Ever more frequently, I see startup companies using SAFE (“Simple Agreement for Future Equity”) investment structures or convertible notes to avoid negotiating a seed-stage valuation for their company. There are at least two problems with this approach:
- The “deferred valuation” schemes are great for companies but unfair to investors, for reasons we will explain
- This approach signals to investors that a company does not know how to estimate its economic value based on sound forecasts.
In this article we will explore “net present value” as a means of estimating the economic value of a company, and we will explain why seed stage investors do not like the deferred valuation schemes.
If you want to increase the chances of getting seed capital for your startup, take heed and be willing to sharpen your pencil and negotiate a fair value for equity in your company—and possibly increase your chances of getting a higher valuation for your Series A.
Simple Explanation of NPV
Few people seem to understand how to use “net present value” to value a startup company, yet the methodology has been shown to provide the best correlation with actual valuations. The method involves straight-forward arithmetic.
Suppose your friend has a machine that produces a tax-free check for $100,000 on December 31, of every year. On January 1, of a particular year (2021), he offers to sell the machine to you, but on January 1, five years later (after you have received five checks from the machine) you must sell the machine back to your friend for $100,000.
The cash flows are as follows;
- December 31, 2021 get a check for $100,000
- December 31, 2022 get a check for $100,000
- December 31, 2023 get a check for $100,000
- December 31, 2024 get a check for $100,000
- December 31, 2025 get a check for $100,000
- January 1, 2026 sell the machine back for $100,000
How much are you willing to pay for the machine?
You will have received tax-free checks totaling $600,000, but some of those checks won’t arrive for five years, so you wouldn’t want to pay $600,000 today. To really answer the question, you have to ask yourself, “What are my alternatives? What else could I do with my money, and how does this compare?”
Suppose, for example, that you are confident you can make a 7% after tax return in the stock market, but with some risk. You might conclude that a risk-free 6% return is a pretty good deal. So, for that first $100,000 you might be willing to pay $94,339.62 ($100,000 divided by 1.06). Do the math and you will see that $94,339.62, compounded at 6% for one year, yields $100,000.00. The “net present value” calculation is simply the reverse of the “principle plus interest-earned” calculation.
Similarly, for the second $100,000.00, which is to be paid in 2 years, you should be willing to pay $88,999.64 ($100,000 / 1.062). You could pay $83,961.92 in 2022 for the third $100,000.00, $79,209.36 for the fourth, and $74,725.82 for the fifth. And another $74,725.82 for the $100,000.00 you receive for the machine at the end of the 5th year.
Adding all these discounted amounts you should be willing to pay $495,962.18 for the use of the machine over a five-year period. You would have received a total of $600,000.00 over the course of five years, but the “present value” (as of the day you buy the machine) is lower because of your return-on-investment expectation of 6% per year.
Following the same formula, if your target investment return is 20%, you would be willing to pay only $339,248.97.
This example illustrates the principles of a Net Present Value (“NPV”) model for the valuation of a startup company:
- The annual payments compare to annual net cash flows generated by the business
- The final “buyback” payment corresponds to the startup’s “terminal value” or value at the end of the forecast period
- The interest rate corresponds to the internal rate of return (“IRR”) the investor is seeking, which is reflected in the “discount rate” given the risk he perceives that the startup will be successful.
“Net present value” is a way of estimating the intrinsic value of a company based on its projected ability to produce net cash flows. The value of the estimate depends on the accuracy of the forecasts used to obtain it, but with reasonable forecasts, the methodology provides a good economic estimate for the value of a company.
NPV Calculation for a Startup Company
To calculate a “Net Present Value” for a startup company, you simply need a (believable) financial projection for the company, including a P&L statement and a balance sheet. The primary information required for the NPV calculation is “Free Cash Flow,” which, in lay terms, is profit before taxes and adjustments for inventory, depreciation, and capital equipment costs. For most startups, the balance sheet items are negligible, so as a very rough approximation to “free cash flow” we can use “EBITDA,” or “earnings before taxes, depreciation, and amortization.” A purist accountant might not care for this, but, remember, we are dealing with crude approximations in the best of cases. The spreadsheet uses the Excel “NPV” formula to calculate the net present value of each cash flow.
How Do Investors Think About Risk?
The basic principle of venture capital investing is that it is (or, should be) possible to make a higher investment return than with other vehicles, such as the stock market or real estate. This leads the limited partner investors in venture capital funds to expect a return in excess of 20% per year, or possibly even 25% per year.
Like other investment returns, venture capital returns vary from year to year and through different stock market and economic conditions. But 20-25% remains as an overall, long-range target.
One of the risk characteristics of venture capital investing is that some number of startup companies in a VC’s portfolio will fail and return no capital. For this reason, VCs use a “hurdle rate” of return that is much higher than their target 20-25%. For seed stage investments, a VC might seek a return as high as 80%. When angel investors say they want to make 10 times their investment over 5 years, they are asking for a 58% internal rate of return. This may be another way of saying that investors want all of their investments to have “home run” potential, to make up for the bunts, singles, and strikeouts that will inevitably occur.
Table 1 below illustrates a typical startup company “hockey stick” revenue and profit forecast. Highlights of this forecast are:
- EBITDA estimated at 50% of sales as a surrogate for “free cash flow”
- Terminal value (year 7) estimated as a multiple of sales
- Seed stage discount factor of 80%
- “Series A” discount factor of 65%
- Net present value (using the Excel “NPV” function) of $2.7 Million prior to the “seed stage” investment and $18 Million prior to the “Series A” investment.
NPV Turns Negotiating into a Logical Process
Creating an NPV model for your startup forces you to make specific assumptions about sales, sales growth rates, costs and expenses and other factors involved in your finances. This process has the unique advantage of converting the negotiating process away from a “shouting match” and more in the direction of a rational conversation with your investors about your assumptions. “If you don’t like this assumption, we will change it and see what the model says.” This can set the stage for a much more productive, logical and professional negotiation with your prospective investors.
Are Convertible Notes and SAFEs Fair to Investors?
The primary risks facing a seed stage investor are as follows:
- Will the technology/product work?
- Can it be built?
- Can it be built for the specified cost?
- Will customers buy the product?
- Will customers buy the product at the specified price?
- Can the product be manufactured in volume at the specified cost?
- What will it cost to acquire customers?
- What is the customer acquisition cost?
- Is feedback from initial customers positive?
For some startups, the seed stage investment may be able to eliminate most of these risks, leaving only the risk of “market scale-up” for Series A investors. This should have a significant effect on the company’s valuation.
The spreadsheet in Table 1 illustrates how the valuation of a startup can increase as it completes milestones that reduce risk and increase value. Using a VC’s discount factor of 80%, the net present value of the startup in year 1 is $2.7 Million. And in year 3, the net present value is $12.6 Million. Does it always or ever work this way? Probably not, but the basic premise—that risk should reduce and value should increase in time—is absolutely valid. If we take it one step further and use a lower discount factor in the third year, because the risk is lower due to progress made, the third-year valuation is $18 Million, making the point even stronger. This is probably unrealistic as Series A investors are unlikely to pay such a high valuation, but it makes the point.
Given the way the net present value math works, why would a seed stage investor—who is absorbing almost all the startup risk—settle for a valuation that is discounted only 20% from the Year 3 (Series A?) investment. In our example, the seed-stage investor is asked to pay over 3-times the fair valuation for the company. For this reason, seed-stage investors would prefer to negotiate a fixed valuation for their investment and hope that if the company performs well it will be able to raise Series A at a higher valuation. For these kinds of reasons, Tech Coast Angels, the angel investor group I co-founded in 1997, will not invest in SAFEs.
If you want to deal with investors on a professional level and increase your chance of getting seed-stage funding, I suggest you do the following:
- Create a realistic NPV model for your business
- Remember that investors are professionals at valuing businesses, so be careful not to look like you are telling them how to do their job
- Try to focus your negotiation on assumptions and not valuation numbers.
Use your NPV model to have an adult discussion about risk in your startup proposition. If you have eliminated some or all of the risks listed above, use a lower discount rate in your model and argue that much of the risk has been reduced, so investors should be seeking a return in the 40-60% range rather than 60-80%.
These steps will help you compete with the other startups for the capital you need and have a productive conversation with prospective investors.
About the Author
Dr. Fred Haney is the founder and President of the Venture Management Co., a firm that provides assistance to high tech companies. He is the author of “The Fundable Startup: How Disruptive Companies Attract Capital,” published on February 6, 2018, by Select Books of New York. Download the first chapter at http://thefundablestartup.com
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