Balancing the Art of Valuation with the Science of Dilution

Key Takeaways

  1. It is imperative for founders to understand factors that help maximize the valuation of their business and increase the likelihood of new investors to come in at the highest valuation possible.
  2. It is inevitable that some dilution will occur when raising venture capital, however, founders can apply strategies to best mitigate its effect on ownership targets for themselves and their investors.
  3. COVID-19 has changed the way investors deploy funds, and founders need to adapt to take advantage of the new regulations.

Founders need to be aware of two fundamental truths: valuation and dilution. As your valuation affects your dilution down the line, any founder's goal should be to maximize valuation while minimizing dilution. The simple premise of this concept may sound simple in the early stages, but the complexity quickly ramps up as you raise capital, appraise different forms of capital, evaluate your current and future valuation, establish equity ownership pools, advisor shares, and establish vesting schedules. The level of dilution you and your investors can experience depends on each of these elements. It is very rare for founders to see the original investors guide them from seed funding all the way to a successful exit in the innovation economy. Your company will inevitably need to reach out to new investors in subsequent rounds of funding. A startup founder should consider where their company is headed from a growth trajectory standpoint, and where they want to take their company, since as a startup scales, it will require more capital, and you will continually dilute your ownership stake. According to industry experts, founders will likely sell between 20 and 35% of their company during the series A round. There are multiple resources available to founders who wish to chart a course to a successful exit, as well as determine just how much ownership a company should end up with (in terms of dilution versus valuation targets) that delivers big wins for all the parties involved.

Understand the Investor Mindset

No matter if you are taking a valuation-first or dilution-first approach to fund-raising, founders need to understand VC economics. Due to the power law dynamics of venture investment, a significant number of companies will eventually fail, so investors need to plot a course with each successful startup they back to a point of exit that will provide a 10X return on investment, giving their portfolio a 3X return profile overall. A company at the time of exit will have a return on money multiple equal to at least 10X the size of the original investment made by investors at the time of entry. Given the long incubation and extended runaway required for most startups to become profitable, investors should ensure that any valuation they consider is one that justifies the time, effort, risk, and ownership they will take on and any risk of dilution if things don't go as planned.  

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

Your startup's lifecycle stage plays a large role in determining an accurate valuation. An established startup can be valued based on core financial metrics, such as revenue, cash flow, growth rates, and financial metrics. For younger startups without revenue or even prototypes, it can become more complex, since you need investors to look at potential rather than performances. Despite the fact that investor valuation may not always be grounded in solid financial metrics, prospective investors often rely on the factors outlined below when valuing your business.

  • Comparable company analysis – This is a basic valuation method based on the "scale" of other (comparable) early-stage companies. The more similar a startup, whether in terms of sector, location, or potential market size, the better. Founders have access to several comps data sources to use when pitching potential investors thanks to industry resources such as Pitchbook and Crunchbase. Additionally, VC fund reports are publicly available to investors for their research.
  • Crystallize your capital needs – Investing in early-stage startups often involves reversing engineering the post-money valuation from the amount of cash that a company is seeking to the stake they need to justify their investment. Having a clear idea of how much money you would need at each stage of your company's development is crucial to determining a figure that is both fair and feasible. In this case, if a startup is asking for $4 million and investors are asking for a 25% ownership stake to justify the investment, then on paper the company has a value of $16 million. However, there is one important caveat. It's crucial for founders to realize that with each subsequent round of funding, they're voluntarily giving up anywhere from 20 to 30% of the ownership stake in their company. Therefore, inaccurately assessing your capital requirements and not meeting appropriate business milestones could mean you will need more funding rounds than anticipated which would expose you and your investors to dilution in the future.
  • Accurately size the market opportunity – The size of a potential payout is another figure that investors consider. Generally, venture investors are looking for 10X or greater exits through IPOs or M&A. Therefore, it is important for founders to map out important milestones along the way to attaining an exit. Founders can try to estimate the market opportunity using the TAM, SAM, and SOM equations. TAM – Total Addressable Market, would be the total universe of people who can be targeted as potential adopters of your product. SAM – Serviceable Addressable Market would be the actual people you target given the limitations of factors such as 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 – Key Opinion Leader (KOL) advocacy is an open secret in the innovation economy when it comes to influencing investor perception. Founders should take advantage of the people on their advisory board, their reputation as serial entrepreneurs, work-history, I.P and anything else that can be leveraged in order to help create buzz around their startup. Everything is negotiable when it comes to valuation. The more people interested in your deal, the more leverage you have to set the valuation.
  • Be realistic – There's no denying that trying to maximize your valuation can benefit you and your company - it means investors will pay more for a slice of your company. However, founders need to avoid aiming too high in terms of valuation, as this can set unrealistic expectations. When you are just starting out and have considerable investor interest, remember that at some point, the numbers will start to matter more - particularly in Series B and C rounds. As such, ensure that your milestones are clear and in line with your valuation so that neither you nor your investors suffer.
  • Look beyond traditional valuations – Founders who are still working on their business model or revenue could possibly postpone any decision about valuation in favor of financial instruments like a SAFE (Simple Agreement for Future Equity) or Convertible Note. Y Combinator popularized these instruments for raising modest amounts from friends, family, and angel investors while delaying decisions about valuation. Upon raising its first priced round, SAFE or notes will be converted into equity, presumably after a better valuation has been determined from actual metrics.

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 keep in mind that every round of funding has a significant impact on dilution as well as the risk of hardship that it may cause both founders and investors. To soften the impact, founders should approach every successful round of funding not just as a cause for celebration, but also as an opportunity to consider the downstream implications for the company. The six tips listed below can help mitigate dilution risks to a degree:

01. Understand the rules of the game- As mentioned earlier, you should understand the amount of money you will need not just for this round, but for later stages as well. Ignoring it now could cost you in the long run. By raising too much cash, you may inadvertently give away too much of your company. Investing too little could lead to running out of cash before you reach the milestones needed to approach investors again. It is important to understand how various financing instruments work-convertible notes, SAFEs, equity rounds-and their long-term implications. 

02. Raise the right amount of capital – As far as dilution is concerned, you should raise as little money as you can early on, since money raised early will be the most expensive. Investors in your startup are buying equity at a time when your company has the least value (and, conversely, the highest risk), so every dollar invested results in a proportionally larger stake. The best way to determine how much you need is to identify in as much detail as possible what your expenses and capital requirements will be to reach each milestone of your journey.

03. Don’t rely on notes for too long - Convertible notes and SAFEs can be an excellent way to raise seed funds from friends, family, and angels because you can get started quickly without having to put a precise value on your company. Holders of notes and SAFEs, however, are usually given a discount when they do the first priced round due to the added risk. These instruments can be detrimental if they are overused as they ultimately make raising a round priced at a high valuation more difficult. Investor management and cap table complexity are also impacted. If, after netting $500,000 through SAFEs or convertible notes, you can only get a $3 million post-money valuation, then your note holders will own more than 20% of your company, less the discount. You might end up giving away substantial ownership of your company even before you reach series A.

04. Using caps as your guide - Caps can be used to determine how dilution will be affected by a SAFE or a note in the future.

A cap protects holders of notes or SAFEs from dilution if a startup raises a priced round at a high valuation, essentially securing a minimum future equity stake. For instance, a $5 million cap would mean that a SAFE or note holder would own the same percentage of the company for any amount raised up to and including the cap. While founders generally dislike caps, deals without them are increasingly difficult to find.

05. Don’t forget about the options pool – Building a great team is important, but founders should also take into account their employee equity pool and their eventual equity stake in the company. Early in a company's existence, its option pool is usually smaller, which is typically increased as the company grows. You should reserve between 10% and 20% of equity for your option pool and decide how much you need to give key employees early (usually between 0.5% to 2% per key employee). An increasing number of tools are available to help early stage founders including & 

06. Be aware of super pro-ratas - This is an arrangement in which marquee investors can increase their stake in future rounds as a condition for seed investments. Although standard pro-ratas, which allow investors to maintain their existing stakes, protect from too much dilution, founding teams should be aware of the implications of super pro-ratas in regard to growth trajectory and investor interest as these may discourage new investors from participating at later stages.

As a rule of thumb, when investors find a potential winner among the companies they fund, they strive to increase their ownership stake as much as possible to ensure a successful 10X exit which may translate into a final ownership stake of 10 to 15%. If faced with this possibility, founders should assertively negotiate with investors, recognizing that even if some investors request a pro-rata split, they will likely be willing to compromise on that demand during negotiations. As much of the advice above revolves around understanding the system, understanding terms, and understanding math, market conditions have a tremendous impact on each of these elements. Thus, it is important for founders to consider market realities.

It’s a Brave New World

A COVID-19 pandemic has changed the rules of the game and given companies more runaway with investors than they normally would have. Currently, there is so much capital in the market that investors and founders are closing deals on a day's notice over Zoom calls. By eliminating the usual measured valuation process and replacing it with this rapid-fire fund-raising process, venture capital investors are now using valuation as a negotiation tool. Larger funds are also showing a greater willingness to value companies higher at the outset in order to reduce the risk of dilution down the road.

In light of all the uncertainty, venture investors are now expecting companies to have anywhere between 24 to 30 months of liquidity between rounds of funding, as opposed to 12 to 18 months. Currently, investors are advocating that companies are given more runway so that they can achieve higher growth milestones. Founders are now raising at a level where there’s added cushion.

Another important point to consider is that a lot of these new rules are sector-specific and do not apply to the entire market. Education, health care, and enterprise security are all experiencing incredible valuations at the moment. Other sectors, such as consumer marketplaces, are experiencing growth but at a much lower volume and velocity. Thus, your sector can affect how you attract capital vis-à-vis your growth milestones because, in the end, everything is an opportunity cost for you and your startup.

Another key difference is that large investment funds like Tiger Global who have deep pockets move quickly and are willing to put out large amounts of money ($20 million to $40 million) as long as it helps them reach their ultimate ownership targets. Rather than being motivated by a specific valuation number, these investors are focused on achieving long-term ownership of the company, which means that once it grows to the size of an entity worth $100 billion, they have enough ownership to affect their returns materially.

It is important to note that some large-scale funds don't exhibit much ownership sensitivity. The challenge these funds face is that as a company grows, do they continue to pump more money into the business to maintain their ownership position, or do they accept dilution as new investors enter, while still holding a substantial enough stake to achieve a profitable exit?

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

While the pandemic brought about some changes in valuation and dilution, these processes continue to be intricately linked. For the benefit of their businesses and investors, founders need to balance the two sides of this equation. As a result, founders need to pay attention to two critical data points.

It's important to ensure that you have an accurate assessment of how much capital you need not just for the current round of funding, but also for the entire journey up to and including the point of exit. Even though it is impossible for founders to estimate everything their business may need during its growth journey, looking at industry figures, comps, and other business intelligence sources can give you a pretty good estimate. Investors are comfortable with dealing with some level of uncertainty, so they will take that into account when valuing your company. 

With an accurate understanding of costs and capital requirements, founders can avoid the temptation of taking on too much capital too early in the process, which could lead to needless dilution later, particularly in current market conditions where funds are knocking on founders' doors and we are seeing companies reach series A funding with less than a million dollars in annual revenue.

It is also critical to accurately identify the true "value-driving" milestones in the business along with the reasoning behind why each milestone is so critical to achieving that 10X+ exit scenario. It helps investors understand why achievement of each milestone, in essence, de-risks future investment in your organization. The result will be that new investors will be more likely to join subsequent rounds of funding at the highest valuation possible and your existing investors will be better protected from unnecessary dilution and decay.