Having a relatively small about of convertible debt on your balance sheet prior to your Series A financing is not a bad thing.  I am a big fan of convertible debt (with appropriate terms).   Typically the convertible debt automatically converts in a Series A round of at least $X within Y time frame.  So $X might be at least $1mm and Y time frame might be within 18 months of the convertible debt issuance.  The X and Y are negotiated, with the Y typically being a date shortly before the convertible debt is all used up by the company in its operations.

One interesting point that comes up a lot is how to factor the convertible debt into the premoney valuation of the Series A round.  Let’s assume the following:

• Common Stock outstanding:  3,400,000 shares owned by the founders.
• Option pool:  500,000 shares (some issued, some reserved, but that is typically irrelevant as the whole pool is normally factored into the premoney share price calculation)
• $62,000 of convertible debt outstanding with $13,700 of aggregate interest accumulated, which also converts as well in the qualifying round.  And let’s assume that the debt has a 20% conversion discount.  I am going to ignore any valuation cap feature.
• Series A premoney valuation negotiated to be $3mm.

So, to calculate the Series A share price, you take the premoney valuation of $3mm and divide it by the number of premoney shares, which again will typically include the whole option pool.  So, $3mm/(3,400,000+500,000) = $.7692 per share.   That would be the share price of the Series A stock being sold to new Series A investors.

But, what about the convertible debt?  The convertible debt has what I like to call “purchase power” equal to ($62,000+$13,700)/(1-20%)= $94,625.  That is how much Series A stock will be issued to the debt holders.

If you don’t factor this purchase power into the premoney valuation, the Series A new investors are going to end up with less than what they expect.  In our example, if the premoney is $3mm and the Series A new investors are putting in $1mm, then they expect to own 25% of the company after the closing ($1mm invested/$4mm post money).  But, when you factor in the convertible debt purchase power, the post money valuation is actually $4,094,625 (just $3mm premoney plus $ amount of Series A sold).  So the new Series A investors end up with 24.4% ($1mm/$4,094,625).   Granted, that is not much dilution, BUT what if there were like $600K of convertible debt instead of $62K.  Ouch, then the dilution is real.

The easiest way to deal with this issue (and the way I like to deal with it), is to simply subtract the convertible debt purchase power from the negotiated premoney valuation.  So, in our example, the new premoney valuation would be $3mm minus $94,625 = $2,905,375; the new Series A share price would be $2,905,375/(3,400,000+500,000) = $.7450 per share (note how it is lower than the per share price calculated above).   And the post money would be $2,905,375 + $1,094,625 (which is the total Series A sold including the convertible debt) = $4mm.  And, viola, the new Series A investors who put in the fresh $1mm own 25% post money.

The one big issue to keep at the front of your mind is that the more convertible debt you have on your balance sheet prior to the Series A round the bigger the impact on the “true” premoney valuation (in the downward direction).   It can get painful so make sure to manage your expectations.

On October 17th I posted on seed and early stage startup valuations.  This morning I read a post by Marty Zwilling on startup valuations.  Here it is.  Marty’s posts are solid in my opinion – short and content driven.  His post on startup valuations lists the following rules of thumb (i.e., possible inputs) for the calculation (and he explains each):

1. Place a fair market value on all physical assets (asset approach).
2. Assign real value to intellectual property.
3. All principals and employees add value.
4. Early customers and contracts in progress add value.
5. Discounted Cash Flow (DCF) on projections (income approach).
6. Discretionary earnings multiple (earnings multiple approach). .
7. Calculate replacement cost for key assets (cost approach).
8. Look at the size of the market, and the growth projections for your sector.
9. Assess the number of direct competitors and barriers to entry.
10. Find “comparables” who have received financing (market approach).

I was a little surprised that his list did not include the following:

1. Demand for your deal, measured by the number of term sheets you have obtained.
2. The reality that an early stage VC is going to want to typically obtain between 20-35% of your company in the financing (the point of my original post).

I actually think that these 2 are probably the most important.   And just for fun here is my quick take on the others that he did list; these factors will help drive where in the 20-35% range you end up.  Critically, I am only talking about seed and early stage company valuations as opposed to valuations for more mature companies:

1. Place a fair market value on all physical assets (asset approach) – pretty much a waste of your time.
2. Assign real value to intellectual property – only worth something if patents have actually issued or the invention is so unique that the application and eventual patent could really serve to block competitors.
3. All principals and employees add value – the team is very valuable.  The better the team, the better the valuation.
4. Early customers and contracts in progress add value – completely agree that real customers are big boosters.
5. Discounted Cash Flow (DCF) on projections (income approach) – worthless.
6. Discretionary earnings multiple (earnings multiple approach) – worthless.
7. Calculate replacement cost for key assets (cost approach) – worthless.
8. Look at the size of the market, and the growth projections for your sector – sure, big markets are more attractive.
9. Assess the number of direct competitors and barriers to entry – see number 2 above.
10. Find “comparables” who have received financing (market approach) – very difficult to ascertain as the information is well guarded and the media is usually wrong on this one.

Add to the list……