Two examples will shed some light: Let's say you are trying to raise $5 million for your technology outfit in a first round of financing. If you can convince VCs that the company is worth $10 million, then their $5 million investment will make the outfit worth $15 million. Since the $5 million investment would be equal to one-third of the postinvestment value, the VCs would feel entitled to a third of the stock. However, if the VCs decide your company is worth only $5 million, then their $5 million investment would make the company worth $10 million, and entitle the investors to half the stock -- a sizable difference.
There's another wrinkle to keep in mind as you go through this process: VCs will invariably demand preferred stock, which, as its name suggests, confers preferred status for certain key events -- things like dividends or a fire sale of the company's assets. This brings us back to the original question: Before they invest, how do VCs determine if a particular company is worth $5 million or $10 million?
GO FIGURE. The short answer: If you can convince VCs that your company's worth three years to five years down the road will allow them to exit -- either via an acquisition or a public offering -- with a compounded annual return of 50-60%, you will be able to negotiate a higher preinvestment valuation.
Returning to the example we started with, let's say the technology startup seeking that $5 million investment has current sales of $5 million annually and, while not losing money, has yet to turn a profit. The projections say that, in three years, it will have annual sales of $50 million and net income of $5 million.
The startup's executives document that similar, public companies are valued at twenty times net income, which would make the startup worth $100 million in three years. If VCs hold one-third of the company's stock, they would have realized a value of $33.3 million, well above a 50% annual compounded rate of return. On the face of it, this particular company should be able to raise the $5 million it seeks in exchange for one-third, or less, of its stock.
Of course, VCs won't necessarily accept your three-year revenue-and-profit projections. They'll imagine all the complications that could delay or prevent achieving those goals -- the prospect of intense and increasing competition, for example, or the possibility that market penetration will prove more difficult than anticipated.
NOT-SO-FRISKY BUSINESS. And here's another issue that will concern them: How they will cash out their holdings even if the business hits its projected numbers? More than any other, this issue helps to explain why VCs are paying less for larger percentages of companies than they were just a few years ago.
In the late 1990s, conditions were extraordinarily favorable for entrepreneurs seeking financing because VCs could see their way to extraordinary returns. Market conditions were such that startups might go public or be sold as little as six months after VCs invested. Delighted VCs didn't have to wait the customary three years to five years to realize their gains.
Today, VCs see a virtually nonexistent IPO market and a very sluggish one for acquisitions. Understandably, they fear having to hang on for much longer periods. What's more, that longer waiting period before cashing out raises the grim possibility that additional infusions of investment capital might be required to sustain further growth, something that will dilute the holdings of earlier investors. All of which makes it more difficult for companies to return 50%-plus compounded annually. That's one way to view the valuation question. Now, here's another: The bear market of the last three years is hitting businesses that aren't yet candidates to go public. Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.