INSIDE ISSUE 33

This article is a basic introduction to one of the most critical aspects of startup financing, namely how investors and the founders of startups negotiate and find a fair valuation for a startup.

If you want to know how much a listed company is worth, you can simply look up its market capitalization. At the time of writing, Apple has a market capitalization of 2.7 trillion US dollars. This means that if you multiply the share price by the number of shares outstanding, you get this result, which means that the stock market thinks today that Apple is worth 2.7 trillion. This number goes up and down and is a result of how many investors buy and sell shares at any given moment. Bank analysts will use very sophisticated models to determine the fair value of the company. Ultimately, the valuation of a listed company today reflects the sum of the future cash flows it will generate.  

A startup’s valuation is determined by a very different mechanism. First of all, the valuation of a startup will be determined at the moment of a financing round, when new investors buy new shares of the company. Usually, financing rounds happen every 12-24 months. They are named Seed (the first round backed by professional venture capital firms), Series A, Series B etc.

The valuation is negotiated by the founders of the company and new investors. One of those investors who is willing to put in the biggest amount of money is called the lead investor. The lead investor will negotiate with the founders, and the other investors (the followers) will be happy to invest on the same terms. The terms of investment are written down in a so-called term sheet. While this document will include other terms that are important as well, its most central point is how much money will be invested at what valuation.

The valuation will determine how much of the company the founders will need to give to new investors for the sum these investors are willing to invest. 

If you want to invest, say, 1 million in a startup, you will get a larger percentage of the company if the startup is valued at 4 million than when it is valued at 40 million.

Example:

If a startup is valued at 4 million before a financing round happens, we call this number pre-money valuation (it means the valuation before new money flows in). If the investment in the company amounts to 1 million, the post-money valuation (after the new cash has hit the startup’s bank account) is 4m+1m = 5 million.

The percentage of ownership an investor gets is calculated by dividing the post-money valuation by the investment amount. In this case, 1 million divided by 5 million = 20%.

If the same investor invests 1 million in a startup with a pre-money valuation of 40 million that raises 10 million in total (1 million from the investor plus 9 million from other investors), the ownership this investor gets is (1 million divided by 50 million post-money) 2%. 

From an investor perspective, the lower the valuation, the more you get (in percent) of the company. Therefore, investors have an incentive to negotiate low valuations. From the founders’ perspective, the higher the valuation, the fewer percent of your company you give away – hence, founders want to negotiate higher valuations. However, there are several reasons why both sides will not push for a maximum in their negotiation position.

Market mechanisms ultimately determine startup valuation. If a startup is active in a field that generates a lot of attention, such as artificial intelligence at the moment, many investors will want to invest in it, which drives valuation up. If it is active in a field that not many investors like for whatever reason, or if the startup struggles to convince investors because it is in trouble, the lower the valuation will be.

Example

A lead investor sends a term sheet to the founding team of a startup that says “We are willing to invest 5 million at a pre-money valuation of 40 million.” There are 2 followers happy to provide 5 more million for a total of 10 million. Some days later a different lead investor puts a different term sheet on the table – they are willing to invest 10 million at a pre-money valuation of 60 million. If the founders accept this second offer, which looks better from their point of view, all the investors that offered less will be out of this financing round.

However, there are other reasons why founders might not want to maximize the valuation even if they could. If they have several competing offers on the table, one investor consortium could be much more valuable than the other because they are known to be very helpful and could bring the startup new customers. Sometimes its also wise not to push the valuation too high because at the moment of the next financing round, there will be negotiations with other people, and there needs to be some progress between now and then to justify a higher valuation. Founders (and investors) will want to see a history of financing rounds that happen at increasing valuations. If problems arise, and the valuation in the next round is lower than previously (a so-called down round), this sends a bad signal to everyone involved.

In a different scenario, when the startup struggles to find investors, those who are willing to invest could try to maximize their shareholding by pushing the valuation as low as possible. They might know that no one else wants to invest, and the startup is running out of money. However, prudent investors know that founders need to be properly incentivized to give all their energy to the difficult work of getting a company off the ground. If the founders get overly diluted (which means that they end up holding just a few percent of the company after the financing round), they might actually lose interest or just work half-heartedly, with the result that the greedy investor might own a high percentage of an unsuccessful company one day.  

If you’re interested in learning more about different valuation techniques, follow this link to find slides and the recording of a webinar dedicated to this topic: Verve Academy page.

_{*Bergos is not responsible for the content of the guest article and does not necessarily reflect the opinion of Bergos and the statements expressed herein do not constitute investment advice. Investments in Start Ups are risky and are only available for qualified investors.}

Bergos AG is an independent Swiss private bank with headquarters in Zurich and offices in Geneva. It emerged from Joh. Berenberg, Gossler & Co. KG, it has been active in the Swiss financial centre for international private clients and entrepreneurs for over thirty years. The Swiss private bank specializes in asset management and advisory services. For its more than 100 employees, the focus is on providing advice in all known liquid and non-liquid asset classes, as well as in alternative investments such as real estate, private equity or art. It provides entrepreneurial clients with access to M&A and other corporate finance services. Bergos AG offers private clients, entrepreneurs and their families a holistic service spanning several generations, which, in addition to investment recommendations, aims at security, neutrality, internationality and cosmopolitanism.

This publication only serves information and marketing purposes. The information provided here is not legally binding and does not constitute financial analysis, a sales prospectus, asset management, or investment advice, and is not a substitute for legal, tax, or financial advice.

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COUNTERTENOR, BORN IN ENGLAND

Hugh Cutting is a graduate of the Royal College of Music where he was a member of the International Opera Studio.  On graduating, he was awarded the Tagore Gold Medal, presented by King Charles III. In the autumn of 2021, Hugh became the first countertenor to win the Kathleen Ferrier Award and is the first countertenor to become a BBC New Generation Artist (2022-24).

Some Feedback from our selection committee:

“incredible promising voice, and listening to him can simply take your breath away” – Alexandra Keller

“Hugh Cutting proves not only through being the first countertenor to become a BBC New Generation Artist but also with his debut at the Opernhaus Zürich that this art of singing is well worth being heard and shared” Phil Raskin

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Frieze and Frieze Masters are already two fairs, one contemporary, the other one classic. There is also 1:54, a fair dedicated to the African and Caribbean world.
There are sensational shows in London, too, Marina Abramovic at the Royal Academy, Nicole Eisenman at the Whitechapel Art Gallery, Philip Guston and El Anatsui at the Tate Modern.

And Paris? Try to see La Bourse de Commerce with the Pinault Collection. Try also the new gallery of Hauser & Wirth with a show of Henry Taylor.

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