Silicon Valley North #18 Apr'00

The Way I See Itů by Michael Volker

The Valuation Question has a Simple Answer

A popular topic among startups and investors is that of valuation. What's my baby worth? How much equity has to be given up to attract investors?

We often hear the term, "pre-money valuation". This refers to the value placed on a business prior to the injection of new capital. Although this is a negotiated figure, company founders jump through hoops trying to justify the value based on various approaches. Startups will little more than an idea have greater difficulty justifying a given value than a company with a little history and a bit of a track record.

Some of the common approaches to valuation are the discounted cash flow method (i.e. basic engineering economics to produce a present value for pro-forma cash flows), replacement cost method, market value based on comparable deals, tangible asset value, or various multiples applied to either trailing or leading revenues or earnings.

Whereas such approaches may be useful to investors or entrepreneurs in justifying their negotiating stance to the other party, I'm not convinced that there is much merit in any of these methods, especially at the nascent stages.

One could argue that in most cases, the pre-money value is zero, or close to it. Why? Without capital, the business will not grow and is worthless. Hence, a more practical approach would be to recognize the fact that without the idea, the people, and the capital the business won't fly.

It may be more productive to look at who is contributing what to the business and then agree on a mutually acceptable division of the pie based on these relative contributions.

When arguing for the size of their share, investors must realize that the founders must not feel squeezed or taken advantage of. It takes the total commitment of the entrepreneurs to make the deal work. And when it does, the investment returns will be so many multiples that it isn't worth quibbling over a few percentage points going in.

There's lots of evidence to suggest that the team, not the technology or the business plan is what counts. The majority of B.C.'s leading technology ventures, e.g. Creo Products, Pivotal Corp, QLT, and Ballard are all successful today in areas that they did not originally identify. Most are not even close to doing what they spelled out in their first business plans!

The point here is that a determination of value is usually based on the wrong aspects of the business (i.e. the technology and the forecasts). It's the team behind a company that ultimately drives the value. And, that's tough to quantify.

In the public markets, Canadian stock exchanges like the CDNX and its progenitors, the VSE and ASE, have unduly fussed with the valuation question and have required companies to hire high-priced experts to produce independent opinions on value so as to protect the investing public.

This can actually hurt a company insofar as the valuations are always on the conservative side. No one wants to be sued for hyperbole. More often than not (e.g. as seen in recent IPOs like Creo, Pivotal, and Sierra Wireless) public offerings are priced well under the market's appetite which means that, although investors are happy, maybe a little too much was left on the table.

And, if you're worried about hyper-values, don't be. Look at it as investors' confidence in the management team to meet expectations. Even though a company's treasury is not affected by a rising stock price, it does allow a company to raise equity at lesser dilutions or make acquisitions with its own paper.

The way I see it, early stage valuations are best addressed by looking at the "post-money" scenario as determined by all participants' contributions and commitments, especially the commitment of the entrepreneurial team.



Michael Volker is a high technology entrepreneur and director of Simon Fraser U's University/Industry Liaison Office. He is a former executive director of the BC Advanced Systems Institute and is chair of the Vancouver Enterprise Forum. He may be reached at mike@risktaker.com.

Copyright, 2000.