Startup Valuation

This post covers entrepreneurial fund raising. Let’s review some of what we’ve discussed in recent weeks.

Review of Valuation

Angels of Brooklands cemeteryIn past articles, I explained that valuation was a number agreed to by the parties involved in a transaction. While quantitative tools are used to estimate, or justify, a range of values, the actual value used in the deal is determined much more subjectively than a first-time entrepreneur would like to believe.

As a starting point, I noted that valuation could be represented by the following equation:

Pre-financing value + investment = post-financing value.

Further, I cautioned that valuation was just one of many elements of an investment, and that it needed to be put in the context of the total deal. In particular, I said that the terms of preferred stock were material.

Review of preferred stock

Preferred stock is called preferred for a reason. It provides the investor with certain preferences, some of which directly affect the value of his investment under different circumstances.

Features of Preferred Stock

Preferred stock is materially different than common stock in many important respects. Some of the terms and characteristics of preferred stock can have significant consequences.

Liquidation
In the world of private equity, the definition of liquidation encompasses most transactions, other than an initial public offering (IPO), through which the investor seeks to “liquidate� his investment.

Liquidation Preference
One of the key features of preferred stock is that higher in the pecking order of who gets paid what and when in the event of a liquidation. Preferred stock shareholders receive distributions from liquidation before common stock shareholders.

Liquidation Amount
This is the amount of money the investor in preferred stock has a right to receive before the common stock shareholders receive anything. The dollar amount is defined in the term sheet. It often starts with the investment amount plus accrued, but unpaid dividends. Then some sort of multiplier is usually applied to that amount.

Participation
Originally, preferred stock was an ‘either-or’ proposition for the investor in the event of liquidation. The investor would calculate the liquidation amount, calculate the value of the common stock if converted, and pick the one that yielded the higher amount. This is called non-participating preferred stock.

The key feature of participating preferred is that the investor gets the liquidation amount first, AND then participates in the distributions on an as-converted basis.

Anti-dilution protection
If the company sells shares at some future date at a share price less than what the investor paid, the investor wants anti-dilution protection, either full-ratchet or weighted-average.

Control
To a large degree, control and percentage of ownership become separate issues in deals including preferred stock.

How preferred stock terms can affect valuation – a scenario

Let’s take a look at how all of this can play out.

The Original Investment
Let’s say an investor invests $1 million in your company at a pre-financing value of $1 million [50-50 ownership]. Let’s also say that the investment purchases Participating Convertible Preferred Stock with a 10% dividend rate and a liquidation amount multiple of two.

The Sale of The Company
Two years after he investment, the company has stalled for some reason, and it has never really gotten significant commercial traction and probably never will. An opportunity comes up for the company to be acquired for $5 million. While not a home run, everyone should be relatively happy. Right? Maybe not.

The Distribution of the Proceeds
After two years, the preferred stock purchase price plus accrued dividends has grown to $1.2 million. After applying the multiplier of two, the liquidation amount is $2.4 million, which the investor gets “off the top.� The remaining $2.6 million is divided pro rata with the as-converted shareholdings, or 50-50, meaning $1.3 million each. The investor has received $3.7 million and you get $1.3 million. Under these circumstances, what appeared to be a 50-50 deal at the outset became a 75-25 deal!

Advice to Entrepreneurs

  • Valuation is only meaningful in the context of the complete deal.
  • Preferred stock provides the investor with extra benefits and rights as compared to the common stock shareholders.
  • Understanding the arithmetic of deals is very important.
  • Surround yourself with professionals, mentors, and advisors who can help you level the playing field.

Next time we’ll begin to look at the role of angel investors and how you can attract them.

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By Frank Demmler adjunct professor of entrepreneurship at Carnegie Mellon

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