A startup company pitches an investment in its shares at a demo days event, or on an equity crowdfunding platform. The founder says that six months ago an angel investor bought a 16 percent equity stake for $500,000, yielding a valuation of $3.125 million. The company has been growing, so today’s investors should value the company based on that earlier valuation, says the founder.
You see this occasionally on “Shark Tank,” where a startup claims a valuation of x dollars because an earlier angel investor paid x/(100y) dollars for a y percent equity stake. The sharks correctly point out that whatever the early investor thought the company was worth is largely irrelevant today.
There are at least two reasons why early valuations are often misleading. First, the early investor might be (a) investing for strategic or even charitable reasons, rather than primarily financial reasons, or (b) a sucker. In either case, the angel may agree to an inflated valuation to help the entrepreneur, or so they believe, get even bigger valuations in later rounds of equity financing. (A strategic investor wants to get “on board” in order to gain access to new technology, buy into an executive position or a seat on the board, or simply hang around a glamorous startup with brilliant founders.)
Deal Terms Vary from Round to Round
Second, early angel investors often get generous deal terms—liquidation preferences, voting rights, anti-dilution provisions, protections, board membership, etc.—in return for taking a big risk at an early stage of company development. You can’t depend on the value of those early shares to calculate the value in a later offering that does not feature the same generous deal terms. In fact, successive later offerings should not feature such generous terms, or the company will sink under the burden of those terms.
The value of shares depends not only on the value of the underlying business, but also on the preferences, rights and other deal terms that are attached to those shares. Different rounds of equity financing usually involve different deal terms, some radically different. So it’s not a simple matter of deriving a valuation in one round from the valuation in previous rounds.
Here is a simple analogy: You wouldn’t buy a side of beef based on the price of filet mignon. Most of the cow is not filet. Thanks to Travis Harms, a certified valuation analyst at Mercer Capital in Memphis, TN, for that one.
Unicorn Valuations are ‘Overstated’
Harms points out that the headlines about unicorns—startups valued at $1 billion or more after a round of financing—rarely take into consideration the preferences and rights of the share class from that round. The calculation (share price times fully diluted shares outstanding) “overstates the value of an early-stage company,” says Harms. “No doubt the values of many ‘unicorns’ are substantial, even when calculated correctly—but the real values are not nearly as obvious as the often breathless headlines would suggest.”
I recommend Harms’s 11/6/15 article “A Few Thoughts on Valuing Investments in Startups.”
— David M. Freedman has worked as a financial and legal journalist since 1978. He is a coauthor of “Equity Crowdfunding for Investors: A Guide to Risks, Rewards, Regulations, Funding Portals, Due Diligence, and Deal Terms” (Wiley & Sons, June 2015). Details: .