# Planning Investment Round Pricing for Startups

Suppose you are just starting to plan your startup company.  It’s a balancing act, to put it mildly.

You’ve researched your market and industry.

You think you understand what products you’ll sell at what price to what target markets.

You and your co-founders already purchased, say, 1,000,000 (common) founders shares at \$.001 per share.

You have built pro forma income statements for five years and see that you expect to achieve revenue (\$19,000,000) and profitability (\$7,500,000) compatible with your goals. Here is what your pro forma income statements might look like:

You have also built pro forma cash flow statements and have learned that you need two infusions of cash: \$400,000 during the first year of operations and an additional \$800,000 during the second year.

After that, the company will grow without infusions of cash. Here is what your pro forma cash flow statements might look like (Note that the cash balance at the end of the first year is negative \$337K, which is why we concluded you need \$400,000 in cash. Note that the cash balance at the end of the second year is negative \$1.17K, which is why we concluded you need \$800,000 more in cash.):

The next big questions you must answer concern the two investment rounds:

• What class of shares should you sell the investors?
• At what price should the shares be sold?

## What Class?

Most outside investors in startup companies want preferred, not common, stock. The reason is simple. Unlike company founders, outside investors typically have little or no influence over decisions and outcomes because they are not part of the management team.

With so little control, they take on much more risk, and thus deserve a higher return. Preferences (specifically Liquidation Preferences, but often others as well) provide that higher return.

## At What Price per Share?

Determining price per share is an iterative process.  In the scenario being discussed, let’s start by guessing that a price per share of \$5.00 might work. See figure below.

Next, take a look at the Internal Rates of Return (IRR) in the last column of the following table.

In this case notice that two problems exist:

1. The IRRs (21.9% and 28%) for both rounds are below external investor expectations.
2. The IRR received by the second set of investors (Series B) is higher than by the first set of investors (Series A). That is inappropriate since earlier investors always take higher risk and therefore deserve a higher return.

With that in mind, let’s adjust the prices per share for the two rounds to \$1.25 and \$4.00, respectively.

This time the relative returns of the two rounds are appropriate, but the Series B investors are still receiving a return too low for outside investors; in fact they’d be better off making a safer investment in the public markets (they would receive a lower return but with a much lower risk).

In this specific case, iteratively adjusting the prices per share will eventually demonstrate that prices of \$1.25 and \$2.75 result in IRRs of 44.1% and 35.5% for the two classes of investors.

Personally, I tend to plan for larger returns for my investors, so I would likely plan my rounds at around \$.75 and \$1.50 per share to at least plan for returns of 51% and 45%, respectively.

Of course, this exercise is a planning exercise only. When you get around to actually raising capital, many other factors are going to come into play including whether or not you have met key milestones, the general availability of capital, the negotiation strengths of both parties, competition, and so on.

Now you have determined the right prices per share to use during the planning stage of your company so that your shareholders receive fair returns. There is just one more step left. It is to look at the cap table for your company to verify that you have not sold too much of the company in the process of attracting investors. If necessary, read How to Read a Cap Table: Advice for Entrepreneurs.

As you can see above, Series A sold 19% of the company, and Series B sold 18% of the company, leaving 63% for the founders and optionholders.

If you are comfortable selling more of the company and offering a larger return (and thus making it more likely to receive investments), lower the price per share for each round.

The price per share is your “lever,” which is equivalent to manipulating the valuation of the company or the “pre-money valuation”.

Planning your investment rounds at company inception enables you to understand the impacts of seemingly small changes to deal terms at a time when you are not under duress. Then when the time comes to deal with investors you can apply the knowledge you learned previously to remain calm.

Dealing with investors requires precision, patience, and a keen understanding of your company’s present and forecasted finances. Operating with the finances as your fulcrum allows you to balance everyone’s interests and give your company the best possible chance of success.

Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

High Wire Photo courtesy of orangebrompton (Creative Commons)

# How Investors Value Your Startup

Let’s start by discarding two myths:

• Investors do not want control of your company! That is the last thing they want. What they do want are (a) handsome returns, and (b) for you to responsibly manage your own company so they don’t have headaches.
• Investors do not care what past valuations were. On previous rounds, you may have received poor advice and valued your company at, say, \$5M, and you found some unfortunate investors to purchase stock at that ridiculous valuation. Oh well, that’s too bad. It has zero effect on what the company is worth today.

## What do investors want?

So, what do investors want? And how will they decide what your company is worth? Five main factors influence them:

1. Is the opportunity exciting? If it isn’t exciting, they won’t bother valuing the company at all.
2. Is the team qualified to execute on the plan? If not, you just aren’t worth the risk.
3. Valuation based on current performance. Based on current trailing financials (i.e., what you have already done regarding revenues and profits), and multiples applicable to your specific industry, what is your company worth today?
4. Valuation at desired time of liquidity. Based on expected performance (i.e., what you say about expected revenues and profits in your plan), and multiples applicable to your specific industry, what will your company be worth in the future? See below and blog on Determining Future Valuation.
5. At what stage is the company? The biggest hurdles a startup has are:
• building a product
• getting the first revenue
• demonstrating a repeatable sales model
• demonstrating sustainable growth without continuing to invest external cash.

As you jump each of these hurdles successfully, the risk of total failure decreases significantly. Investors have their own rules of thumb about how that “risk of total failure” affects valuation. Here are my rules of thumb:

• If you have not yet built your product, assume valuations will be no more than 25% of the valuations calculated using the techniques shown below.
• If you have built your product but have not yet received revenue, assume valuations will be no more than 50% of the valuations calculated using the techniques shown below.
• If you have built your product, started receiving revenue, but have not yet demonstrated a repeatable sales model, assume valuations will be no more than 75% of the valuations calculated using the techniques shown below.
• If you have demonstrated a repeatable sales model and are looking for investments to “ramp up,” then the following techniques for valuation are applicable.

## What To Do With Future Valuation?

Let’s talk a bit more about item 4 above. What will investors do with that future valuation once it is computed? They certainly won’t use it for today’s valuation. What they will do is use it to determine what value the company needs to have today so they can receive an acceptable return on their investment. Assuming that FV is the computed future valuation of the company at the time of liquidity, IRR is the investor’s desired rate of return and n is the number of years between now and the liquidity event, the calculation goes as follows:

Current Value of Company = FV / (1 + IRR)n

So, for example, let’s say the FV is determined to be \$15M (using the techniques of the blog, Determining Future Valuation), and the investors desire a 50% IRR (not unreasonable considering the degree of risk) over 5 years. Plugging those numbers into the above formula, we get:

Current Value of Company = 15M / (1 + .5)5 = \$1.98M

So, if you are looking for those investors to invest \$500K now, expect them to ask for 25% of the company (because \$500K is 25% of \$1.98M); if you are looking for those investors to invest \$250K now, expect them to ask for 12.5% of the company. And so on. But this applies only after you have demonstrated a repeatable sales model.

Now you need to factor in the risks described above. If your company is:

• Pre-product, valuations decrease by around 75%. So continuing with the above example, the company now has a current valuation of around \$500K. So, if you are looking for those investors to invest \$500K now, expect them to ask for 100% of the company (obviously not a good idea); if you are looking for those investors to invest \$250K now, expect them to ask for 50% of the company.
• Pre-revenue, valuations decrease by around 50%. Continuing with the above example, the company now has a current valuation of around \$1M. So, if you are looking for those investors to invest \$500K now, expect them to ask for 50% of the company; if you are looking for those investors to invest \$250K now, expect them to ask for 25% of the company. And so on.
• Pre-repeatable sales, valuations decrease by around 25%. Continuing with the above example, the company now has a current valuation of around \$1.5M. So, if you are looking for those investors to invest \$500K now, expect them to ask for 33% of the company; if you are looking for those investors to invest \$250K now, expect them to ask for 16.6% of the company. And so on.

None of the above is motivated by greed or a desire for control; it is pure economics. Investors want (and deserve) a fair return for their investment.

Of course many other factors come into play including experience, negotiation skills, degree of desperation to obtain cash, and availability of competition for deals (for the investor) and investors (for the entrepreneur).

Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.