Startup Notes: Valuation & Cap Tables Fundamentals
Follow-up post to my WeWork Labs session with the same title held on 7th May 2020
Investor-Founder Disconnect
Investors and founders have very different mindsets which can often lead to unwanted friction between them, potentially jeopardising the future of a valuable startup. One way of resolving this conflict is to never have it in the first place! If both parties have a healthy understanding of how the other thinks, effective negotiations at the start of the investment would guarantee a long and fruitful relationship. Investors are good at thinking like founders (after all, it is one of the most important part of their job to source deals) but founders are not very good at understanding the investor mindset.
Setting the Scene: Valuation
Startups don’t always approach valuation with the same focus that investors do. For most startups, especially earlier stage ones, setting a valuation is not high on the agenda as they have bigger fish to fry i.e. actually developing a successful product. While a product mindset is admirable, ignoring valuation leads startups to ineffective investor negotiations which means they end up giving more of their company to investors for a smaller amount of funds. The sensible founder stands behind a justifiable valuation range, signaling to investors that they are ready to negotiate a fair price for their company.
As John Doerr puts it, you should “measure what matters” — a good valuation ties the worth of your startup to the most important metrics you should be measuring. If it is important, tie it to your valuation so that you measure it constantly and revise your valuation expectations in real time. For instance, if you raised funds at 5x revenue with £200k revenue (£1m valuation), measuring growth (or fall) in revenue will help you keep up with potential valuation revisions in real time. If your revenue rises, your valuation should exceed £1m while if it falls, you might have to settle for a future down round.
All successful startups have great teams working tirelessly to build the next amazing product. But as a founder, how do you hire and retain the best employees without being able to offer some of the perks bigger companies can? One way is to offer them significant upside to their current compensation in the form of equity in a well-valued startup. If the startup succeeds, the gains from equity would usually far exceed the compensation from a well-paid stable role in an established company. A good valuation with plans for growth can help you hire and retain outstanding employees.
Valuing early and late stages startups is very different. Earlier stage startups rely more on informal valuation and sometimes issue convertible notes as they might not have relevant metrics to justify a valuation. This could include methodologies such as valuation benchmarking and modified Berkus method. Later stage startups have well-defined valuation ranges using different methodologies in addition to the ones listed above: VC returns valuation and intrinsic valuation (discounted cash flows) to name a few.
Valuation is driven by both quantitative and qualitative factors:
In practice, you should always sense check valuation numbers by asking yourself some key questions throughout the process of valuing your startup:
- How much equity are you (and current investors) willing to give up for the quantum of funds?
- How does the current valuation compare with expected future valuation and consequently investor returns?
- Does the increase you are expecting from the utilisation of funds (i.e. future accretion due to higher valuation) justify the current dilution you are facing?
- Which uses of funds are clearly value additive and which uses can you cut down on to reduce current dilution?
Setting the Scene: Cap Tables
In its most basic form, a cap table is a list of owners (founders and investors) and their stakes in the business. As the company starts to negotiate more complex funding arrangements through different levels of equity and quasi-equity instruments (such as convertible notes and SAFEs), the cap table gets complex to include the as-diluted impact of such instruments.
An effective cap table should include different returns scenarios and what each owner would make (in money terms and multiples) at different levels of exit events. This should include the impact of term sheet provisions such as liquidation preferences and anti-dilution provisions.
While there is no set timing for starting a cap table, I would recommend starting one before you accept any external funding, preferably at the time you start discussing ownership dynamics with your co-founder. Cap tables are a powerful tool to monitor and visualise the financial roadmap of your startup and should be updated in real time to assess valuation levels and returns scenarios.
Review of Key Valuation Methodologies
- Valuation Benchmarking
Benchmarking is one of the most common methods of arriving at a valuation range and is used by all investors, bankers, and finance professionals. The idea behind it is that if you can find companies or deals similar to yours, the price paid for them should be comparable to the price you can negotiate. The price here does not refer to the valuation in terms of money but rather it refers to an earning or KPI multiple. For instance, if an investor paid £1m for a company with £200k revenues, in multiple terms they paid 5x for each £1 of revenue. This implies they would be willing to pay 5x for each £1 of revenue for similar companies. If your company is comparable but has £400k revenues, at a 5x multiple, you should be able to set a £2m valuation.
Ritesh Agarwal, founder of Indian hotel unicorn Oyo, justified the valuation for his 2019 share buyback from Sequoia and Lightspeed using benchmarking. He mentioned that he arrived at the $10bn valuation for Oyo by comparing it with Netflix, Uber, and Peloton’s 4.5x to 5.0x revenue multiples. As Oyo had $2.7bn — $2.9bn revenue at the time, the valuation made sense.
It is easy to arrive at high valuations using carefully selected multiples but in terms of fundraising, an artificially high valuation leads to expectations of artificially high future growth and if the growth is not achieved, future down rounds devalue the startup and lead to considerable tension amongst founders and investors.
WeWork’s $47bn private valuation was not accepted by public markets when it tried to IPO in 2019 and the latest valuation estimate of $8bn saw a 6x fall in value which can only be explained by Softbank’s entry valuation of $47bn being completely off.
2. Returns Based Valuation
Investors assess valuations not just based on the startup and its future prospects but also their own returns requirements. One question to constantly ask yourself as a founder is:
- Can an investor afford to buy in at the current valuation and exit with their returns requirement (for instance 5–10x their money)?
This will force you to look at your valuation from the lens of the investor and assess future exit prospects and their implication on investor returns.
Arriving at a future exit value is not easy especially if you are an early stage startup; you can apply benchmarking techniques to arrive at a sensible exit assumption using long term industry multiples to expected earnings in 3–5 years. If possible, try having more than one exit scenario (including a reasonable worst case scenario for your reference).
3. Modified Berkus Method
For earlier stage startups where you do not yet have reliable metrics to base a valuation on, the methodology used by Dave Berkus can be adopted. The idea is to have 5 reliable qualitative metrics which reduce some level of risk for investors. For each risk factor you mitigate, you can add £500k to your valuation to a maximum of £2.5m (sensible size cap for early stage startups).
For instance, Dave Berkus used the following 5 metrics:
- Sound Idea (mitigating product risk)
- Prototype (mitigating technology risk)
- Quality Management Team (mitigating execution risk)
- Strategic relationships (mitigating market risk and competitive risk)
- Product Rollout or Sales (mitigating financial or production risk)
You can modify these metrics to make them more relevant for your startup.
The best way of using the Berkus method is in conjunction with other valuation methodologies. For instance, if your £400k sales at 5x multiples imply a valuation of £2m, you can use the Berkus factors as a check-box exercise to strengthen your valuation.
4. Intrinsic Valuation / DCF
Using present value of future cash flows to value companies is probably the most commonly used methodology for later stage companies. The accuracy of this approach depends on highly reliable cash flow projections into the future which makes it notoriously hard to use for earlier stage startups.
For the purposes of this post and the corresponding session, I decided not to focus on this approach as it is not very relevant to the vast majority of attendees and readers. If you would like more details, please reach out to me separately.
Starting a Cap Table
Rather than using pre-built cap tables (such as the one I have provided as an illustration), I would encourage you to build a rolling cap table to meet the needs of your startup, as they occur. This has the added benefit of providing you with more context around verbal term sheet negotiations and what they mean in terms of dilution and returns.
Your cap table should have the functionality for you to change the agreed valuation and assess what happens to dilution and future returns at different investment amounts, i.e. the valuation and investment amounts should be inputs which drive the dilution and returns.
For instance, you can drive your valuation using revenue and the revenue multiple (£400k revenue at 5x multiple i.e. £2m pre-money or pre-investment valuation). If an investor were to invest £0.5m in your startup, they would own £0.5m / £2.5m i.e. 20% of the post-money valuation. The number of shares would depend on the pre-money valuation divided by the number is shares in issue before the investment. In the absence of any overriding terms, in the event of an exit at £25m, the investor would make £5m or 10x their money.
In practice, investors, especially VCs will have multiple term sheet provisions which will complicate your cap table and returns.
Before discussing specific terms, it is worth mentioning that VCs generally invest through preferred equity (as opposed to common equity) which is what gives them these special rights above those of common equity holders. VCs also have the option to convert their preferred holding to common equity usually during an exit event at a pre-agreed conversion price.
- Liquidation Preferences
As downside protection for taking on high risk in startups, VCs will often negotiate liquidation preferences which is a fancy way of saying that they demand to have the first slice of the pie in an exit event. What happens if the pie is not big enough?
Usually VCs will demand that they make 2–3x their initial investment amount before anyone else. If the exit event is not large enough to cover the amount promised first to the VCs, no other owner gets anything and the VC walks away with the whole amount.
An interesting phenomenon of term sheet negotiations is that the liquidation waterfall (i.e. who gets paid how much in what order) prefers the investors that invested last to receive their returns first. In challenging times, this structure can prove to be catastrophic as later stage investors with downside protection would vote to have a quick exit even if it is at low valuation levels while earlier stage investors and founders would prefer to wait for higher valuations. Term sheet negotiations should try to minimise these misalignments so that the business has a fighting chance in challenging times and is not taken out by infighting.
Apart from downside protection, investors like to share in upsides which is why liquidation preferences often have a participating clause. After extracting their minimum liquidation amount, VCs will often ask to share proportionally in the remaining profits. Usually a middle ground is struck where the VC shares in the profits up to a maximum cap. For instance, for an investment amount of £5m, a VC might negotiate a 3x participating liquidation preference upto £20m. In terms of returns, this means that the investor would make at least £15m (or the total exit amount if less) and would share in the remaining amount upto £20m.
Of course, the VC always has the option to convert their entire preferred stake into common equity and participate in sales proceeds as a % of ownership. Usually this would happen when the company has a homerun and the % stake amount is greater than the participating preference cap. In the above example, if the VC owns 10% of the startup at an exit event of greater than £200m, it would choose to convert to common equity as the total amount due 10% * 200m+ would be greater than the £20m participating preference cap.
2. Anti-dilution Provisions
Another key term to include and assess in your cap table is the anti-dilution provision which provides a way for VCs to protect against economic dilution during down rounds.
This provision works by adjusting the conversion price of preferred equity i.e. if the valuation of a later round is lower than the valuation the VC invested at, the conversion price of the VC’s preferred equity is reduced (or the number of common shares their preferred shares convert to increases) to compensate them for economic dilution.
This happens through two main methods:
- Full Ratchet: The entire preferred holding has the option to convert to common equity at the lower price of the new round, regardless of how many shares were issued at the lower valuation. Even if one share was issued at the low valuation, the entire preferred holding can exercise the full anti-dilution provision. This is extremely unfriendly to founders and is rarely used in term sheets.
- Weighted Average: Adjusts the conversion price lower based on the new shares actually issued to the new investor vs. the expectation of the old investor regarding the number of new shares that should have been issued in a theoretical equal round. More realistic and therefore, more commonly used.
The anti-dilution protection to VCs comes at the cost of earlier investors and founders as the additional ownership of the VCs dilutes the ownership of earlier investors and founders who do not get any options to additional shares.
3. Convertible Instruments
In instances where you are not ready to set a valuation range for your startup (earlier fundraising rounds), there is always an option to do an unpriced round in the form of convertible notes.
Before taking the decision on whether to do an unpriced round, you should consider why these instruments are so attractive to VCs:
- Discounts & Valuation Caps: Usually offer a conversion discount in the future when there is a priced round; this means that the investor can convert their note into equity at a price (10–30%) discount or a valuation cap (i.e. the price implied by a much lower pre-agreed valuation). In practical terms, this means that the investor gets more shares than they would had they invested in the new round as a normal investor.
- Interest: Attractive 8–10% interest rates which accrue and make the final conversion amount higher than the principal invested
Ask yourself the following questions before raising funds through convertibles:
- Is it worth kicking the can down the road or are you offering discounts to delay a lower valuation?
- How much dilution would you face from the ultimate conversion compared with raising equity at a fixed valuation now?
Finally, model the convertibles as scenarios in your cap table and calculate future dilution upon conversion at different prices & valuations.
If you are expecting a high valuation in the near future, negotiate the pricing discounts and valuation caps to reflect the high future valuation. It might even be better to price an intermediate round at a lower valuation if the discount and valuation cap imply an even higher dilution scenario in the future.
Wrapping Up
Finally, as many of you requested access to the XLS spreadsheet and slides that I used in the session, these are available at the below link:
The next session in this series will cover:
- Pitching to Investors: Effectively communicating and negotiating with investors
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