The art of valuation and the science of dilution

Valuation and dilution are two intricately linked fundamental truths that all founders need to be aware of. Since your valuation will determine your dilution down the line, the universal goal for any founder is to maximize valuation while minimizing dilution.

While this may seem like a straightforward premise at the start, it can quickly become very complex as you start to raise capital, appraise different types of capital, assess your current versus future valuation, equity ownership pools, advisory shares and vesting schedules. All these elements impact the level of dilution that you and your investors can experience over time.

Considering the nature of the innovation economy, very few, if any, founders will manage to see their original investors guide them from seed funding all the way to a successful exit. As a result, you will inevitably need to go into further funding rounds, which will bring in new investors into your company. At this point, founders need to consider where you see your company from a growth trajectory perspective and where you want your business to go. As your startup scales, so will its needs for capital and you will continue to dilute your ownership stake with each subsequent round. Most industry experts estimate that founders will probably sell 20 to 35% of their company during their series A.

While this may seem unnerving at first, founders have multiple resources available to help chart a course to a successful exit as well as find the right balance between what your company is worth (valuation) and just how much of it you should end up with (ownership targets vis-à-vis dilution) that delivers a big win for all parties involved.

Understand the Investor Mindset

Whether you take a valuation-first or dilution-first approach to fund-raising, founders need to understand how VC economics works. Venture investment operates in power-law dynamics, meaning that a significant number of companies will end up failing. Therefore investors need to plot a course with each successful startup they back to the point of exit that provides a 10X return on investment to give their portfolio an overall 3X return profile. That is to say, the company at the time of exit will have a return on money multiple that is at least 10X the size of the original investment that investors made at their point of entry. 

Given the long incubation and extended runaway required for most startups to reach profitable maturity, investors need to be sure that any valuation justifies the time, effort, risk and ownership they will take on and the accompanying risk of dilution if things don’t progress as planned.   

Some Ways to Arrive at a Valuation that is Maximized to Your Startup’s Benefit 

Getting to an accurate valuation of your company depends a lot on the lifecycle stage of your startup. Estimating the value of an established startup on core financial metrics can be easy, as there are factors like revenue, cash flow, growth rates and financial metrics to help reach an agreed number. But for younger startups that are just getting started with little or no revenue and maybe not even a prototype, it can become a more complex exercise, as you need investors to focus on potential rather than performance numbers. While investor valuation may not always be built on solid foundations of financial metrics, prospective investors often use the factors listed below to arrive at a valuation decision for your business.

 

• Comparable company analysis – This is a basic valuation method based "on scale" of other (comparable) early-stage companies. The more similar the startup—be it sector, location or potential market size—the better. Thanks to the plethora of industry resources such as Pitchbook and Crunchbase and publicly available VC fund reports, founders can access several comps data sources for their pitches to prospective investors.
• Crystallize your capital needs – When evaluating early stage startups, investors often reverse engineer a startup's post-money valuation based on the amount of cash a company is seeking and the investors' ownership stake to warrant their time and money. Therefore, having a clear idea of how much money you would need at each stage of your company's development is crucial to reach a viable figure for all parties involved. For example, if a startup is asking for $4 million and investors ask for a 25% ownership stake to rationalize the investment, then on paper, the company is worth $16 million. There is, however, an important caveat. Founders need to understand that with every subsequent round of funding they're giving up anywhere from 20 to 30% of their company's ownership. So inaccurately assessing your capital requirements and not hitting appropriate business milestones could mean needing more funding rounds than anticipated which could open you and investors to dilution down the road.
• Accurately size the market opportunity – Another figure that drives investor calculations is the size of a potential payout. Given how venture fund math works, most investors are looking at that 10X or greater point of exit, either through an IPO or M&A. So, founders must chart a course highlighting mission-critical milestones along the way to reach an exit. Founders can try to size the market opportunity by using the TAM, SAM and SOM equations. TAM – Total Addressable Market, would be the total universe of people targeted as potential adopters of your product. SAM – Serviceable Addressable Market would be the actual people you target given the limitations of market access, regulations etc. Finally, SOM – Serviceable Obtainable Market would be the active share of market that your company ultimately hopes to capture and derive revenue from.
• Create the right buzz – It is an open secret in the innovation economy that Key Opinion Leader (KOL) advocacy goes a long way in influencing investor perception. Founders need to be strategic on using people on your company's advisory board, your reputation as a serial entrepreneur, previous work-history, I.P and anything else that can be used as a deployable asset to help create buzz around your startup's profile. Founders need to remember when it comes to valuation, everything is open to negotiation. The more people want in on your deal, the more leverage you have to control your valuation. 
• Be realistic – There's no disputing that trying to maximize your valuation can be good for you and your company- it means investors will pay more for a slice of it. However, founders need to avoid seeking too high a valuation, as it can set expectations that could prove impossible to fulfill. Even if you are just starting out and have considerable investor interest, always remember that at some stage the numbers will start to matter more -particularly in Series B and C rounds. So make sure that your milestones remain achievable and aligned with the valuation so that you avoid any hardship for yourself and your investors.
• Look beyond traditional valuations – One option for founders who are still searching for a business model and revenue may be to postpone any decisions on valuation and use financial instruments like a convertible note or a SAFE (Simple Agreement for Future Equity). Popularized by Y Combinator, these instruments allow companies to raise modest amounts from friends, family or angel investors while putting off a decision on valuation. The SAFE or notes will convert into equity when the startup raises its first priced round, presumably at a time when it will have actual metrics to determine a better valuation.

Understand the Impact of Dilution and Workarounds to Achieve Your Ownership Goals 

While the factors above can help maximize your startup’s valuation, founders also need to be mindful of the significant impact that each round can have in dilution terms along with the risk of possible hardship that it may cause founders and investors over time. 

To soften the impact, founders need to approach every successful round of funding as a cause to celebrate as they propel their company forward and as a moment to reflect on the downstream implications. The six tips listed below can help mitigate dilution risks to a degree: 

1. Understand the rules of the game– As mentioned earlier, you need to understand how much capital you need not just for this round but ideally for later stages. Not planning now will hurt you later. If you raise too much, you could give away an unduly large portion of your company. If you raise too little, you risk running out of cash before achieving the milestones needed to return to investors again. It is essential to understand the ins and outs of various financing instruments—convertible notes, SAFEs, equity rounds—and their long-term implications.  
2. Raise the right amount of capital – From the perspective of dilution, you should take as little outside capital as you can get away with early in the process, as money you raise early on is going to be the most expensive money you ever take. Your initial backers are getting equity at a time when your company has the least value (and conversely, the highest risk), so each dollar invested buys a proportionally larger stake. Again, the best way to decide how much you need is to map out, in as much detail as possible, what your expenses and capital requirements will be to get to each success milestone in your journey.
3. Don't rely on notes for too long - Using convertible notes or SAFEs to raise pre-seed funds from friends, family and angels can be helpful as they allow you to get going quickly, without having to put a precise value on your company. However, note and SAFE holders typically get a discount when you do your first priced round because of the added risk they assume. Overreliance on these instruments layered through time can be detrimental as they ultimately build pressure to raise a priced round with a high valuation. It also increases the complexity of cap table and investor management. For example, say you've netted $500,000 through SAFEs or convertible notes. When it comes to a priced round you can only command a $3 million post-money valuation. Your noteholders will own more than 20% of the company, after accounting for the discount. This could result in you giving away significant ownership of the company even before you hit series A.
4. Using caps as your guide - Caps are useful for understanding how much a SAFE or a note will impact dilution down the line. A cap offers note or SAFE holders protection against dilution if a startup raises a priced round at a high valuation, basically locking in a minimum future equity stake. A $5 million cap, for instance, would mean that a SAFE or note holder would own the same percentage of the company for any amount raised at or above the cap. While founders generally dislike caps, it is becoming increasingly hard to find deals without one.  
5. Don't forget about the options pool – Building a great team is crucial to your success, but founders need to be aware of their employee equity pool and its long-term impact on overall equity ownership. It is common to have a smaller option pool in a company's early phases, which is often increased at a meaningful financing event. Reserve between 10% and 20% of equity for your option pool and decide how much you need to give key employees early on (usually in the range of 0.5% to 2% per key-resource). An increasing number of tools are available, including HirignPlan.io, Pave, and others to help guide early stage founders.
6. Be aware of super a pro-rata – These are arrangements that let marquee investors reserve the right to increase their stake in future rounds as a condition for their seed investment. While standard a pro-rata, which allow investors to maintain their current share of ownership, serve as protection from too much dilution and are common, founders should be aware of the implications of a super pro-rata in relation to the growth trajectory and investor interest as these may deter new investors from coming in at later stages. In addition, VF economics dictate that when investors find a possible winner among the companies they back, they want every opportunity to cement their ownership to ensure a successful 10X exit, translating into a final ownership goal of 10 to 15%. Founders, faced with this possibility, should assertively negotiate with investors with the realization that while some investors may ask for a super pro-rata, they also don’t want to create a situation that hinders future investment in the company, so they will likely be open to ceding on that demand during negotiations. 

While much of the advice above revolves around understanding the system, terms, and math, these three factors are hugely impacted by prevailing market conditions. So it behooves founders to take a hard look at market realities.

It’s a brave new world 

The COVID-19 pandemic has significantly changed the rules of the game and given companies more runaway with investors than they usually used to have. There is so much capital in the market with almost a FOMO effect and investors and founders are closing deals on a day's notice over Zoom calls. The replacement of the usually measured valuation process with this rapid-fire approach to fund-raising has made valuation a more integral negotiation tool for venture investors. Also, larger funds are showing a greater propensity to value companies higher at the start in order to lower the risk of dilution further down the line.

Due to all the uncertainty, venture investors who would normally expect companies to have 12 to 18 months of liquidity between rounds of funding are now working with companies to have anywhere from 24 to 30+ months of liquidity on hand. The conventional wisdom now has become that investors need to give companies more runaway to continue to grow and march on to those next set of growth milestones. For founders that old axiom of "only raise what they need" has somewhat evolved to "raise what you need but bake in a bit of a cushion" because investors are wary of what the world will look like in the short term.

Another important consideration is that many of these new rules are sector-specific and do not apply across the market. For example, some sectors like ed-tech, healthcare, and enterprise security are red-hot, and we see some fantastic valuations. However, while there is still growth in other sectors like consumer marketplaces, dollars are flowing at a much lower volume and velocity. So your sector can make you more or less cautious in the way you attract capital vis-à-vis your growth milestones because ultimately, everything is an opportunity cost for you and your startup.

Another key difference is that many large investment funds like Tiger Global who have deep pockets are moving fast and are willing to put out large amounts of money ($20 million to $40 million) in the early stages as long as it helps them hit their ultimate ownership targets. For these investors, the motivation is not driven by a particular valuation number but by long-term ownership goals, i.e., once a company becomes that $100 billion entity, the investors own enough of a stake to make a material difference to their return profile.

It is worth noting that for some large-scale funds, there isn’t much ownership sensitivity. The choice that these funds face is that over time as a company grows, do they continue to put more money in to maintain their ownership position or be content with being diluted as new investors enter while still continuing to hold a meaningful enough portion of the business, despite dilution, for a profitable exit to occur. 

How to Find the Perfect Balance? Go Back to Fundamental Truths and have good Counsel

Despite the changes brought on by the pandemic, valuation and dilution continue to be intricately linked. Founders need to balance both sides of this equation to ensure they come out ahead for the benefit of their business and investors. To make that happen, founders need to come back to the two key sets of data points.

The first is to ensure that you have an accurate assessment of how much capital you need for the current round of funding and the entirety of the journey to the point of exit. While founders can't estimate everything their business may need during their entire growth journey, looking at industry figures, comps and other business intelligence sources can get you fairly close. Remember, investors are comfortable dealing with some level of uncertainty so they will account for that when putting a value on your company. In addition, by having an accurate idea of costs and capital requirements, founders can avoid the temptation of taking on too much capital earlier in the process which can expose you to the risk of needless dilution down the line, especially in current market conditions where funds are knocking on founders' doors. We see companies reach series A funding with less than a million dollars in ARR faster than ever before. 

The second is accurately identifying the true "value driving" milestones in the business along with the reasoning behind why achieving each milestone is so critical to that 10X+ exit scenario. Doing this explains to investors why the achievement of each milestone is essentially de-risking future investment in your company. This will increase the propensity of new investors to come in at subsequent rounds of funding at the highest possible valuation and better protect the positions of your existing investors from needless dilution and decay.

Finally, founders should know that they do not have to be on this journey alone. Working with aligned partners such as SVB, leading accelerators and top law firms provides an ecosystem of resources and advisors that can offer insight into current market conditions, comparable valuations and how to negotiate to optimize your goals.  

Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup's early life. 

This article was originally published on Techstars' The Line.