Raising Capital Cookbook – Valuation Ain’t All That
Sometimes we focus on certain details at the expense of the big picture. For instance many entrepreneurs seeking venture funding focus solely on valuation as the key factor to choosing an investor. Valuation is just one of many factors that contributes to the division of the spoils upon an exit and it is important to understand the impact of all the factors.
There are multiple elements in a term sheet that can undermine the goal of exit monetization maximization. For instance some venture capital firms can actually add more value than others and added value may lead to a much larger pie in which a smaller slice would be beneficial.
As an example, take two different scenarios for a company raising $5 million dollars:
- Scenario 1: New VC with no history or apparent ability to add value offers your company $5 million dollars on a pre-money valuation of $5 million.
- Scenario 2: A Mega-VC with a history of high value-add including the ability to help recruit, deep ties into potential strategic partners and other important relationships offers $5 million on a pre-money valuation of $4 million dollars.
In this scenario the high value-add VC is offering a valuation that is 12% lower than the no value-add VC. Now a quick lesson in valuation. When a VC values a company at $5 million pre-money, that means before the company receives the investment they were worth $5 million. Flush with $5 million in cash the company is now worth their pre-money valuation of $5 million, plus the additional $5 million in cash translating to a post-money valuation of $10 million. Capiche?
In scenario 1, the company maintains 50% ownership and in scenario 2 they retain 44%. So why would anyone give up an extra 6% of their company for the same $5 million? Well it depends on the expected value of the value add. If the value-add contributes a 25% increase in exit value then an $80 million exit in scenario 1 would translate to a $100 million in scenario 2. In Scenario 1 the company would clear 50% of the $80 million or $40 million, $4 million dollars less than the $44 million they would receive in the exit from scenario 2.
This is a simplistic, yet effective view that illustrate the fact that a smaller slice of a larger pie maybe consistent with your goals. In upcoming editions of the Raising Capital Cookbook, we’ll look at other factors that effect exit maximization for the entrepreneur including participation, multiple classes of stock, liquidation preference, and the formation of the option pool.