Here is a simple prescription for killing the tendency of founders to produce hockey-stick financial projections. Base the valuation of their company on the money being invested and let them ‘earn in’ to the extent they actually meet those projections.
A recent phone conversation drifted into the question of valuation for start-up and early-stage companies. My own opinions on the matter have been formed through work with many such companies and on behalf of many investors in them. The ‘traditional’ approach to allocating equity between investors and management breaks down regularly – with both sides more than occasionally feeling that they are getting the short end of the stick. Some years back, I had the opportunity to try a completely different approach. The company had been taken through bankruptcy and 100% of the equity was held by the investors. Out of that situation, a new method of allocating equity emerged – one that seems to work very well even in the more normal situations of investors participating in start-ups and early-stage companies. Here is the thumbnail:
In my view, the correct valuation for early-stage funding is the sum of the investment plus a small amount for the founders. I then structure an earn-in program that allows the senior team to accumulate equity based on performance against pre-agreed to metrics. These programs can allow the team to achieve controlling interest in the company. I like this approach for two reasons. First, it virtually assures that projections are achievable in the eyes of management. The days of ‘promoting’ investors into a deal using hockey stick projections quickly fades away. Second, the plans allows investors to maintain a steadily increasing value while splitting the value created by the founders and management between the two interests.
© Dr. Earl R. Smith II