By Andrew Maxwell
In my last blog I talked about how specific entrepreneurial characteristics are linked to venture success and to an entrepreneur’s ability to attract money. In this blog, I will try and explain another factor investors consider when making their investment decision – company valuation. It often surprises entrepreneurs that experienced investors can make rapid investment decisions with very limited information. This is because experienced investors develop simple routines (known as heuristics) that leverage their previous experience. The case of an entrepreneur’s valuation of their own company provides interesting insights for entrepreneurs seeking finance. It also shows the importance of the information exchanges between investor and entrepreneur and how specific actions and comments provide a rich data source that influence the investor’s decision.
Let us take a case where an entrepreneur decides to ask for $300,000 in return for 30% of their company. It is interesting to understand what an investor can tell from this about the venture and specifically the entrepreneur. In the first case, the investor will want to understand exactly why the entrepreneur needs $300,000. They will want to see that the money is being used wisely, that it will allow the entrepreneur to reach an important milestone in the venture and that it will allow the venture to progress to the point where it can either attract additional funds or revenues. Next, the investor will look to see that the company can not get away with raising less money at this stage (and therefore giving up less equity) or perhaps they may need to raise more money (despite the fact that they will have to surrender more equity). Importantly, the investor will also evaluate if equity is the best way to get this money, sometimes debt can be a more appropriate instrument (for example if you are buying a building or inventory then debt could be better).
The investor then looks at the amount of money required in the context of the whole venture. It is commonly assumed that an entrepreneur providing 30% of the companies equity for $300,000 values the company after investment at $1 million. This assumes that the valuation before the investment is $700,000 (known as the pre-money value). While this is a simplified approach, it is a good first approximation. The investor will then look at the entrepreneur and decide whether $700,000 is a reasonable pre-money valuation. If it is, then the investor will not only be interested, but also have confidence in the ability and judgment of the entrepreneur. If this value is much too high or too low, then the investor will not only be less likely to invest, they will doubt the competence of the entrepreneur.
Importantly, while there is a link between equity percentage and valuation, there is also a link between equity percentage and control of the venture. If the offer of 30% is related to the control of the company, then the investor will construe important information about the entrepreneur’s view of future investment rounds from the percentage offered. There are two reasons for this, in the first place, an investor working with an inexperienced entrepreneur might want to own 50% of the equity in order to control the venture in order to ensure that the entrepreneur does not make foolish mistakes. In the second place, if the company is on a high growth path, it will likely need to attract future funding. Giving up equity now can cause a problem, as there will be less to give up in the future. Alternatively, a willingness to surrender equity can be viewed as a positive sign that the entrepreneur recognizes the need to dilute their equity position in the long term (for example in companies making an Initial Public Offering founders typically have only 4% of the companies equity at that time).
As you can see, experienced investors can learn a good deal from a single piece of information, and we have not even discussed the effect of alternate equity mechanisms or syndicated investors. Understanding the importance of each of the signals provided by a single piece of information should encourage the entrepreneur to think carefully about the implications of their initial valuation.