Before the advent of Internet-related businesses creating exponential growth curves that defied all logic and experience, certain basic premises existed to allow for a somewhat scientific assessment of a start-up company’s value.
Investors understood the rate of return that was expected on their equity – 30% to 40% annually on a compounded basis was common – and the entrepreneur could create a set of projections that indicated that the sought-after return was achievable within the targeted time frame of the investors.
It has been difficult to benchmark the value of Internet-related businesses on those tried and true methods. The cost structure and growth patterns of Internet businesses do not conform to historical models.
Take the example of a start-up in the field of wireless communications. The company consists of an Ivy League computer science professor (the founder) with a keen understanding of the architecture required to minimize the size of a computer’s hardware. Along with a graduate student or two, the founder has created a working prototype of a hand-held computer that fits into a jacket pocket, yet has a screen with the resolution of a standard personal computer. The founder believes that he has a winning application if he can get to market before the major players in the field come out with a competitive model, but he has never created a company, has no capital and may never have even received a paycheck for a day’s labor in the real world. His projections indicate that the first stage of development will require an investment of $10 million. Spending the $10 million will allow the company to refine its technology from the theoretical to the point where the working prototype can be mass produced. It may only be at that stage that it is possible to forecast with any accuracy the cost of manufacturing and its price to consumers.
Unlike most businesses where value is based on a blend of historical performance and projected earnings, the assessment of value in a start-up begins with the cost required to get to the next stage of development. In the example of the wireless company noted above, the projected cost to reach a revenue stage is $10 million. Without spending that amount of money, there is no point in spending any money at all. Once the revenue stage is achieved, and the cost and price structure in the marketplace are clearer, it may be possible to create projections that allow for a valuation based on a multiple of projected earnings.
In the wireless venture, the investors know that under any logical assessment of value, they should have 100% of the value of the enterprise, and the founder should transfer his rights to the product in exchange for an employment contract at most. Yet experience shows the founder usually retains at least 50% of the nominal equity in this type of situation and the investors will allow their money to be used for a year or more before they start to assess whether they have made a wise choice in hitching their wagon to this would-be entrepreneur. This result is achieved through the interplay of a number of emotional factors.
First of all, at this early stage, the founder often has a powerful attachment to his project and is unwilling to part with a greater degree of control or potential wealth.
Second, despite the recent retrenchment in the high-tech sector, there remains a sizable flow of funds seeking to cash in on the phenomenal success of technology ventures over the last 10 years. Some of those funds are inherently “throw-away” dollars – money that exists because of the inflation of the stock markets over the past decade. Investors do not like to lose “throw-away” dollars, but they do not have the same sense of attachment to them that they might to funds that are required for daily living and expenses.
The investor community continues to require new investment outlets for those funds. While it may seem counter-intuitive, the money cannot just sit around uninvested in a mattress. As long as the alternative options, such as Old Economy stocks or bonds, yield anemic returns, the money will seek out higher yielding investments and as a consequence the founder will have leverage in his negotiations with the venture capitalists.
There is also a slight of hand at work in these negotiations. The VCs recognize that value within an enterprise shifts over time. A wireless concept that may be valued very highly in the first round of financing given its embryonic stage of development, allowing the founder to retain a majority interest in the equity, actually usually falls in value relative to the value of money as it progresses from concept to reality. This phenomenon holds true even in highly successful ventures.
In the example of the wireless venture concept, if the founder is able to obtain his financing, the capital structure post-financing might look as follows. The parties agree on a pre-money valuation of the company of $20 million based solely on the perceived needs of the enterprise for cash and the desire of the parties to retain a certain degree of ownership. Based on that enterprise valuation, the investors commit to make a $10 million injection, but only advance $5 million at the outset based on their desire to see some progress on the venture before advancing the full commitment.
In return for their investment, the investors receive a “double dipping” Series A Preferred equity instrument that allows them to get all of their money back, plus a yield of 10% per annum compounded. In addition, the preferred equity converts into 30% of the common equity (16.5% of the common equity if the investors do not advance the second $5 million tranche). The founder has retained two thirds of the common equity, valued in accordance with his assessment at $20 million and probably gives away a good portion of that to the two graduate students. The founder is also required by the investors to create an equity pool to attract good management talent and that pool will likely come out of his side of the pie as well.
At the end of the day, our founder may have retained only a bare 50% of his company, but of course he now has money to work with, so he may not be at all unhappy.
In practice, all that has changed is that the investors have made a bet of $5 million on the wireless concept and on the founder, and the founder has thrown his lot in with an investor group that may or may not be able or willing to finance his next required round.
Nine months later, when the first $5 million has been spent, and the technology has begun to prove itself but the enterprise is experiencing cash constraints, the parties will reconvene to make a new assessment of value. At this stage, the investors normally assume the upper hand because the rights that they have obtained in the first financing round preclude a free market for the founder to take his concept elsewhere. The founder will have transferred his concept to the company and will have entered into a non-competition agreement and a non-disclosure agreement that prevent him from taking up employment elsewhere. He will also likely have developed a team that works with him to whom he has emotional ties. As a consequence, his negotiating leverage may actually be weaker even though he has now proven out his concept’s basic viability.
The value of the enterprise at the initial round of investment was based as much as anything else on the costs required to be invested into the enterprise to determine its viability. By the time of the second round, the investors, now armed with cold-hearted calculators, will have had a better look at the technology and will have begun to formulate a real-time value for the concept based on their perception of its probable market.
Where once it seemed as if the sky was the limit, there may now be very real limitations to the viability of the technology. The early-round investors may already be maneuvering to create an exit strategy, through a sale of the company or a merger with a competitor.
In the second round of negotiations, which may take place either before or after the second $5 million tranche has been invested, depending on whether the benchmarks of the original financing have been achieved, the investors may value the company at a higher level, at $40 million or even $100 million, but the growth in the overall company value is unlikely to be reflected fully in the value of the founder’s shares.
If the value of the enterprise has doubled, from $30 million to $60 million, the portion of that value attributable to the founder may be reduced to 30% or less. Thus, in a capitalization chart for the second round of financing, the first round investors will retain their preferred status while the second round investors will be seeking a preferred and common equity return closer to their target range of perhaps 50% per annum. The founder may be relegated to a real-time value of 20% of the company because even if he retains 30% of the common equity, the likely returns on the preferred investors’ shares, given the earnings potential of the company, indicate that in a liquidation of the company he will be lucky to take home that much of the pie.
The moral of the story is that valuing a start-up enterprise is not so much a science as a process. Value is far more about leverage and legal rights than it is about what a third party might pay for an equity interest. Winners recognize that value shifts dramatically over time based on changing circumstances. Until a liquidation event occurs, such as a sale or a public offering, the best one can hope for in any round of value negotiation is to be setting the stage for the next negotiation.
Has the founder fared so poorly? At least he is now rich, by almost anyone’s standards, and the miniaturized hand-held computer that he once beheld as beautiful, is on its way to serve the world. Not bad for an Ivy Leaguer. t
Jonathan Bell is a shareholder in the Boston office of Greenberg Traurig LLP, an international law firm. He specializes in corporate and securities transactions.