The Discussion and Negotiation of Valuation is one of the most important conversations a company must have when raising capital.
By Jeffrey Stanger, ITB Solutions, & Mouane Sengsavang, Buttonwood Law Corporation
Discussing your company’s valuation with investors, investment banks, funds, and, in some cases, with shell companies for a reverse takeover is the toughest part of funding your company and, in fact, can lead to the end of financing discussions. You, as the entrepreneur, may know that your business will be successful and lead to great rewards for all stakeholders; however, the investors may not understand this as well. We will discuss some options for successful negotiation of valuation so that all parties are happy with the end result.
The first step is to present your company properly to investors or financiers - sometimes they may know your business as well as you and sometimes they just know that there is an opportunity in your industry. To present effectively you should have four items: a one-page executive summary, a presentation, a business plan, and forecasted financials.
Executive Summary - The executive summary should be in point form and only one page. Most investors and financiers have limited time to read more than this in order to determine if they will schedule out more time to look into your company. This initially shows them that you respect their time and that working with you will be timely and efficient.
Presentation - The presentation should not be longer than 15 pages and should cover all aspects of your company, the market, competitors, future plans, and highlights.
Keep in mind that since you have been building your idea and company you might not “see the forest from the trees”, which could lead to the audience not fully understanding the opportunity. A good exercise is to have someone who doesn’t know the industry or your opportunity read these documents ahead of time and determine what their level of understanding is afterwards.
Business Plan - “No one reads a business plan”. That is true to a certain extent but having a business plan shows investors that you have gone through the exercise of examining all the opportunities, pitfalls, and logistics of your business, especially if you do a SWOT analysis (strengths, weaknesses, opportunities, and threats). The business plan will also save you time and money as it will be used in due diligence for the financing and will form part of the content for the prospectus level disclosure you will need in going public transactions.
Forecasted Financials - Forecasted financials give you and the investors an idea of the future earning potential of your company and the company’s growth potential. Forecasted financials should go out to 5 years. In addition, as long as they’re based on reasonable assumptions, forecasted financials can be used in determining the valuation of your company.
When going into valuation discussions with investors/financiers it is good to have a strong, well-founded idea of what you believe the value of your company is, and which valuation approach to use. Valuation approaches are primarily either income-based or asset-based. An income-based approach is appropriate when future earnings will be more than the value of the net assets used to operate the business. An asset-based approach assumes the business is a going concern but has no commercial goodwill or the going concern value is closely related to the liquidation value.
Standard valuation methods can be grouped into five general categories:
1) Cost approach, reflecting the original cost of the assets and/or business or the cost to reproduce the assets;
2) Market approach (or sales comparison approach), which uses the sales price of comparable assets as the basis for determining value;
3) Income-based approach, which considers the earnings to be derived through the use of the asset;
4) Rule-of-Thumb approach, which involves the input of specific industry competitors and professionals; and
5) Combination of any of the above.
To value an asset or business, you can look at open market transactions involving the shares or operating assets of your company. If there are have been no open market transactions, consider using the following methods:
1. DCF - Discounted Cash Flow - This value gives a Net Present Value – NPV of your company using 5 year cash flow projections.
2. Technology Factor - This valuation method is for technology companies where the company’s technology is being valued and not the entire company.
3. Comparables – This would be valuing your company in comparison to other, usually more mature, companies that are in the same business as you.
As you can see, there are many different methods of valuing a company and Certified Business Valuators will typically use a combination of methods to determine the value of a company.
With your valuation in hand and having properly presented to the investors, you have successfully generated their interest in financing your company. Now you must have the "discussion”. Too many companies go in with their valuation and say this is the valuation, when is the financing going to be done? This never proves to be the case. The investors will inevitably have a much lower value of your company in mind and your goal is to bring this up. You must always look at what you currently have in the company and not what you will have. Someone once said that discussing valuation with investors for your start-up company is like playing 5 card stud poker with someone who has unlimited money - they will always win if you don’t recognize this; you are not playing Texas Hold’em where everyone is equal.
This is not about winning but about coming to a fair valuation for both sides. If you are talking about valuation with investors that means they are already interested in your opportunity, so now you have to mitigate the risks. Do you have the right expertise? Do you have top-level experience in this industry, have you done this before? If not, then recruit individuals with experience to your management team, board of directors, and/or advisory board. Have you test-marketed your business, or your technology? Do you have the proper intellectual property protection? All of this will help you in getting the best valuation you can.
We’ve all seen the strategy that entrepreneurs implement to increase or keep their valuation. They will complete a small (or large) financing with family, friends, and business associates at a higher valuation, for this exercise let’s put it at $5,000,000. Now the company feels it can go into valuation talks with a larger group of investors for a larger financing at a minimum valuation of $5,000,000. In the real world the investors will not give the previous financing much weight. They will stay with what they feel the valuation is, which usually is a lot less. If you do accept the financing at this level then you will have issues with your previous investors, issues you should not have to deal with while growing your company.
Now that you’re sufficiently worried, we now have to look at how investors/financiers typically fail at negotiating valuation. One of the main issues is not providing the entrepreneurs enough incentive to dedicate all their waking hours in making their business a success as they are not looking at the return they thought of when going down this path but feel compelled to continue down.
Is there a structure that suits both sides? There are many structures that can help solve this issue. For example, ABC Company pays for a valuation of their company which comes out at $15 million. They feel confident that when going into valuation discussions with investors/financiers at 50% ($7.5 million) of this valuation they will be able to strike a deal immediately. The investors come back at a valuation of $1 million. One method would be to structure a deal where the initial valuation is $1-$2 million and the entrepreneur starts off with 10-15% of the company. With agreed upon milestones, which could be revenue, earnings, or status of project development, the entrepreneur can increase their ownership to a pre-determined percentage of 50%, 60%, 70% etc. as those milestones are achieved.
In the end, the final valuation should benefit both sides for the success of the company. Be prepared, be reasonable, and understand that the funds are there to fuel the growth of your company. Look at working with a group that has expertise in negotiating valuation and structure between investors and entrepreneurs.
About the Authors
Mouane Sengsavang, LL.B, founded Buttonwood Law Corporation, a law firm providing advice in the areas of securities law and corporate law to public and private companies, in January 2009. From June 2010 to May 2011, Ms. Sengsavang served as a director and corporate secretary of Biosign Technologies Inc. (TSXV: BIO), as well as serving on its audit committee and the compensation committee. Since December 2010, Ms. Sengsavang has been the corporate secretary of Avagenesis Corp. (TSXV: VVA). You can reach Mouane at 604-908-9209 or by email at email@example.com.
ITB Solutions is devoted to assisting private companies with accessing the capital markets in Canada. ITB Solutions brings a full range of services that empowers businesses, whether public or private, to achieve all of their milestones required to access financing and if desired become public. Since 2005, ITB Solutions has provided listings development services to the Canadian Securities Exchange. CSE is the first new stock exchange approved in Canada by securities commissions in over 70 years and has also been designated by the Federal Department of Finance as an eligible stock exchange for RRSPs and TFSAs. We assist companies with the listing application and managing the process to become publicly tradable on CSE, as well as offering advice on how to make the most of your public listing. We also assist the exchange in marketing to potential public companies worldwide. You can reach Jeffrey Stanger at 647-500-0492 or by email at firstname.lastname@example.org
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