Startup Valuation on the Back of an Envelope

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Startup Valuation on the Back of an Envelope” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“Over the years, I’ve developed a deck of slides and some related spreadsheets walking through how venture investors think about valuing startups.

I’ve given the talk to dozens of audiences mostly consisting of entrepreneurs and angel investors. It usually takes about an hour. Recently, I was asked to cover the subject in about ten minutes. Honestly, my first thought was that it couldn’t be done.

But then, as most entrepreneurs discover early on, necessity proved the mother of invention. So, if you are looking for the basics – just the bottom line, actually – on startup valuation here it is.”

Click here to read more.

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Tumble in Start-up Valuations May Lead to More Down Rounds

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Tumble in Start-up Valuations May Lead to More Down Rounds,” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

The last couple of years have been pretty good for entrepreneurs seeking venture capital. Valuations have been going up, and financing terms have been loosening up. Something like 150 so-called “Unicorns” – VC-backed private companies valued at $1 billion and up – have débuted. Alas over the last couple of months a handful of those Unicorns have seen their valuations plummet well below $1 billion. Conventional wisdom tells us the age of the Donkey is nigh.

Click here to read more.

What to Say When an Investor Asks for your Start-up Valuation

By: Paul A. Jones

I have written several times suggesting that entrepreneurs not put price tags on their startups. For a variety of reasons (see most recently), entrepreneurs should postpone the valuation discussion until an investor capable of leading the financing steps up to the plate and suggests serious interest in doing the deal.

What if, as all too often happens, when less sophisticated investors are involved, an investor asks for a pre-money valuation in an initial presentation or even initial contact? Several thoughts.

First, figure either that the investor is not very sophisticated; and/or testing your sophistication; and/or trying to determine if your valuation demands are simply unrealistic or in any event beyond their investing criteria.

Second, factoring in the above possibilities, consider as well the context of the question. Is it in a private discussion, or a public forum? Is the question being asked by an investor you know to be a credible lead investor prospect, or by someone who is either an unknown or an unlikely lead investor?

With all of this in mind, consider the following kinds of answers to the premature “what valuation are you looking for?” question:

  1. “You know, that is something we can’t really figure out until we get a credible lead investor candidate at the table with a specific proposal.”
  2. “There are so many factors beyond the price of the deal: who the investor is, what value add they bring to the deal beyond money, other important deal terms; like dividend provisions, exit provisions and such, that factor into the discussion that it just isn’t possible to put a specific number on the valuation at this stage.”
  3. “At this point, there are so many variables that it is hard to pin down a specific number. What I can say is that we understand where the market is for sophisticated investors, and know that we will have to live within those constraints.”
  4. “When you are ready to show me the money, I’ll be ready to talk about the terms of the deal.” Ok, you should save this one for the right circumstances, but in those circumstances it can send a pretty good message to every good potential lead investor in the room and maybe beyond. A variation of this might be “We are open to  serious offers that leave enough on the table for the team, considering the immediate deal and the long-term financing plan.”

If these kinds of answers don’t suffice, the chances are the investor is unlikely to lead the deal, and probably not someone you would want to lead the deal at a reasonable price (they might want an inappropriately low price, or being willing to pay an inappropriately high price). In any event, the chances you want to give a prospective investor a fixed price (or even a range, as the investor will figure the bottom of the range is the actual price) on a first meeting are vanishingly small, because if you do you will have sent a signal to this investor and likely through this investor or anyone else in ear-shot to the investor community at large, that you are likely a bit naïve/inexperienced at the game (obviously not a good thing) and/or that you can ultimately be had for something less than the price you named. So, unless/until you have a credible lead investor ready to talk serious turkey, don’t tell them what the meal will cost them.

Thoughts on Convertible Debt Valuation Caps

By: Paul A. Jones

Convertible debt with an equity kicker, typically either in the form of warrant coverage or a discount on the conversion rice, is a common vehicle for seed stage financings.  As people on both sides of these deals have become more familiar with the convertible debt structure, a number of bells and whistles have begun popping up.  One twist is the notion of a cap on the conversion price of the debt.  As of today, valuation caps are included in most West Coast convertible debt deals, and are becoming more common in the Midwest.

While valuation caps may be here to stay, entrepreneurs and investors alike should understand when and how a valuation cap might negatively impact downstream financing.

First, it is probably worth asking why the “market” seems to be moving towards the regular use of valuation caps.  The answer is that the same market seems to have settled on an equity kicker in the 10%-30% range: that is, whether the kicker is in the form of warrant coverage or a discount on the conversion price the effective kicker in most convertible debt seed rounds is somewhere in the 10%-30% range.

Assuming a very common 20% for the kicker, what is the problem? Why, with a 20% kicker, should a seed investor also want a capped conversion price?  Two situations come to mind, the first understandable but ultimately not very persuasive, and the second understandable but somewhere out there in “what would you do if you won the lottery?” land.

In the first case seed investors use the valuation cap to try and end run the 10% to 30% market price for the convertible debt kicker.  And for good reason.  Be honest, here, Ms. Entrepreneur: capping a seed investor’s return at 10% to 30% from the seed round to the A round is pretty, well, parsimonious.  Considered in this context, the point of a valuation cap, from the investor’s perspective, is to juice the return.  The idea is to get a cap below the likely A round valuation, so that the cap will have the effect of juicing the kicker on the seed debt.

Assuming juicing the convertible debt kicker is the point of the cap, what is the problem?    Well, the same problem that would exist if in the alternative you just bumped the basic kicker from the 10%-30% range to say the 50%-100% range.  The extra juice would likely be too much added dilution for the A round investors to accept.  A round investors can generally live with seed kickers to the extent they, at least in terms of optics, don’t seem to undermine the fundamentals of the A round price.  But when a kicker starts changing the fundamentals of the deal – that is when the seed round is either too large (say more than 1/3 the size of the A round) or the kicker too big (say more than 30%) – the dilution from the seed round at conversion begins to look more than marginal and the A round investors will likely start pushing back.

The second, and I think much more convincing, rationale for a cap on the convertible debt conversion price is the “what if we win the lottery?” scenario.  Here, the point of the conversion price cap is to protect the investor if the A round price ends up being far beyond what either the seed investor or the entrepreneur might reasonably have expected when the seed round closed.  So, for example, consider the typical situation where a seed investor puts in $100k with a 20% kicker, on the assumption, shared by the investor and the entrepreneur, that if the deal goes well the A round will be priced at, say, $3-5 million pre-money.  What happens if, between the seed closing and the A round the entrepreneur catches a venture capital thermal and suddenly finds herself looking at an A round pre-money north of $15 million?  In this scenario, the point of the seed conversion price cap is to make sure that the benefits of the unexpected windfall are shared by the seed investor as well as the entrepreneur.  And I think, at least, that such sharing seems entirely appropriate.

That leaves one question.  What, in general, is a “fair” conversion price cap?  Given that the “good” rationale for a conversion price cap is to share an A round valuation windfall, the question becomes what constitutes an A round windfall.  I don’t know that there is a “right” answer to that question, but my sense is that it is twice what the seed investor and entrepreneur reasonably thought the upper end of the A round price range would be at the time of the seed round.  In the example in the prior paragraph, that would be $10 million.

The Perils of Diversification

By: Paul A. Jones

As anyone familiar with the conventional wisdom on investing in the stock market knows, the most fundamental rule of investing in stocks is to diversify your investments across a number of different stocks in different businesses. While there is some room for argument as to whether some small subset of investors can consistently beat the market over time, for the vast majority of investors following a diversification strategy to mimic the market’s overall return is pretty solid advice.

The diversification strategy can reduce risk within a business as well. While assembling a group of widely divergent businesses under one roof, the conglomerate approach, pioneered in the 1960s by Harold Geenen at ITT, is mostly frowned upon (with mutual funds, it is easy enough for investors to get this kind of diversification on their own). The idea of a large company diversifying its risk by investing its capital in multiple initiatives, be they product lines, technologies, business models, suppliers, etc., is something most larger companies do as a matter of routine.

Alas, while managing risk by diversifying capital investments makes sense for most large businesses, it makes no sense for high impact entrepreneurial businesses. There are a couple of reasons. First, as noted in earlier blogs, the venture capital and other high risk/reward investors who back these companies have a business model that is based on every deal having home run potential. These investors do their own diversification by diversifying their own investments across a portfolio of, in most cases, at least ten or so companies, each one of which needs to have a 10x return potential. Put differently, high risk/reward investors limit their investments to companies with high risk/reward profiles: by definition, they are not looking for individual portfolio companies to reduce their risk/reward profiles.

A second reason early stage high impact businesses are better off focusing their capital investments on a very narrow front, or another take on the first reason, is that venture and other high risk/reward capital is so scarce, which is to say expensive. That means that it is very hard to get: as any entrepreneur knows, cash is always scarce. As a practical matter there just isn’t enough of it around to fund multiple initiatives, even if there was enough talent around to do that, which, talent being so stretched at most early stage high impact businesses there seldom is.

This all may seem abstract, but in my experience investing in, starting/managing, and counseling high impact entrepreneurs, I have seen all too many of them look for ways to lower the risk of their business by investing in “fall back” business models in case the “home run” they are really after doesn’t pan out. For example, I recall a stem cell business a while back where the entrepreneur’s pitch included the idea that, “and if our therapeutic strategy doesn’t ultimately work we will have this business selling stem cells to other companies as a backstop.” It took several years for that entrepreneur to attract funding, several years being the time it took him to separate the two businesses (both of which ended up getting capital, from two very different kinds of investors).

So, if you are a high impact entrepreneur remember this: high risk/reward investors like venture capitalists want to see you focus virtually all of your limited resources, capital as well as human, on “the big one.” Like Cortez, they want you to hit the beach with everything you’ve got, and burn the ships on the beach so there is no temptation when things get dicey ashore, to think about plan B.

IRC 409A: Good Faith is Good, but not Good Enough

By: Paul A. Jones

From very early on, one of the distinguishing features of the Silicon Valley school of innovation was the notion that virtually every one on the team – from the receptionist at the front door to the founders in the corner office – should have a stake in the success of the venture. While founders and in some cases other very early employees often acquired their “sweat equity” in the form of common stock, most later employees got their “upside participation” in the form of options to purchase common stock – typically at a price substantially less than the price paid for shares of preferred stock by more or less contemporaneous venture capital or other sophisticated investors. How much less? Well, therein lies a tale; alas, an increasingly frightening tale in recent years.

By way of background, in the good old days of sweat equity pricing – say, before 2004 (more on that later) – the task was in principal more or less what it is today. The option exercise price was supposed to be set at the fair market value of the common stock on the date the option was granted. The “technical” problem of figuring out fair market value was as much ritual as science: the process typically culminated in a boilerplate board resolution that implied a timely, exhaustive, good faith effort by the board – that in reality was mostly driven by rules of thumb. Among those rules, the “common is worth 1/10th the preferred at the time of a first round venture financing” was one of the most popular. Life was more or less good for founders, employees and investors alike. As for the IRS, well, if you stuck to the rules of thumb and backed it up with the appropriate boilerplate, the IRS generally looked the other way.

And then came 2004, and Internal Revenue Code Section 409A, and the game was up. Valuation rules of thumb were out (bad enough) and the cost of getting it wrong went way up (much worse). Whereas in the good old days a board could be pretty confident that using a rule of thumb to set the valuation (albeit dressing it up in the board resolutions) would keep the IRS agents away, these days a board often does considerably more than that if it wants to sleep well at night, IRS-wise. First, because 409A essentially eliminated using rules of thumb to determine fair market value in favor of some very particular – in terms of factors to be considered in setting a valuation and who should do the considering and how often – guidelines. Second, because the cost of getting it wrong (in the old days mostly theoretical if occasionally somewhat problematic from an accounting perspective in an exit transaction) went up. Way up. For the employee, the company, and potentially even the individual members of the company’s board of directors.

Okay, first to the valuation question. 409A provides (in broad substance: this blog is a business heads up, not a comprehensive or even summary legal analysis) a specific list of factors that must be considered in making a valuation determination. It also provides specific criteria as to who can do the valuation analysis if you want the IRS to take it seriously. Alas, for most venture-backed companies the folks that qualify under the criteria are generally independent,  appropriately experienced, and expensive (say $5k to $50k depending on stage of development of the business and complexity of the capital structure) professional appraisers. Follow the rules (i.e. absorb the expense) and you can be reasonably (if not totally) certain that the IRS will find better ponds to fish in than yours. Don’t follow the rules, and ….

What can happen if you mess up a 409A valuation? It’s not pretty. Let’s take a hypothetical, and to make it both simple and less scary, let’s start with what happens if an employee is granted a vested option to purchase a single share of common stock at an exercise price of $1.00, and that the IRS later (say 12 months later) decides the fair market value was $3.00. Well, first the employee is on the hook for not paying federal and state taxes on the $2.00 difference between the option exercise price of $1.00 and the IRS determined fair market value of $3.00. Oh, and on top of that a 20% penalty tax and likely interest. And in some states, like California, an additional 20% penalty. And the company – and if the company can’t come up with the money, the various directors of the company personally – are on the hook for the unwithheld withholding taxes on the $2.00 – over and above the cost of redoing the accounting books to reflect the added compensation expense. Ugly, indeed.

And, of course, it gets worse. Because in most cases stock options vest over time; that is, an award of say 1,000 option shares might vest over four years. At each vesting date, figure out the difference between the exercise price and the then fair market value and repeat the calculation for the shares that vested. Even uglier.

So it looks like directors of venture backed companies that want to sleep well at night need to comply with 409A, such compliance most likely to include spending scarce corporate cash resources on periodic (at least every 12 months, and in many cases more often than that) professional appraisals of their common stock. Among the prices we pay, I guess, for living in a post-Sarbanes-Oxley world.

An important footnote. Some entrepreneurs and investors take the view that the fair market value exercise price problem posed by 409A can be avoided by simply setting the option exercise price at least equal to the then preferred price. That’s true, if perhaps too clever. If you live someplace where likely employees don’t understand the value of having an option exercise price below the current investor preferred price, well, good for you (not really, but that is another story). Except that if you ever find yourself needing to bring on board a key player who does understand the difference you are going to have a problem figuring out how to explain to everyone else why their options are priced higher than the new guy’s.

Convertible Debt Financing: Thoughts on the Default Conversion Price

By: Paul A. Jones

Convertible debt financing structures, with or without equity kickers, are a popular choice for many seed stage entrepreneurs and investors.  (Disclaimer: this blog is about first money in seed investments, and not about the many other situations where convertible debt structures can be profitably employed.) The ability to punt on the contentious and often problematic valuation issue until some combination of greater opportunity visibility and/or attracting larger post-seed investors to the table can be very attractive to the entrepreneur and seed investor alike. However, while the concept is based on the notion that a valuation will ultimately be established in the context of a future, larger round of equity financing, what happens if no such round ever takes place? Presumably, the seed investor will want to have the option to convert at some valuation (to participate in the upside) – without being obligated to convert to equity at any valuation (to protect on the downside). It thus seems that while convertible debt financing makes the valuation issue at the seed stage less contentious than it might otherwise be, it doesn’t completely remove valuation from the negotiating table. The entrepreneur and seed investor will still have to agree on a default conversion valuation if the anticipated post-seed “conversion trigger” financing doesn’t, for whatever reason, happen.

Before talking about the default conversion valuation, let’s consider when it comes into play. A typical seed convertible debt financing anticipates that there will be a larger downstream “conversion trigger” financing, with the valuation in that financing serving as well as the valuation for conversion of the seed debt. Usually, entrepreneur and seed investor alike put a lot of thought into how big the future finding has to be to trigger conversion of the debt. While each party may have its own ideas on what the trigger valuation needs to be, those ideas are more often than not relatively easy to bridge. Both sides will want a trigger financing to be big enough (particularly if there is an equity kicker associated with the convertible debt) to assure that the “convertible tale does not wag the trigger investment dog” so to speak. And both parties will presumably have some more or less similar ideas on at least the minimum amount of next round capital the business will need to get to the round after that (or exit, if you are an incurable optimist).

But there is a more subtle piece of the trigger financing question. How long does the company have to pull it off? Put differently, besides defining the amount of capital that must be raised to trigger conversion of the seed convertible debt, you also have to set an outside time limit on that financing: a time after which, if no trigger financings has occurred, the seed convertible debt will have the option to convert at the default conversion valuation. On that score, sooner is better for the seed investor and later is better for the entrepreneur – but at the end of the day, the entrepreneur should not rush into a short fuse no matter how certain she is that the trigger financing will happen sooner rather than later. In my experience, most seed investors will accept a 12-18 month time frame for the trigger financing, and, well, the longer the better.

Finally, we get to the heart of this blog. Given that higher is always better for the entrepreneur, and lower is always better for the seed investor, how should the parties approach setting the default conversion valuation?

Let me cut to the chase and then circle back on the rationale. In my experience, a good default conversion valuation is one that will, if the seed investor decides to convert at that time/price, result in a fully-diluted ownership stake in the 10-20% range. If that sounds arbitrary, well, it is. But capricious it is not. Here’s why.

Lets start by predicting the future of the entrepreneur’s business, focusing on just those futures that are most likely if you assume that no conversion trigger financing ever takes place. It seems to me that the vast majority of such futures will fall into one of two buckets. Either the business the business tanked without ever getting additional financing, or the business took off without needing additional financing, or. In the later case, the seed investor will not want to convert, it being all but certain that remaining in their creditor position will maximize the amount, if any, of their investment that is recoverable. And this should be fine with the entrepreneur (who, of course, was wise enough not to sign any personal guarantees (which, if you think about it, makes sense – but that is a digression).

So what about the case where the business became wildly successful, without ever needing to raise additional equity capital? Shouldn’t, in that case, the entrepreneur fairly expect a very high valuation for the conversion of the seed debt?

In theory, yes, but lets look at the practicalities of the assumed outcome. The entrepreneur will, in my 10-20% dilution scenario, find themselves with 80-90% ownership of a business that, short of an exit transaction (or perhaps bank or other non-dilutive financing), by definition does not need additional equity capital. Sure, at a higher default conversion valuation, they would own an even bigger piece of the pie. But at some point, shouldn’t the entrepreneur ask herself something like the following question: “Just how rich does the seed investor have to make me before I will be satisfied – given that the seed investor’s money is what got me all the way home, and that my expectation going into the seed round was that there would ultimately be a lot more than 10-20% dilution before we got home?”

Now, every situation is different, and there are situations where my 10-20% default conversion rule of thumb may not be the “right” answer (whatever that is). But it does seem to me that an entrepreneur who hits a home run so much faster, and with so much less risk capital than even she thought possible, well, she ought to be able to share a little of her good fortune with the seed investor who made it possible.