Professor Raiton’s Inside Perspectives: Entrepreneurship, Creativity, Innovation

From The Startup Lawyer

When your startup company raises capital, valuation is a key question that must be tackled Rey Maualuga style. (If you are unfamiliar with “Rey Maualuga style,” click here for a Youtube example.) The two main valuation concepts in a venture capital financing are pre-money and post-money valuation.

In a venture capital transaction, the venture capital firm invests cash in the startup company in exchange for newly-issued (preferred) stock. The startup company’s value immediately before the funding is called “pre-money valuation” while the startup company’s value immediately after the transaction is called “post-money valuation.” (Technically, pre-money and post-money are more about price than a startup company’s valuation.)

Pre-money Valuation and Post-money Valuation Equations

(1) Pre-money Valuation = Post-money valuation - Venture Capital Investment

(2) Post-money Valuation = Venture Capital Investment/Venture Capital Ownership Percentage

You can determine share price by the following equation:

(3) Share Price = Pre-money Valuation/Number of Pre-money shares.

You can determine how many shares to issue the venture capital firm by this equation:

(4) New Shares Issued = Venture Capital Investment/Share Price

Pre-money Valuation and Post-money Valuation Examples

Example 1

Let’s say Google’s new venture fund comes to you and offers to invest $3MM into your startup for 30% of the company. Plugging the numbers into equation (2), we get:

Post-money valuation = $3MM/.30 = $10MM

Thus, to calculate pre-money valuation, we use equation (1) as we now know the post-money valuation and the investment amount:

Pre-money valuation = $10MM - $3MM = $7MM

Example 2

Now let’s say a venture capital firm offers your startup company a $4MM investment at a $6MM pre-money. To determine how much your startup would give up in exchange for the $4MM, we use equation (1) and get:

$6MM = Post-money valuation - $4MM, and solving for Post-money valuation (Post-money = Pre-money + Investment) gives us $10MM

Next, we use equation (2) to find the Venture Capital firm’s percentage:

$10MM = $4MM/Venture Capital Firm Ownership Percentage (VCFOP), solving for VCFOP (VCFOP = $4MM/$10MM) we get 40%.

• The Basics of Convertible Debt Financing
• Don’t Hate On Your VC For Exercising Anti-Dilution Provisions
• The Startup Lawyer 2008 Recap
• I Got a Term Sheet, Now What?
• Virgin Money Goes to Waste

From Get Venture by Mark Davis

The average company exiting through a public offering is more mature than a company that exits through an acquisition, at least since 2000.

There is good reason for this extra maturation. Public investors are often seeking to buy shares in companies that will continue to operate independently long into the future. In contrast, corporate acquirers may buy companies when they are very young before the company has demonstrated its ability to sustain itself. There are a variety of reasons why a company might be bought without demonstrating financial sustainability; a fledgling company might be acquired for its assets (technology, customer, contracts or management) or it may be acquired as a defensive maneuver – to eliminate the opportunity for the company to become a long-term threat.

It could also be argued that Sarbanes-Oxley legislation, which requires additional internal process documentation and oversight by public companies traded on U.S. exchanges, has delayed public offerings. Companies must ensure they will be compliant with Sarbanes-Oxley regulations, and that they can afford to pay the associated costs, before they can issue public stock for the first time.

From the period of 1996 to 2008, the average company that IPO’d was 8 months older than the average company to be acquired. It’s worth noting that this pattern didn’t hold true during the Internet boom. In the period of 1996 to 1999, the average software company making its initial public offering was five months younger than the average company being acquired (according to Dow Jones Venture One data).

The general trend of IPOs taking longer to realize than acquisition also puts pressure on investors to push for larger exit values. VCs are judged by their investors based upon a number of metrics, one of which is call the Internal Rate of Return (IRR). An IRR is an accurate way of measuring the average annual rate of return on invested capital adjusted for the timing of cash flows. A simple relationship that comes from this math is the fact that longer times to exit reduce the effective annual return. Returning 200% of invested dollars in 1 year implies a higher average annual increase in value than returning 200% of invested dollars in 10 years. As a result, the delay in exit time drives VCs to require higher exit values to adjust for the delay. While in theory the increase in value can be justified by the company’s ability to expand its operations and increase revenues over that period, every exit is ultimately a negotiation and this delay drives VCs to target higher exit values.

From Get Venture by Mark Davis

IPO or initial public offering is another of the four types of exits. In an initial public offering, a company first sells a portion of it shares in a public market, such as the NY Stock Exchange or the NASDAQ.

By “going public,” a company sells a portion of its stock to investors that are entitled to freely sell their shares over the specified exchange. Through the exchange, they can sell directly or indirectly to virtually any buyer in the world.

It’s worth noting that not all of the company’s stock is publicly accessible at the IPO. Companies typically sell only a portion of the company to investors through the public exchanges.

What makes IPOs so special is that subsequent public offerings are less risky for the company as they have more information about the stock’s pricing once shares are being freely traded and priced by the market. During the IPO, the company’s investment bankers are tasked with creating a small marketplace and identifying clearing prices for the initial shares. After those shares are sold, the buyers can transact them freely, yielding prices that reflect the valuation applied by more buyers and sellers, creating a price that is truly reflective of the market’s estimate of the company’s value.

VCs, entrepreneurs and others often participate in the public offering, meaning that they include their shares in the group that is sold to the market. This enables VCs to exit at least a part of their investment – shares are converted into cash which can be distributed to their limited partners.

VCs generally like exiting through IPOs. While IPOs present investors with some liquidity risk, as insiders are often subjected to lock-up periods during which the investors and entrepreneurs cannot sell their shares on the market immediately after the IPO, IPOs offer VCs several advantages. First, public companies remain going concerns, enabling VCs to take credit for investments that they made (potentially) long into the future. An IPO not only offers a VC a merit badge that can be promoted to entrepreneurs and limited partners, but it also enables the VC to leverage its contacts at the newly public company to help future portfolio companies in many ways (from acquiring customers and partners to initiating acquisitions).

Many stories have been written about the huge number of initial public offerings that got pulled in the second half of 2008. The markets were cruelly volatile and investors were stuffing money under their mattresses, making the prospect of selling new shares highly unattractive.

But going into 2009, there are dozens of stock sales stuck in a kind of I.P.O. limbo, not having been withdrawn but also unlikely to proceed until global markets stop convulsing.

A week before the end of 2008, there were 124 United States companies with initial offerings in the “pipeline,” valued at a combined $25.7 billion, according to Thomson Reuters.

(Read More)

Dr. Brian Druker found a way to defeat a rare leukemia. The result was the miracle drug Gleevec. Now, Druker hopes to build on his success

By John Carey, BusinessWeek 

For Dr. Brian Druker, innovation requires putting up with grueling work hours and taking some big risks. “In science, most things are not very likely to work,” explains the tall, slim researcher. “But there are some that would be so incredible that you have to take a leap of faith and give them a try.”

That certainly describes Druker’s own crowning achievement, the revolutionary drug Gleevec, now a $3.6 billion per year blockbuster. Druker didn’t actually invent the drug, but it would never have made it to the market — and to patients — without him. An advance like Gleevec “only comes along once in 10 lifetimes,” says cancer center consultant Dr. Joseph Simone. “The way Brian stuck with it when people said it was a blind alley and got it into clinical testing was amazing.”

(Read More/View the Video)

From The Startup Lawyer by Ryan Roberts

Selecting the optimal structure when raising capital for your startup can be a challenging task. When clients ask me for my recommendation, I find myself recommending the convertible debt financing route more often than traditional equity financing (i.e., I’ll give you $100k for 20% of your company’s stock).

So what is convertible debt?

Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date.

When does convertible debt convert to equity?

Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).

How does convertible debt convert to equity?

Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)

So why do I recommend convertible debt so much?

Simple: It delays the valuation discussion. I see many founders struggle with their investors over a valuation to do a straight up cash-for-shares equity investment. And this struggle can last for months and eat up development time.

From Altgate blog 

A while ago I wrote about how a liquidation preference works and I’ve noticed that this has quickly become one of the most popular posts on Altgate and a top-10 result in the Google search for that term.  Well, I guess it’s a sign of the time.

This week I’ve spoken with two startup CEO friends who have raised inside rounds and got clobbered with a 3x participating liquidation preference.  I called up a couple of attorney friends and a couple of VCs to see if this was in fact becoming “normal” and everyone said “ya, pretty much.”  From what I can tell the increase in the cost of capital for startups is partly to do with projections being revised down, but also (maybe even more so) because of a big mismatch in supply and demand for capital.  Even companies that have countercyclical businesses are finding cash more expensive.

Let’s recap how expensive a 3x liquidation preference really is.  Say you raise $8MM at $17MM pre-money ($25MM post) with a 3x participating preferred.  Further assume that that money lasts you 2 years until you sell the company for $50MM to Microogle which would certainly be a “happy” ending all things considered.  In that scenario your last round investors will get $24MM of that sale off the top (3x their $8MM investment).  Then your other preferred investors will get their preference (let’s assume they have $12MM at 1x invested in two rounds at a $17MM post-money valuation which would make the “current” round flat).  When you throw in the $5MM of dividends that have accrued on the preferred, then Common shareholders will get approximately ZERO from this sale for $50MM.  If the sale price goes up to $75MM, Common gets to split about $5MM in proceeds.  Yippee.

In reality, what happens is the board will negotiate a carve out for then-current management if an opportunity to sell comes along or a refresh if an exit is still far off.  But non-management employees and founders will be thrown table scraps and crushed down.  You could probably find some pawn shops that offer cash more cheaply.

What’s the alternative?  The only potential alternative is crazy cuts to your expenses that allow you to survive.  What’s crazy?  Could be you need to consider cutting back to just a couple people and then reboot to have any hope of retaining founder economics. 

From Basil Peters - AngelBlog - Best Practices for Angel Investors and Entrepreneurs by Basil Peters

The most important new data on angel investing comes from Robert Wiltbank of Willamette University and Warren Boeker of the University of Washington.

Robert Wiltbank is one of the world’s pre-eminent researchers on angel and VC investment.

One of the fascinating aspects of this research is how VC investors affect the exits of angel-backed companies.

When I first saw this data, it leapt off the page at me 

This graph shows what the greybeard VCs and angels have known for a while. If your company has VC investors, they will reduce the probabilities of an exit that would produce a 1-5x return for the angels. That exit might have produced a 100x return for the entrepreneurs (because they paid much less than the angels for their shares).

Having VC investors does increase the probabilities of exits above a 5x return.

But there is no free lunch. The data shows that after a VC invests your chances of failing completely also increase significantly.

The other important factor, which unfortunately this data doesn’t show, is that adding VC investors will also increase the time until a successful exit by about a decade.

This is an important message in my new book: “Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs“.

From YoungEntrepreneur.com Blog

12) Customers Repeat For Three Years Or More

The main reason why most businesses fail is that they run out of cash. You can run a profitable business but because people take too long to pay you, the business shuts down. When you’re in startup mode, cash is king!

Venture capitalists like to see that you have a way to make ongoing revenues from your existing customers. Once you sell a client do you have to go out and few new business or can you continue making money every month / year from them? If you can build a recurring revenue model from your products or services it will help put your company on solid financial grounds as well as help you secure VC funding.

13) Easy To See $20 Million In Three Years

VCs like to see companies grow quickly. If you get venture capital funding, where do you see your company in three years? If you’re not around the $20 million in sales mark then you might want to consider changing your business model or looking at a different source of funding (friends, family, angels, etc). You have to have a plan to get there in three years and be confident that you can achieve the goals you set out.

14) Significant Barriers To Entry

What is in place to prevent other companies from copying what you’re doing? Assuming that your product takes off and is the next iPod, what measures are in place to make sure that people can’t come along and offer the exact same offering as you. Do you have patents in place? Do you have exclusive agreements with suppliers? Have you tied your customers into long term contracts? Showing VCs that you’ve thought about how to protect your business from competition will show your sophistication and increase the chances of landing the money investment.

From The Latest From VC Ratings

No real surprises here, but a new National Venture Capital Association survey out Wednesday reports that next year is going to stink for VCs and venture-backed startups.

The poll, culled from 400 VCs between Nov. 24 and Dec. 12, found that 92% of venture capitalists predict a slowdown in investing next year. Most said the investment level in 2009 will decline below $27 billion (for this year, that figure is predicted to be between $28 billion and $29 billion).

In another nonsurprise, clean technology was viewed by the highest percentage of respondents as the sector that would grow next year. The strongest negative sentiment was aimed at the beleaguered chip industry. Seventy-nine percent of respondents said investments would decline in that capital-intensive sector.

More results:

• Almost all respondents predict that fewer VC firms will be able to raise money in 2009, and 85% said institutional investors will commit less money to this asset class.
• 18% of VCs see the IPO market opening in the fourth quarter of next year.
• 81% said the economy will stay the same or worsen next year. Only 15% predicted the Dow Jones Index would top 10,000.

See NVCA survey results