Valuation Strategies

Determining the value of the business is never an easy task. If a company has significant operating history its valuation will be based on its assets and profits. When we talk about a startup entity with zero or limited commercial activities, the amount of money an investor will be ready to pay for a number of company’s shares will usually depend on the industry statistics and past deals with similar businesses. Entrepreneurs are also advised to research the sales prices of comparable companies in their industry sector.

 

While price is subject to open negotiation between two independent market participants, the seller and the buyer or the investor and the founder, the parties should be careful about the formula they use to determine how much equity is being sold and acquired. Corporate entities usually have issued shares, which belong to the founders and other shareholders of the company, and reserved shares, which are authorized but not issued. Instead they are reserved in the option pool for future hires and partners. The price for a particular percent of the company equity may be based either with consideration of the option pool or without. What does this mean? For example, an investor offers $4 million for 40% of the company including the reservation of 1 million shares for future options. Under this formula the investor will be entitled to 40% of the company even after the options are exercised and the founders’ shares will be diluted to cover the options. Factually the investor would be entitled to 4.667 million shares, not 4 million shares, for his $4 million. This is not in the best interests of entrepreneurs. They want investors to participate equally in the dilution if additional shares have to be issued in the future. Then entrepreneurs may propose that 1 million reserved shares are not taken into account in the valuation of the company. In this case the investor and entrepreneur will jointly bear any dilution for the reserved shares to be issued in the future.

 

The deals are done on both bases. Most early-stage venture capital deals include an option pool reserve in their valuation. The stronger market position and potential growth of the company the more bargaining power its founders have.

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