital to grow the company, and now you have to raise new money at a very flat valuation, or, God forbid, at a lower valuation you did at your earlier stage/ that’s be a tough pill for you to swallow.
So if you think of the initial pre-money valuation as essentially being a benchmark or a threshold that you’re really focused on trying to surpass when your raising your next round of financing, you can see why perhaps artificially high pre-money valuation in an earlier stage could really be something that you have to contend with when you’re raising money down the road.