Valuation and Fund-Raising - A Few Tips for Entrepreneurs

One of the most important and difficult questions facing privately-held companies – especially early-stage companies – is the issue of valuation.  What is my company worth?  Being able to answer this question accurately is key to securing investment capital on reasonable terms, and can become important in other ways as a business evolves.

In a sense, the only correct answer to the question of valuation is: whatever an investor will pay.  But there is no single, "correct" way to put a universally accepted value on a company, and the earlier stage the company is, the greater the range of uncertainty.  A company that appears worth $10 million to one intelligent investor might seem worth less than $1 million to another equally savvy individual or fund.

Companies with revenues and profits are generally valued as a multiple of profits, either current earnings or, in the case of rapidly growing companies, future earnings.  Earnings multiples generally range from 10 to 20, but an attractive, fast-growing company can sometimes get several times this.

Companies with revenues, but that are not yet profitable, are generally valued as a smaller multiple of revenues.  A general rule of thumb is that large, stable companies with small to moderate growth are worth about 1x revenues.  However, the ratio can vary considerably if the company is unusually valuable (or has an unusual lack of value) due to other factors, such as lots of intellectual property (on the plus side) or lots of debt (on the minus side).  Conservative evaluators will sometimes apply the 1x rule to VC-stage companies as well.  But most VC-stage firms with good prospects can command a higher multiple than 1x revenues.  Such firms can often raise capital based on a company valuation between 2 and 5 times either their most recent 12 months revenues, or their projected 12 months revenues for the current year.  Some companies can do much better than this.  During the "bubble era," some pre-profit high tech companies got valuations of 100x revenues.  Those days are long gone, but it’s still not unheard of for pre-profit companies to get valuations of 10-20x revenues.  But a majority of deals are probably done within the range of 1 to 5 times revenues.

Valuing pre-revenue companies (companies that have yet to generate significant sales revenues) is the most difficult proposition of all.  In such cases, the investment is purely a "future value" play.  In other words, the investor is looking some number of years down the road, usually about five, and asking, what will the revenue or earnings multiple be at that point in time, how fast will the company be growing, and what will be the likely valuation under those conditions?  Using a typical future valuation method, an investor will take its estimate of the company’s 5-year future value and discount it back to the present time, accounting for both the time-value of money and risk.  Usually, an internal rate of return (IRR) of about 40% is used to account for both these factors by VC firms making high-risk investments.  At an IRR of 40%, a company expected to be worth x dollars in five years will be worth about 1/3x today.  So if you can convince an investor that your company will triple in value in five years, you are one step closer to being able to get an investment.

For companies at all stages (pre-revenue through profitable), investors weigh numerous intangible factors along with their dollar/multiple calculations.  These factors include (in no particular order):

  • Experience of management and technical team
  • Intellectual property (patents, trade secrets, etc.)
  • Strategic partnerships
  • Prior investors
  • Competitive advantage/barriers to entry
  • Scalability of current production
  • Gross profit margin
  • Size of addressable market/total revenue potential
  • Track record (number of years in business, achievements)
  • Quality of corporate record-keeping
  • Credibility of financial projections
  • Risk
  • Other potential assets and liabilities

Following the above formula, a pre-revenue company that is extremely strong in most or all of these areas might be valued at 1/3 of what its models say the company might be worth in five years.  This would most likely apply to a company with prior investors, that had been in business for at least 3-5 years, with lots of patents, several working prototypes, and maybe even some pre-orders.  However, for very early stage companies, such as companies that are basically still in the "idea" stage, it can be harder to convince investors of the validity of 5-year financial projections.  With no track record, it can be very difficult to judge whether an entrepreneur’s 5-year projection is highly reliable or just a pipe dream.

For this reason, very early stage entrepreneurs can usually expect to give up a large percentage of their company for their first round of private capital, and will often find it difficult to raise more than a few million dollars.  There are always exceptions, such as in the case of entrepreneurs who have already built one or more successful companies.  But for an unproven entrepreneur, securing that first round of venture capital can be difficult and costly.  As a result, it often makes sense for start-up businesses to focus on securing government contracts or grants before attempting to raise capital.  Companies with products in the zero-emission transportation sector can often qualify for funding from government agencies that promote research into technologies that reduce emissions or improve energy efficiency.  Government agencies that operate large numbers of vehicles, such as the military and the postal service, are also good candidates to fund promising new transportation projects.

A second recourse is to seek money from "strategic partners" – companies in the same field that could have a strategic interest in seeing an entrepreneur’s proposed company or product succeed.  Strategic partners will often invest in early stage companies at terms that are more attractive to an entrepreneur than typical VC deal terms.

When it does come time to raise money from a venture capitalist, it is often better to ask for more money rather than less.  Put simply, some experts subscribe to the theory that an entrepreneur will give up half of his or her company for that first round of capital, no matter how large or small the investment.  If you subscribe to this theory, you may as well ask for a larger investment, since you will give up half your company anyway.  Another reason to seek a larger investment is that many investors won't look at a deal unless it's for at least $5-10M.  There's so much work involved in the due diligence for an investment, many major VC firms won't bother if investment is much smaller than this.  So by asking for more, an entrepreneur can actually broaden the range of investors who will consider the deal.  Other advantages of raising more, rather than less, include:

  • More cash on hand for unexpected expenses
  • More time before management has to focus attention on raising another round of capital
  • Legal and accounting expenses for each round can be significant, so the larger the round, the lower these costs are as a percentage of the amount raised

Of course, the counter-argument is that if an entrepreneur really believes the value of his or her company will rise tremendously before he or she needs the next round, and the entrepreneur can reduce the amount of equity given up by raising a smaller round today, then in this scenario it is sometimes better to make do with less today, and do another round at a much higher valuation in a year or two.  But when all is said and done, the number one factor influencing how much money an entrepreneur can raise – and the amount of stock he or she will have to give up to get it – is the ability of the entrepreneur to convince the investor that he or she has a convincing estimate of the company’s valuation.

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