There is an important distinction between value and price. The sale of shares to an Angel or venture capital investor seldom reflects “value” and normally reflects “price.”
Fair Market Value (FMV):
“the highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length, and under no compulsion to act, expressed in terms of money or money's worth.”
“the consideration paid in a negotiated open market transaction involving the purchase and sale of an asset.”
More casually, “value” is what something is worth and “price” is what you get for it. Here are some of the reasons why the two results may be materially different:
Fair Market Value is calculated in a “notional” market, while Price reflects the real world;
Fair Market Value assumes equal negotiating ability between the parties, while Price is affected by different negotiating strengths;
Fair Market Value assumes both parties have equal knowledge, while Price reflects differences in information or assumptions;
Fair Market Value assumes there are no “special purchasers”, while Price may reflect the influence of a purchaser that has a unique incentive;
Fair Market Value assumes neither party is under compulsion to transact while, in reality, vendors are usually under some financial pressure to sell, and one or both parties are acting on emotion; and,
Fair Market Value assumes there are many buyers in the “notional market”, whereas in reality there are often only a few that often confer.
Notwithstanding this important distinction between “value” and “price,” most discussions on the topic inherently use the term “value” to refer to “price.” This whitepaper will follow that same practice. Just remember though, all discussions on value really refer to price – i.e. what you can get for your company, not what it is worth.
With the higher risks inherent with earlier stage companies, the valuation methodologies are much more subjective than the methodologies used for Later Stage companies.
Trends in Pre-Money Valuation
Overall ObservationsVentureOne Corporation has been tracking the US VC industry since the 1980s. Figure 1 presents their findings respecting quarterly changes to pre-money valuations across the major venture capital investment classes (i.e. investee company maturity stages) during the period between Q1 1998 and Q3 2001. The NASDAQ performance is overlaid across the VentureOne research for comparative purposes. A few observations can be made:
The further distanced company maturity is from IPO status, the less dependency there seems to be on changes to NASDAQ values. Seed Stage pre-money values seem to be influenced by NASDAQ activity very little. Valuation methods for early stage companies are different from traditional methods used for public companies.
As compared to Series B and Later Stage pre-money valuation trends, the pre-money valuations for Seed Stage and Series A Stage are relatively flat. Valuation methods for these very early stage companies result in a narrow band of valuation possibilities.
Seed Stage Pre-Money Valuations
A longer period of pre-money valuations is shown in Figure 2. The data indicates that Seed Stage pre-money valuations have fluctuated within a narrow band of between, US$2 million and US$5 million across more than ten years. This seeming stability contrasts some meaningful external market forces, such as a major recession, the “dot com” cycle, the “telecom meltdown”, and a few major market “corrections.”
This data indicates that Seed Stage pre-money valuations are normally between US$2 million and US$5 million. That same research also includes data on typical issue sizes, indicating that Seed Stage investors typically own 20% to 30% of the company's post-money fully diluted equity. The issue sizes are normally between US$500,000 and US$2 million.
Given the relatively few possible outcomes, Seed Stage investors typically use very simple valuation methodologies. Some of the reasons for a more simple approach include:
The final pre-money valuations will be within a narrow band and will be more affected by negotiating strengths than “mathematical” determinations
Many Seed Stage investors recognize that much of the company's business plan and product concept will likely change over the next few years
With so much “uncertainty” and perceived risk, Seed Stage investors typically rely on more “intuitive” or subjective valuation models and support their subjective views with reality checks (i.e. due diligence) in a few key areas
Seed Stage investors also recognize that, without a lot of substance in the companies upon which to do meaningful due diligence, they should be able to reach an intuitive assessment relatively quickly.
Many Seed Stage investors recognize the “subjective” nature of their Seed Stage investment decisions and expect a high “mortality rate.” To offset this exposure, most Seed Stage investors are prepared to invest in one or two more financing rounds for the more promising investees.
Here are a few “data points” supporting the above summary observations:
MIT Entrepreneurship Center
Research Findings February 2000: Seed stage technology ventures were typically US$500,000 to US$3 million. Pre-money valuations greater than US$5 million required an extraordinarily compelling story.
The Tech Coast Angels:
Website: “we look for pre-money valuations below US$5 million”
Presentation March 2002: "sweet spot" for investing is a pre-money valuation of US$1.5 million to US$3 million.
Sand Hill Angels:
Website: invest US$250,000 to US$2 million at a valuation of less than US$5 million.
New Jersey Entrepreneurial Network Angels:
Presentation: Valuation of US$1 million to US$5 million, for 20% to 30%
Winning Angels, Amos/Stevenson (Noted Book):
Most Angel investors want pre-money valuations between US$2 million and US$5 million, with US$2.5 million as the “sweet spot”
The more diligent investors will attempt to provide more “quantification” to their assessment of pre-money value. As one such attempt, some Seed Stage investors estimate the amount of cash required to achieve a major development milestone and, often without regard to how much that is, equate that amount to 50% to 60% of the company (post-money, full dilution).
Rule of “Thirds”
The Rule of “Thirds” simply implies that 1/3 of a new company's equity should go to the Founders, 1/3 to management (i.e. an Option Pool), and 1/3 to the Seed Stage investors. This methodology is used most often as a “sanity check” to other valuation methodologies.