From Pieter Welten – Prime Ventures (@pieterwelten)

Company valuation is quite challenging. There are many aspects of the business to look at, including ‘type’ of company, growth rate, market conditions, ‘quality’ of revenues, competitive positioning, profitability margins, market size, growth potential and so forth. Many of these ‘inputs’ for the valuation process are also difficult to quantify. This is in particularly the case for early-stage, fast-growing, cash burning start-ups.

 What is sometimes even more challenging, though, is to agree on a company valuation that satisfies both entrepreneur and investor. Unsurprisingly, entrepreneurs want to dilute as little as possible and investors want to acquire a significant stake in the company in exchange for their risky, equity investment as well as ‘advice / support’ going forward. As a result, entrepreneurs often seek the highest possible valuation, whereas investors go for a relatively low valuation (‘buy low, sell high’ is their mantra, isn’t it?).

In my opinion, both parties should always put in serious effort to understand and get sympathy for each other’s position in order to get to a ‘fair valuation’. A fair valuation is eventually in the best interest of an intended long relationship post-investment and hence the best interest of the company.

 Why is this the case? Post-investment a lot can happen. First of all, any business can be impacted by both internal and external factors, which will have an impact on (projected) growth and profitability. Secondly, valuation multiples can go up or down due to market forces of the industry / sector. Combined, any assumed exit valuation at the time of investment can be significantly affected. You should take an estimated exit valuation perhaps with a grain of salt, but to an investor it is important in order to get a rough idea whether an investment can deliver a required return.

 Obviously, when everything is going to plan (i.e. the company is growing according to plan and operates in a ‘hot’ market), plenty of shareholder value will be created and both entrepreneur and investor are happy. The value of their respective shareholdings (in whatever currency) will increase and a desired exit (return) is more likely to be achieved or, in case of a another funding round, an up round will be triggered. On the flip side, though, we all know that the vast majority of start-ups don’t live up to expectations. A hard and bleak truth is the fact that nine out of ten start-ups ‘fail’! As a result, it is more likely that a company will underperform and in such scenario clearly less shareholder value will be created. A depressed market (which could deliver lower (trading and acquisition) multiples) can further decelerate creation of shareholder value. 

 Lets have a look at two different scenarios: (i) a scenario in which a company grows nicely, but valuations go down and (ii) a scenario in which (due to whatever reason) performance is not as good as expected and therefore the market won’t price you at a similar multiple as in the past. In both scenarios the founder / CEO will have a 10% equity stake on a fully diluted basis.  

 SCENARIO 1: In this scenario the investor invests at a 10x revenue multiple, whereas its peers trade on average at a 4x revenue multiple. With a turnover of €5 million this translates into a pre-money valuation of €50 million (i.e. 10 x €5 million). The investor will acquire a 16.7% equity stake when it invests €10 million. Now lets assume that the company grows fast in three years time (i.e. 320%), but markets deteriorate and multiples go down. In such scenario, despite the growth, the company’s valuation only increases by 75% (assuming an exit multiple of 5x, significantly lower than an entry multiple of 10x). This would result in a 1.75x money multiple (‘MM’) on investment instead of a 3.5x MM. A nice return, but not great since the investors paid a relatively high entry multiple (i.e. 10x whereas the average was 4x). The high entry valuation (or multiple) eventually hits back when the company exits or raises another funding round at a lower multiple. Exit proceeds are lower for the investor or there will be more dilution by the Series X round.

SCENARIO 2: In this scenario everything is similar to the first scenario. However, in this scenario the company has grown revenues not as fast (i.e. 80% growth in three years time) as projected, but will still trigger a relatively ‘high’ exit multiple (i.e. a 6x instead of average industry multiples at 4x). As you can see in the table below, since growth has been disappointed and the exit multiple is below the entry multiple, the equity value of the investor has decreased by 10%! The investor’s stake is now worth €9 million instead of €10 million. Obviously the value of the shareholding of the entrepreneur will also be 10% lower. Assuming there are no liquidation preferences involved, the investor ‘loses’ €1 million, whereas the entrepreneur pockets €5.4 million.

However, in the second scenario, if the company intends to raise another round at a lower valuation (hence lower share price) it is likely that anti-dilution clauses will kick in, further diluting the entrepreneur. In such scenario the investor is often compensated. This would not have been the case if the entry multiple was not 10x but lets say 6x which is more in line with average trading multiples in the industry. A high entry valuation can, from that point of view, seriously hit back on the entrepreneur in the future when the company is not living up to expectations! Raising investment at a relatively high entry valuation is great for the entrepreneur, but not when things pan out differently..

 So, while there are a lot of nuances to both scenarios I won’t get into, in my opinion it is paramount to get to a reasonable or fair valuation. Obviously, other deal terms should also be reasonable or ‘entrepreneur friendly’. Relatively high entry valuations can come with high investor expectations and eventually hit back when the company is underperforming or markets turn south. A fair valuation gets the relationship between entrepreneur and investor off to a good start. It satisfies both parties’ interests and makes the relationship lasting. Nobody wants its marriage to land on the rocks, and don’t forget the following: it should be investor & entrepreneur versus the world, not investor versus entrepreneur!