The question:
As the economy has been gaining strength, so have the number of entrepreneurs seeking private equity investments through pre-packaged structured private placement offerings, and negotiated venture and angel capital sources. A question that arises almost daily in my practice is how to determine a valuation for a development stage or start-up venture. Determining a valuation is instrumental to answering the overriding questions of what percentage of a company is being sold and at what price.
The Answer:
For business entities with operating history, revenue, profit margins and the like, valuation is determined by mathematical calculations and established mathematically based matrixes. For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist.
In the case of a pre-packaged private placement offering for a development stage or start up venture, valuation is an arbitrary guess, a best estimate. In the case of a negotiated investment with a venture capital or angel investor, valuation is a negotiated guess or best estimate. The guess and best estimate is based on in-depth due diligence, market studies, competitive analysis, and perhaps most importantly, an assessment of management ability.
In determining valuation a company must consider both pre and post money valuation. That is, what is the business worth prior to an investment and what will it be worth after the private placement taking into consideration the use of proceeds from the private investment. The Company will want the investment to be finalized at the higher post money valuation and the investor will want it at the lower pre money valuation.
Discussion:
Establishing valuation for a development stage or start up entity ultimately comes down to an investor’s perception of risk vs. reward. Risk is easy to determine, if $xx are invested, $xx dollars can be lost. Reward on the other hand is an elusive prospect based on the potential success of a business. In the case of an investment by a venture capital or angel investor, such investor will conduct an in-depth due diligence and review of the business and determine the valuation they are willing to invest at, as a result of their findings. I advise clients preparing a private placement offering memorandum to conduct that same due diligence review and present the results to potential investors, in the form of a private placement memorandum and business plan that supports the offering price and percentage. Moreover, doing your homework upfront will ensure the best chance of success in the long run.
As further discussed below, in setting value, an analysis (due diligence) should be conducted on a minimum of the following: market data; competition; pricing and distribution strategies; assets and liabilities; hidden liabilities; inflated assets; technology risks; product development plans; legal structure; legal documentation; corporate formation documents and records; and management, including backgrounds on paper, and face to face assessments.
Whether preparing a private placement memorandum or negotiating with a venture investor, it will be the Issuer (company seeking the money), that will propose a valuation which may or may not be in sync with the valuation proposed by the investor. It is important that this proposed valuation be grounded in reality and supported by research, or investors will not take you seriously and will not believe in management’s ability.
Areas of Consideration in Determining Valuation
The following areas should be researched and considered in determining a pre-money, development stage or start-up valuation. The below list is in no particular order.
1. Investment comps: have other investors, either private or public, recently funded similar companies and if so on what terms and conditions and at what valuation;
2. Market Data: who what is your product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;
3. Competition: who are the major competitors; what is their valuation; how do you differ from these competitors;
4. Uniqueness of product or technology: how is your product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;
5. Pricing and Distribution Strategies: what are the major impediments to your successful entry into the marketplace; what is your plan for successful entry into the marketplace; have you considered order fulfillment including transportation costs; connections to end users for your product or service; what are profit margins and will the margins increase as the business grows and scales;
6. Capital investments to date: what capital investments have been made to the Company to date, including both financial and services; remember that you must believe and invest in your entity before others will;
7. Assets and liabilities: what does the balance sheet look like; are their hidden liabilities; any off balance sheet arrangements; how are assets valued; are any assets either over or under valued; is their clear title to all assets;
8. Technology Risks: what technologies do you rely upon; what is the state of evolvement of those technologies; can you keep up;
9. Product Development Plans: do you have a model and samples; have they been tested; have you established manufacturing channels; exclusive contracts with manufacturers; what is your overall plan to bring your product to market and subsequently become a competitor in the industry;
10. Legal Structure: type of entity – LLC, C Corp, partnership..; legal structure of current outstanding equity – just common equity or common and preferred and if preferred what rights are associated therewith (redemption rights; liquidation preferences; dividends; voting rights..);
11. Legal documentation: not only whether corporate records are in order but are all contracts and arrangements properly documented;
12. Future financing needs: Will significant future financing be necessary to achieve the business plan; what is the risk of a future down round (note that a down round is a future financing at a lower valuation resulting in dilution to the current investors);
13. Exit strategies: is the company planning on going public; is it or will it be a good buyout candidate; is the offering structured to include payback via either a debt instrument or dividend distribution;
14. Management: this is perhaps the most important consideration for the investment community; does the management team have a proven history of success; prior business experience in this and other industries; work ethics; general management skills; organization skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face to face discussions;
15. Flexibility: how flexible is management in structuring the deal and considering outside advice
16. Developmental milestones: has the Company achieved is developmental milestones to date;
Conclusion
Valuation is only one piece in the overall determination of an offering structure. Regardless of a Company’s pre or post money valuation, the investor must make an ultimate decision regarding risk vs reward. Valuation will help determine the offering price per share or unit, but another very important piece of the puzzle is the investment vehicle being offered. The company and investor have a broad range of options including common stock; preferred stock with varying rights and preferences and debt instruments. A follow up blog will discuss these various investment vehicle options.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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