By Alan Lobock
Valuation is one of the top challenges for young companies and startups looking to raise capital, and it’s among the issues investors study the most when considering a potential investment. Presenting an unrealistic pre-money valuation (PMV) will adversely affect your chances to receive that much-needed infusion of capital to grow your business, ultimately leading to a negotiation that might not end in your favor.
To raise equity capital, a start-up needs a PMV, but most entrepreneurs don’t know how to calculate one that’s credible and defensible. Here are five matters to consider in a PMV discussion:
What is a PMV?
Your pre-money valuation, or PMV, is your company’s deemed value immediately prior to accepting new equity funding. If you are looking to sell a stake within your company in exchange for financing and you aren’t using a convertible instrument, you must know your PMV ahead of time. This will ultimately determine how much ownership you, your co-founders, and other existing members or shareholders will give to investors in exchange for their money.
Why is it so important?
As an entrepreneur, you will be asked how much you believe your venture is worth and how much ownership you are prepared to give up in exchange for the funds you are seeking? Set the value unrealistically high, and investors are likely to turn away from your opportunity because they wouldn’t be able to meet their expectations for the return on their investment or because they will perceive you as unreasonable and unknowledgeable. Set the value lower than you could command in the marketplace and you and other existing members or shareholders will end up with less ownership than you deserve, reducing the level of wealth you would accumulate should the venture be successful.
How do I calculate my PMV?
Many entrepreneurs and even some of today’s angel investors are not well versed when it comes to valuing early stage ventures. When discussing your PMV, make sure it is not only defensible, but be prepared for investors to test the validity of how you came up with the number. That said, there are options available to assist you.
One option is to hire a qualified consultant to come in, evaluate your venture, and provide you with a PMV. Unfortunately, this tends to be a costly alternative, often running as much as $10,000. Another option is using a spreadsheet that is available online at a low cost, but these tend to require hours upon hours to customize for your venture and most often employ the discounted cash flow method to determine the PMV. This is a method that most seasoned investors find inapplicable for valuing an early stage venture. A third option is to make use of a more sophisticated Web-based tool that will take your responses to a questionnaire and apply to them both a blend of those valuation methods angel investors most commonly use and valuation comparables derived from completed financings of companies at a similar stage of development and that operate in your company’s industry and geographic area. Such a tool would present you with the best of all worlds—saving you time and money while yielding a credible and defensible PMV that will withstand an angel investor’s scrutiny.
Are there any other factors that will affect my company’s value?
The factors to consider in deriving a credible PMV are numerous—quality and completeness of the management team, sustainable competitive advantages, product or service maturity and your go-to-market strategy are just a few. Prevailing market conditions will also play a factor in your venture’s PMV. Your best bet is to enter negotiations with prospective investors well prepared, meaning you can demonstrate a defensible, rigorous and reasonable thought process and methodology underlying the PMV you propose. If you can do that, then you can enter negotiations confident that your PMV is not likely to differ greatly from a prospective investor’s expectations, greatly improving your odds of securing your funding.
You’ve determined your PMV, now what?
Now, you need to prepare for your meetings with potential investors. Remember that the first rule of public speaking is to know your audience; the same applies to pitching investors. Learn to see your opportunity through an investor’s eyes and prepare your business plan and pitch deck with their needs and concerns in mind. Combine those documents with a defensible and credible PMV, and you’ll be well prepared and well received. Now get out there and pitch!
About the Author
Alan Lobock is the co-founder of Worthworm (www.worthworm.com). Having been on both sides of the start-up investment scene– seeking investment for his ventures and as an angel investor himself, Alan launched Worthworm to solve one of the biggest challenges young companies and their prospective investors face—how to compute a credible and defensible PMV for an early stage venture seeking angel investment. Prior to Worthworm, Alan co-founded SkyMall, the company whose shopping catalog is found in the seat-back pockets of most U.S. commercial aircraft. He served as the company’s CFO and EVP Marketing before pursuing numerous other entrepreneurial opportunities in which he participated in raising millions of dollars of angel and VC funding.