Takes A Whack At Stubborn Valuation Question"
July 12, 2000
Matt Bolton says he's always asked this question when he sits on
a Venture Capital panel: "How is valuation determined?"
So Matt, what's the answer? When I asked him this question a couple
weeks ago he said, "Mike, the market will dictate the value. It
has a way of working itself out."
I thought about that for a couple weeks and decided I had no idea
what that meant.
So Matt, can you help me out? "The only way you can really determine
a valuation is to go through the process. And both parties must
remain flexible. I can tell you what some of the factors are - the
strength of the management team, market size and leadership, the
competition's obstacles to entry, potential return on investment.
"But it still can be a subjective process. It's not like putting
a value on a public company," Matt says.
Comparables can come into play, such as valuation determined in
similar deals. There can be back-and-forth negotiations.
"There hasn't been a huge discrepancy over valuation with the deals
we've done," Matt says. "A lot of it has to do with the partnership
that has been built during the due diligence process and how much
both sides are willing to work with each other.''
But both sides are trying to make the best deal possible for themselves,
right Matt? Doesn't a company have to watch out for someone taking
advantage of them?
"There can be that risk, but then it is a question of how do entrepreneurs
choose their investors. Entrepreneurs need to do their own due diligence
on potential investors just like we're evaluating their companies.
One of the jobs of a CEO is to do what is best for their shareholders.
"But to do it right you have to have realistic expectations about
valuation, be open and listen to what potential investors are saying.
Many people don't do that."
Qualified early-stage companies (first institutional round of financing)
with previously successful management teams could have values that
range between $2 million and $20 million with most being toward
the higher end of the range, Matt says. Investors tend to pay a
premium for “been there, done that" executives.
Matthew J. Bolton is an analyst with Woodside Fund, a leading early
stage venture capital fund who partners with visionary, passionate
and talented entrepreneurs in building innovative technology enterprises.
Founded in 1983, the firm has four funds with more than $200 million
Here is a glossary of terms you'll need to know before you make
your pitch to investors:
Woodside Fund will work with you to determine an appropriate valuation
for your company. It’s not something you have to figure out on your
own. Simply put, the value of a company is what drives the price
investors will pay for a piece of the action. The information used
to determine valuation comes out of the due diligence process, and
has to do with the strength of the management team, market potential,
the sustainable advantage of the product/service, and potential
financial returns. Another way to look at valuation is how much
money it will take to make the company a success. In the end, the
value of a company is the price at which a willing buyer and seller
can complete a transaction.
Ownership and valuation is typically calculated on a fully diluted
basis. This means that all securities, including preferred stock,
options and warrants, that can result in additional common shares,
are counted in determining the total amount of shares outstanding
for the purposes of determining ownership or valuation.
Type of Security
Investors typically receive convertible preferred stock in exchange
for making the investment in a new venture. This type of stock has
priority over common stock if the company is acquired or liquidated
and assets are distributed. The higher priority of the preferred
stock justifies a higher price, compared to the price paid by founders
for common stock. "Convertible" means that the shares may be exchanged
for a fixed number of common shares.
When the company is sold or liquidated, the preferred stockholders
will receive a certain fixed amount before any assets are distributed
to the common stockholders. A "participating preferred" stockholder
will not only receive the fixed amount, but will also share in any
additional amounts distributed to common stock.
Dividends are paid first to preferred stock, and then common stock.
This dividend may be cumulative – so that it accrues from year to
year until paid in full, or non-cumulative and discretionary.
Preferred stock may be redeemed or retired, either at the option
of the company or the investors, or on a mandatory basis, frequently
at some premium over the initial purchase price of the stock. One
reason venture firms want this right is due to the finite life of
each investment partnership managed by the firm.
Preferred stock may be converted into common stock at a certain
conversion price, generally whenever the stockholder chooses. Conversion
may also happen automatically in response to certain events, such
as when the company goes public.
The conversion price of the preferred stock is subject to adjustment
for certain diluting events, such as stock splits or stock dividends.
The conversion price is typically subject to "price protection,"
which is an adjustment based on future sales of stock at prices
below the conversion price. Price protection can take many forms.
One form is called "ratchet" protection, which lowers the conversion
price to the price at which any new stock is sold no matter the
number of shares. Another form is broad-based "weighted average"
protection, which adjusts the conversion price according to a formula
that incorporates the number of new shares being issued, and their
price. In many cases, a certain number of shares are exempted from
this protection to cover anticipated assurances to key employees,
consultants and directors.
Preferred stock has a number of votes equal to the number of shares
of common stock into which it is convertible. Preferred stock usually
has special voting rights, such as the right to elect one or more
of the company’s directors, or to approve certain types of corporate
actions, such as amending the articles of incorporation or creating
a new series of preferred stock.
Right of First Refusal
Holders of preferred stock typically have the right to purchase
additional shares when issued by the company, up to their current
aggregate ownership percentage.
Founders will often enter into a co-sale agreement with investors.
A co-sale right gives investors some protection against founders
selling their interest to a third party by giving investors the
right to sell part of their stock as part of such a sale.
Registration rights are generally given to preferred investors
as part of their investment. These rights provide investors liquidity
by allowing them to require the company to register their shares
for sale to the public - either as part of an offering already planned
by the company (called piggyback rights), or in a separate offering
initiated at the investors’ request (called demand rights).
Vesting on Founders’ Stock
A percentage of founders’ stock, which decreases over time, can
be purchased by the company at cost if a founder leaves the company.
This is a protection for the investors against founders leaving
the company after it gets funded.
To learn more about term sheets and valuation, you may want to
take a look at these books:
The Silicon Valley Way by Elton B. Sherwin
The Small Business Valuation Book by Lawrence W. Tuller
Guide to Business Valuations by Jay Fishman