VC insights: Valuations in early-stage investments – beyond the headline price
Our last post looked in some length at how investors and founders might agree a headline valuation. We’re now going to look at how to take that figure and turn it into a price per share that the lawyers can put into an investment agreement.
Sounds simple. In practice, there are some wrinkles. And they can make a huge difference to the investor’s entry price.
The purpose of all the following isn’t to take advantage of the founders. It’s simply to preserve the value of the investor’s stake: either by getting a bigger share of a smaller pie (say because the company has debts) or making sure that their agreed share isn’t diluted by the need to cut in some other shareholders (like option-holders).
Calculating the price per share / pre-money and post-money
The investors and founders need to agree a price per share at which they invest. So, they need to agree the overall valuation, and then how many shares there are / will be in the company, to work out that price per share.
We’ll pick up the mechanics as we go through the blog-post, but the important point to make up front is: make sure that you match the chosen valuation with the correct, corresponding number of shares.
Clearly the company will be worth more after the funding round, pound for pound to the value of the investment made. The price per share can be worked out from either point, but the important issue is to match the chosen valuation (either pre-money or post-money) with the corresponding share capital number (either the current issued share capital, or the share capital as enlarged by the newly minted shares).
In these illustrations we are going to calculate the share price based on the pre-money valuation divided by the current issued share capital.
Bridging the enterprise value and the equity value
What’s the difference?
Enterprise value is the value of the business itself. Equity value is the value of the shares in the business. The difference is the extra value of any free cash on the balance sheet, or a deduction for debt. This isn’t a concept specific to venture capital, but to all investing and company sales. A business might have cashflows, brand, contracts, team and so on worth £20m to an investor or acquirer. That’s the enterprise value. If the company that owns the business has, say, £3m of cash that can comfortably be considered surplus, then the company has an equity value of £23m.
Looking specifically at a venture capital example, let’s revisit little SaaSco. Last time we saw them, we were looking to invest £1m for a 20% stake, meaning a £5m post-money valuation. This is the negotiated value of the business today (£4m, being the enterprise value and also, without any other factors, the pre money equity value) plus the £1m of funding needed to deliver the next stage of the growth plan. The £5m is the post-money equity value. The vanilla cap table is pretty straightforward (for illustration, we’ve assumed that there are presently 100,000 shares in issue and that management hold 10% alongside the founder):
It’s worth noting that the new monies invested, whilst increasing the post-money equity value, don’t increase the enterprise value, which remains at £4m. You’ll see that in none of the scenarios below does the enterprise value change. It’s always £4m. It makes no difference whether the company has cash or debt, or which shareholder has what percentage.
So much for the vanilla scenario.
Next, we find out that SaaSco has £350k of loans outstanding. Also, as the business has been running on fumes for a while, the company is behind with last quarter’s VAT payment and the last two months PAYE and NI, which will cost £50k to rectify.
These figures have to come off the enterprise value to give the equity valuation. That’s because these debts will reduce the monies available to grow the business or will get repaid on an exit and taken off the proceeds by the buyer. So, the post-money equity value has gone down by £400k to £4.6m; the pre-money value is therefore £3.6m.
Let’s revisit the cap table with this debt scenario:
The price per share has fallen from £40.00 to £36.00, so the investor has got proportionately more shares (they now hold 21.7%, versus 20.0% in the vanilla scenario). That’s because the equity is worth less, due to the pre-existing debt, whilst the investment amount remains the same.
You might well ask – what should go into this adjustment? Usually it can be worked out by common sense – basically anything that is going to be a one-time drag on the company’s cashflows, or that could reduce the proceeds on an exit. By that analysis, you wouldn’t take off the non-overdue payroll tax liabilities because they are an evergreen source of funding, gratis the government, that are replenished each month. Essentially, we are looking to adjust for debt, or debt-like, obligations. Other typical adjusting items include founders’ and shareholders’ loans, undrawn salary, and trade creditors not paid to terms and needing to be unwound.
Adjusting the pre-money valuation for options
There needs to be an option pool. Even if the entire existing staff have shares or options, new options will be needed to attract and incentivise new staff, and maybe to reward existing staff as they grow in stature. We normally set aside a pool of 10% to 20% of the enlarged (post investment) share capital. The exact amount tends to reflect how well-enfranchised the current team is, and how many senior new hires are envisaged.
Setting up the option pool doesn’t increase the value of the company. It just recognises the inevitable cost – by way of dilution – of delivering the business plan that we’re all buying into. This cost therefore needs to be borne by the founders and other existing shareholders. We can price in the cost of the resulting dilution in one of two ways: either increasing the number of shares or reducing the pre money value. Either way works and produces the same answer. As noted above, we’re going to adjust the pre-money valuation.
So if we’ve set up a pool worth, say, 15% of the enlarged post-investment share capital, then we would need to make an adjustment to the pre-money valuation. That works out as 15% of the post-money valuation of £4.6m (remember, we took £400k off the original £5m post-money figure due to pre-existing debt) being a £690k deduction. Let’s have a look at the option scenario cap table.
The effect of setting aside £690k of stock to help complete the management team’s incentive package has been to reduce the value of the currently issued share capital. Those 100,000 shares are now worth less, at £29.10 each, versus £36.00 in the previous scenario. The investor gets more shares as a result. The investor’s shareholding percentage is, however, unaltered. That’s because this exercise incorporates the dilution into the pre-money valuation.
The founder’s share just shrank again as they made room for an option pool for new hires (and 15% of the post-investment share capital is more than 19% of the pre-investment share capital) so for the founders this is starting to feel painful. There’s not really much that can be done; the founders need to hire and retain good staff in order to deliver what they just sold the investors; this has a cost which must be acknowledged and recognised in the pre-money valuation. It does however create a lively negotiation on just how big the option pool needs to be.
So we’ve seen that existing debt on the balance sheet reduces the equity value (and the share price the investor pays) although it doesn’t affect the value of the business itself. We’ve also seen the effect of options in reducing the pre-money equity value of the business and, again, the price per share the investor should pay.
The effect on the investor’s entry price is already material, and in our next post we’ll look at some further adjustments that can make an even greater difference.
Partner, DSW Angels