Alternative To Company Valuation For Startups

Guest post by Andy Cars, the founder and CEO of Seedcap AB based in Stockholm. Seedcap AB help entrepreneurs and start-ups to raise capital. You can read Andy's previous post on the 10 Mistakes Entrepreneurs Often Make When Raising Capital here. Here Andy talks about an alternative to locking-up your valuation too early.

Many entrepreneurs that seek external capital to finance their startups often find the valuation of their companies difficult. How do I know what my company is worth? Moreover, by its very nature the founder often believes his company to be worth more than what the investor is prepared to accept, which in the end leaves the founder without a deal.

How can we find a solution to the process of valuing startups?

One suggestion that has gained ground in the USA, and which business angels in the Nordics would do well in examining closer, is simply to avoid the discussion of company valuation during the seed stage altogether. Instead wait until the company is able to present a more solid history on which to base the valuation.

If we don't take an equity stake in the company how should we be compensated?

Instead of receiving shares in the startup for x amount of cash, business angels may offer a convertible loan that is exchanged for shares during the next financing round and to the valuation that is made at that time. To compensate the business angel for the risks associated with seed financing, the business angel should negotiate a 20 - 25 percent discount on the agreed valuation. The loan should also include a 6 - 8 percent interest rate, which is paid in full upon completion of the first round.

According to Ron Conway, founder of Angel Investors LP funds that invested in Google and PayPal  amongst others, they also add a valuation cap. Thus, the variables that the business angel can use in negotiations with the entrepreneur are the interest rate on the convertible loan, the discount on the valuation during the first round, and the maximum valuation that they are willing to accept (the cap).

That way the entrepreneur and the business angel postpones the often unnecessarily complicated and arbitrary process of valuing seed stage companies until more substance and history can be presented.

Editor's Note: If you're interested on the subject you can further explore the pros and cons of convertible debt here and here.

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Seth Elliott September 15, 2010

I've used this model for many years in both pre-seed and even pre-institutional funding phases.

As you've noted, a valuation cap is often an important consideration. Though you did not specifically set forth this term, the note is usually converted automatically upon a next round of funding (appropriately defined to address valuation caps and minimum funding size).

It's critical to have this mandatory conversion term in place - or a convertible note holder can cause significant difficulties at the next round of funding.

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JohnG September 20, 2010

Can you explain a bit further how the valuation cap works in practice? Any specific examples you can cite would be helpful.

Thanks