By Alan Lobock, co-founder, Worthworm
As an entrepreneur, you’ll face a bevy of challenges. Sometimes the list of challenges may feel never ending – from writing the business plan to finding the right partner – but one of the single most important challenges entrepreneurs face is calculating a realistic, defensible pre-money valuation.
What is a pre-money valuation and why should I care?
A pre-money valuation (or PMV) is the amount a company is valued at immediately before it receives investment. If you are seeking capital and you set your PMV unrealistically high, then you will dramatically reduce your chance of raising money; if you set it too low, you will end up owning less of your company than you could have. As an entrepreneur, every time you seek money in exchange for ownership, you will face the challenge of setting a reasonable and defensible PMV. The stakes will always be high—at one end of the spectrum you fail to raise the capital you need and at the other end you give up more ownership of your company than necessary to secure funds. With that much at stake, do your best to get it right.
How does my pre-money valuation affect negotiations with potential investors?
PMVs are important for both angel investment and venture capital pitches. When you go into a pitch, you’re given the opportunity to highlight the merits of your venture, to share expertise of your partners and to outline the competitive landscape. But negotiations will inevitably come down to the bottom line: how much is your venture worth, and how much ownership are you willing to give up in exchange for the investment?
Not only do you have to have your PMV in mind, but it has to be defensible. It’s not uncommon for potential investors to dig deeper into a PMV with questions like: How did you come up with this number? What did you take into consideration? What valuation methods did you use? Or worse, “Are you kidding me?” Further, investors are likely to do their own PMV analysis– and if your PMV differs drastically from theirs, you can bet conversations will come to a head in a hurry.
But how do I get my pre-money valuation? I’m an entrepreneur – not an accountant?
I was lucky to come from a financial background at Price Waterhouse (now PricewaterhouseCoopers) before starting my first venture, but the reality is that many entrepreneurs do not. Figuring out how to realistically calculate a PMV can feel like speaking another language.
That may be why many entrepreneurs, to their misfortune, often reject the analytical process altogether and simply come up with the amount of ownership they are willing to exchange for an investment, not even realizing that in doing so they establish the venture’s PMV. For example, in a brief discussion shortly after starting their company the co-founders decide they are willing to give up 10% ownership in exchange for $1 million. Unwittingly, they have just placed a $9 million PMV on a brand-new venture that has yet to build a prototype or secure any customer validation. Try defending that value to a seasoned investor.
Instead, entrepreneurs have a few options for setting a credible PMV that takes into account the myriad variables that affect how much a start-up or early stage company is worth. One option is to hire an external consultant who can come in, evaluate your venture, and provide you with a PMV, but that’s an expensive way to go. As an entrepreneur bootstrapping a venture, spending funds on consultants isn’t usually kind to your budget.
As part of a DIY approach, a second option is to use one of the many “spreadsheets” that exist, but these are of limited use since they typically employ only one valuation method (most angel investors recommend using a blend of valuation methods rather than just one) and are generic in nature. Going this route will require a significant investment of your time to modify the spreadsheet to fit your venture, and the chance of making errors is high. As an entrepreneur working 70- or 80-hour work weeks, spending time late at night wrangling single-method spreadsheets that will be lightly regarded may not be appealing.
Since neither of the first two methods typically serve the interests of either entrepreneurs or angel investors, my partner and I recently started developing a web-based tool that will collect an entrepreneur’s answers to more than 70 questions focused on the venture’s key value drivers and apply to them a blend of the valuation methods angel investors most commonly use while also factoring in valuation comparables. If you’d like to sign up to receive updates as we approach the release date for the tool, please visit www.worthworm.com.
What happens once I do come up with a PMV?
Well, then the real work begins. Assuming you also have created a comprehensive business plan and a brief, focused pitch deck, you’ll be ready to approach prospective investors. Armed with a credible and defensible PMV, you can be confident entering into negotiations with any one of them.
Alan Lobock is the co-founder of Worthworm. Having been on both sides of the start-up investment scene – seeking investment for his ventures and as an angel investor himself, Alan launched Worthworm to solve one of the biggest challenges young companies and their prospective investors face. Prior to Worthworm, Alan co-founded SkyMall, the company whose shopping catalog is found in the seat-back pockets of most U.S. commercial aircraft.