Strong Fundamentals

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Valuing a business for fundraising

Nic Brisbourne

Managing Partner @ Forward Partners

Companies that are good at fundraising have a much better time than those that aren’t. They raise more at higher valuations, and spend less time doing it. If that doesn’t sound good enough already, consider the alternative - spending months getting knocked back by investors whilst you get increasingly desperate and your team starts to doubt whether your round will ever close.

Key takeaways:

  • Raising finance is a core capability for venture backed CEOs - get good at it

  • Understand your target VCs and how they might value your business

  • Test the market by proposing a valuation range

  • Consider the deal as a whole - preference structure, option pool and share price

Raising money is a complicated multi-stage process that successful entrepreneurs master from first contact (or earlier) right through to cash in the bank. Establishing a valuation is one of the most important steps along the way. Aim too high and investors will look the other way. Aim too low and you will leave money on the table, or worse, you will lose investors who think you lack ambition.

One strange fact about the fundraising process is that the more you raise, the higher the valuation tends to be. This seemingly illogical link between round size and share price comes because investors want to make sure founders retain enough equity to keep them motivated, even after multiple rounds of financing. As a result the market has settled on the convention that early rounds of investment typically result in ~20% dilution. Therefore, given the dilution is fixed, if the round size goes up, increasing the valuation is the only way to square the circle.

The first thing to do then is to work out how much money you want to raise. The short answer is that you should raise enough money to get you to your next valuation milestone and then have time left to go out and find the next round. For very early stage companies that’s usually 12-18 months. 18 months is more comfortable if you can do it. For a longer answer see this post by Mark Suster.

The second thing to do is to put yourself inside the mind of your target VC. If you can second guess how they would value your business then you can make sure the amount you are raising is consistent with the 10-25% dilution guideline and structure your pitch accordingly. As I wrote back in 2011 there are three ways that VCs value startups:

1. The right way for a VC to value a company

The right way for a VC to value a business is to estimate what it would fetch on a successful sale and then divide that figure by the return appropriate for the risk involved. So if the planned exit is for £100m and the investor is targeting a return of around 10x then the post-money value today would be £10m. If the investment was for £2m then the pre-money would be £8m (£10m-£2m) and the investor would get a 20% stake.

In practice it is slightly more complicated than this because adjustments need to be made for liquidation preference and dilution from further rounds.

A number of data points will be taken into consideration when forecasting the exit value:

  • Likely turnover and profits (losses) of the target company at the point of exit

  • Revenue and profit multiples that likely acquirers trade at

  • Multiples that other similar businesses have been acquired at

  • Track record of potential acquirers in making high value acquisitions

  • Strategic importance of the target company to potential acquirers

After projected exit value the next driver of the target valuation is the target return. There is very little science here and most VCs think of the risk inherent in a startup, and hence the required target return, in three bands – low risk = 3x return, medium risk = 5x return, and high risk = 10x return. At the early stages at which Forward Partners invests, all companies are high risk and therefore in the 10x band.

2. The rules of thumb

As noted above, one enduring rule of thumb is that an investment round should get around 10-25% of a company. When they hear how much a company is planning to raise the first reaction of many investors is to multiply the amount by four to ten and see if that feels like an appropriate post money valuation range for the business. If it does then the deal immediately feels like it is more likely to happen.

Do you see how circular this is? In a perfect market, valuation would be independent of the amount of cash being raised but in the real world the two are interdependent and entrepreneurs must balance the cash requirements of their business and the valuation needs of investors.

Other rules of thumb come and go over time depending on sector trends and market characteristics. At the time of writing (June 2017) a prevalent rule of thumb in the UK is that most angel investors don’t like valuations greater than £4m for seed rounds.

3. Market forces

In practice valuations are arrived at by VCs figuring out what they think is a fair valuation using the methodology and rules of thumb described above and then stretching them up or down depending on the prevailing market conditions and the competition for an individual deal.

If you are successful in making your deal competitive, or in creating that impression (and many great entrepreneurs excel at this) then VCs will often look again at their analysis and see if they can justify a higher valuation.  The most common route to justify a higher valuation is to look again at the exit valuation and work to build a stronger case for a larger exit.

Note that there’s no mention of Discounted Cashflow (DCF) analysis here. DCF requires projecting cashflows many years into the future and then estimating a ‘terminal value’ - which in the case of startups would be a presumed trade sale or IPO. The prospects of startups are very uncertain and the many assumptions this analysis requires can only be guess work. No matter how sophisticated the model: if the assumptions can’t be trusted you end up with the garbage in - garbage out problem.

Having developed a view on what the valuation of your business might be, the next step is to test the market. The best way of doing that is talk with investors. Ideally you will be doing this 2-3 months before you plan to start your fundraising process and you will also use the meetings to warm people up, determine interest in your company more generally and prioritise your list of investor targets.

To maximise the usefulness of the feedback it’s helpful to present investors with a wide valuation range. Rather than ask directly about the valuation it’s good practice to focus on the amount being raised and the target dilution. Because the amount raised and the dilution combine to determine the valuation, relatively small ranges of raise, size and dilution amount to a large range of valuations. For example, saying you are thinking of raising £2m-2.5m for 15-20% dilution is equivalent to saying you are thinking of raising at £8-14.1m pre-money, but sounds more credible because the ranges are tighter.

When you present the valuation range look for the body language clues as well as the straight up verbal response. Remember that most investors want to keep their options open so to give themselves the best chance of winning the deal they will be wary of talking down the valuation, so evaluate the feedback in that context. Also remember that the investor probably hasn’t yet worked out how much they like your company, which also makes it hard for them to know how high they would want to push the valuation. One way of getting round this obstacle is to pose the question about valuation hypothetically: “If you were to make us one of your investments this year, does this range feel right?”, and “Which end would you be at?”. You won’t get an answer from everyone, so be prepared to ask a few people.

Then once you have received feedback from a few investors you are ready to make a decision on how much you will raise and how you will approach the valuation issue in the formal fundraising process. Perhaps the most important question is whether to put forth a valuation or to ask your investor to price the round. There is no right answer. Here are a few of the issues to consider:

  • If you are raising from experienced investors ask them to price the round. You could maybe give them an indicative range, but if they go first you stand a better chance of getting to their best price.

  • When raising from angels it’s generally best to tell them the valuation of the round. They are often less experienced, will have less recent transaction data to help them, often don’t have much time to think about valuation, and generally don’t want the responsibility of setting a valuation that other angels have to follow.

  • If you want to close quickly, getting a number out there early will help

  • When a deal is hot it’s hard for investors to know how high they should push the valuation. Giving them a number can help nudge them higher.

Finally, remember that the effective valuation is a combination of the headline pre-money, any preference structure investors ask for, and any increase in the pre-money option pool. At the early stage it’s imperative not to get seduced by investors who offer a big headline price but then claw it back via structure or the option pool.

Nic Brisbourne

Managing Partner @ Forward Partners

Nic is Managing Partner at Forward Partners. He has 15 years experience in the venture capital industry and prior to founding Forward Partners in June 2013, was a Partner at leading venture capital firm DFJ Esprit. He has worked and invested in London and Silicon Valley, leading over 25 investments and enjoying a number of successful exits including (acquired by AOL for $125m) and Zeus Technology (acquired by Riverbed for $140m).

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