I observe at least once a month seminars being held entitled, “What is a company worth?” Not having attended such early stage discussions, I may be too critical since many of these programs throw classical financial models that only reveal a single vision of that evaluation. Technically, a company is worth whatever a third party is willing to pay for 100% of the company or for even one share. And, when the final objective is to find liquidity of the vested equity, those static models do not work. What should be adopted is a long term view of financing attached to growth.
However, I recently attended a high level investment technology conference which revealed that a) companies on the average retain 23%-24% of the equity after an IPO, and b) IPO levels have dropped to revenue lines around $40-$50 million. Wall Street and even “smart” money look at these numbers since everything on Wall Street analysis is all about matching an investment to comparables – comparing the potential investment against industry standards. So that implies that to reach those averages in the company’s financing, the company must grow, raise capital, and negotiate valuations for those capital raises so that the company falls within those averages. In other words, too little revenues and too low valuation early, it will not achieve an IPO. Too early revenues, and too much equity sold, it will also fail to attract the IPO market since it falls outside those boundaries. Therefore, valuation is a moving target with one final objective: an IPO or M&A. And that valuation has to be established from day 1 of the Company. The valuation is future based and flexible, but not static.
Now, I have been introduced to a company seeking $8 million as a Series B. In terms of IP, yes, it has a lot of interesting patents in its space. And, yes, it has a pipeline of upcoming sales with brand name clients that underscore the value of the IP. Its current revenues are less than $500k. Under any other scenario, this company could secure that financing. But it has a major hurdle: the company sold 40% of its common equity in return for $2 million. Why is that a valuation barrier? If the company attempts to reach an IPO, one subtracts 30% (the standard IPO historics comparable). That leaves only 30% left to raise additional capital. If the company sold 40% for $2 million, what would the additional financier demand for $8 million? Certainly at least 40%. That leaves 20% for the Company and the management team. In one fell swoop, the company has locked itself out of different options in raising capital. And no one can predict how many additional rounds of capital the company will need to reach even $50 million revenue stream. And this company is already running of common stock to sell for even Series B tranche.
Another scenario will be that the initial investor already owning 40% will seek to own 51%. Then the management team will be ousted. Then the whole idea of founding a company independently will fall apart. As I recall, that is what happened to the original founders of Cisco – they lost control when selling too much equity early. Another well-known natural cosmetics company sacrificed 50% for $500k in an early stage financing round. The founder, a woman, didn’t reach out to other advisors. Although the company did become successful in the long run, the other “partner” had to be bought out.
The company might claim that its current valuation is so high that it can stated that 15% of its shares are worth $8 million, but that would be increasing its valuation astronomically. And then consider the argument, that for $8 million, the company receives less than a third of the previous investor. Not a forceful argument. In fact, I addressed this same scenario to very experienced bankers in this space and they also foresaw the difficulties with this company’s financing problem. The valuation process should have been forward looking from inception, since potential follow-up rounds might be deterred. That might be a fatal mistake.
What this discussion suggests that long term strategic financing must be in place during the early stage of the company. The company must take into account during its negotiations what could be potential percentages for each tranche. Growth and financing intertwine.