Industry insight article - fundraising 101: Valuation of start-ups – some key considerations

By Lip Kian Ang, Mark Tay and Yong Wei Tan

1. Why is valuation important?

The valuation of a start-up seeks to determine the worth of its business in dollar terms. This serves as an important reference point in evaluating the start-up and its business, and has significant implications for the start-up’s ownership. For example:

(a) Proportionate ownership stakes

The agreed valuation in a fundraising round determines the proportionate ownership stake that an investor receives in return for its investment, and conversely, the proportionate ownership stake relinquished by the founders. This significantly influences the respective bargaining powers of the founders and the investors when negotiating the terms of the fundraising. A higher valuation translates into a smaller ownership stake obtained by an investor for the same dollar amount invested, limiting the investor’s leverage to demand better economic, governance, information and other rights. On the other hand, a lower valuation would yield a larger ownership stake obtained by an investor for the same dollar amount invested, thereby reducing the portion of proceeds that the founders would receive on a future sale of the start-up due to the founders’ proportionately smaller ownership stake.

(b) Employee recruitment and incentivization

The valuation of a start-up can act as an important recruitment tool. A high valuation could indicate a good business model, healthy prospects, and/or financial wherewithal to pay wages and other expenses – all of which are important considerations for a prospective employee.

The start-up’s valuation is also an important consideration in equity incentive plans which are commonly included in start-ups’ remuneration packages to attract and incentivize employees. Since an equity award gives an employee a share in the growth of the start-up’s valuation, the higher the potential upside is, the more attractive the equity award would be to the employee. In this regard, the Employee Share Option Plan Primer in the Venture Capital Investment Model Agreements 2.0 suite of documents (VIMA 2.0 Suite) provides an overview of employee incentive plans commonly used among start-ups in Singapore. On a related note, it would be important to obtain an appraisal of the start-up’s shares at the time the equity incentive plan is established, in order to help justify the exercise price of options or the value of the share awards that will be granted to employees.

(c) Modelling, planning and decision-making

Valuations play a key role in the business modelling, operational planning and strategic decision-making of a start-up. The start-up can use the valuation to assess its financial state, and correspondingly plan the next steps for its business (including as to financing, and the optimal deployment of resources and capital).

2. Why is there a gap between the founders and the investors when it comes to valuation?

There are various methods of valuing start-ups which may be applicable depending on the type of business and the stage of a start-up’s life, as described in the article Valuation Considerations of Start-ups. However, a valuation gap could still arise between founders and investors for a variety of reasons, including disagreement on the choice of valuation methods, differing views on how certain metrics of the start-up have been curated, applied or analyzed, and different confidence levels (specifically, the not-uncommon divergence between a founder’s conviction and an investor’s wavering confidence in the business, especially in the context of an uncertain macroeconomic landscape plagued by persistently high interest rates and geopolitical tensions). These are discussed further below.

(a) Challenges in applying valuation methods

It is often said that valuation is part science and part art – the “science” harnesses quantitative methods, historical data and mathematical calculations, while the “art” involves the qualitative opinions of expert valuers. While traditional valuation methods seek to arrive at a rational valuation based on an analysis of objective factors such as historical financial indicators, even the choice of valuation methods can lead to different valuation outcomes for the same company. The inherent subjective elements and biases in any valuation method open the door to possible manipulation of the valuation process (by cherry-picking comparables, using aggressive future cash flow estimates, and/or using an aggressively low discount rate in a discounted cash flow valuation, etc.) to achieve the desired valuation outcome.

The challenges of arriving at an unbiased and rational valuation are exacerbated when valuing start-ups, which, by nature of being emerging companies, tend to lack many of the objective characteristics that would help justify their valuations. Some start-ups may not even have a working product or service to speak of, most start-ups lack extensive historical financial information, and even a relatively mature start-up may find that its past performance is not a reliable indicator of its business prospects due to its flexible and fast-evolving business models. In addition, the core strengths of a start-up, such as its innovative products and solutions and absence of competitors, mean that valuers may have a limited or imperfect frame of reference from which to predict the start-up’s future performance. A start-up may also be more focused on growth and gaining market share without a clear idea of how to generate substantial revenue and profits. This lack of clarity on future income streams can make it difficult to apply traditional valuation methods.

(b) Changes in market conditions and differing perspectives

The “anchoring effect” (i.e., the influence that initially presented information, data or numerical values could have on subsequent determinations and judgments) plays a material role in influencing the valuation of a start-up. In particular, the valuation set by investors in prior funding rounds could influence a founder’s view of the valuation that should be ascribed to his/her start-up in a subsequent financing round. However, given that such valuation would have been based on the earlier investors’ opinions of the start-up and market conditions prevailing at the time of the prior funding round, the same view may not be shared by investors in a new financing round. For instance, while the founders and prior round investors may ascribe a high valuation based on the valuations of similar businesses in the same geographic market, a new investor may have a different opinion based on its own expertise and experience, as well as proprietary information that such investor may have in respect of comparable businesses or across regions. In recent years, the drop in market sentiment has contributed to the widening of the valuation gap, as many investors have become markedly more cautious and selective with their investments against the backdrop of a persistent high-interest rate environment and geopolitical uncertainties. While some founders may continue to hold a high degree of conviction in the potential of their businesses, it may be difficult to convince investors of their view, particularly if the investors being courted are becoming more conservative in selecting investment targets. Despite such sentiments, founders may still be reluctant to accept valuations that are lower than earlier valuations prevalent in the market just recently, or that are lower than what their start-ups had achieved in prior funding rounds. These tensions position investors and founders increasingly further apart in their respective assessments of what constitutes an accurate valuation of a start-up.

3. How can founders and investors bridge the valuation gap?

There are several common methods in the market that founders and investors can employ to help bridge the gap between their respective valuations of the start-up.

(a) Convertible instruments

One solution is for founders to raise funds by issuing convertible instruments instead of shares in the start-up, thereby deferring the determination of the valuation to a later date. This can be useful for investors who face difficulties in valuing an early-stage start-up and is particularly advantageous for founders who would obtain the necessary capital while also delaying the dilution of their ownership stake until the conversion of the instruments. The instruments are typically structured to convert during a subsequent equity financing round, potentially at a time that the founders believe the business has further developed or has recovered from any temporary set-back such that a higher valuation can be achieved. If the start-up can command a higher valuation at the time, the founders would experience a lower degree of dilution of their ownership stake. Meanwhile, investors can safeguard their interests and still be rewarded for their earlier (and riskier) investment in the start-up by using valuation caps and/or discounted conversion prices in the convertible instruments.

Both investors and founders can typically expect to incur lower legal costs when negotiating a market standard convertible instrument with simpler terms reflecting its intended temporary nature. One such instrument commonly used in many markets for early-stage fundraising is the Simple Agreement for Future Equity (“SAFE”) developed by Y Combinator. Additionally, the VIMA 2.0 Suite contains a Singapore-style model convertible instrument called the Convertible Agreement Regarding Equity (“CARE”), as well as a model Convertible Note Purchase Agreement which incorporates traditional debt terms not found in the SAFE and CARE, such that it accrues interest on the principal and has a maturity date for the repayment of the note. A convertible note which has been structured as a debt instrument arguably offers investors more downside protection over the SAFE or CARE, as debt has priority over equity in the event of a liquidation. However, this may be of limited practical value if a start-up fails and is unable to repay the note. Such a convertible note may be more meaningful for investors that are investing in a more mature start-up with more material assets, which would be in a better position to repay the note even if the start-up fails to raise its next equity financing.

The relevant parties should seek professional advice on any accounting implications prior to using a convertible instrument in a financing.

(b) Staged closings

Founders and investors may also consider using staged closings to bridge the valuation gap. Under such an arrangement, the investor does not provide the full investment amount upfront. Instead, payments are made in installments contingent upon the start-up achieving pre-agreed milestones.  These milestones can be tailored to align with the unique needs and characteristics of the start-up. For example, a start-up developing a new drug may receive funding in stages based on the successful completion of clinical trials or the receipt of regulatory approvals (which would usually lead to an increase in valuation). Similarly, a consumer-focused start-up may choose to structure its targets around product sales volumes or expansion into new markets.

(c) Valuation adjustments

Founders and investors may agree upfront to a higher valuation sought by the founders, but condition the maintenance of that valuation on achieving certain pre-agreed milestones, key performance indicators or financial results. These could be similar to the conditions for completing staged closings (as mentioned above). However, in this case, if the metrics are not met, the valuation would be retroactively adjusted to either a pre-agreed number or a number determined based on a pre-agreed formula. The adjustment can be effected, for example, by adjusting the conversion price of the investors’ shares or issuing more shares to the investors. As a result, the investors would have a larger stake in the start-up, reflective of the lowered valuation due to the less optimal business results in the event of the metrics not being met.

(d) Warrants

Founders and investors may close the valuation gap through the use of warrants issued by the start-up, which are rights to subscribe for more equity in a company. Such warrants may be designed so that they are exercisable at a discounted (or even nominal) price if the start-up does not achieve certain milestones. This structure is useful where a founder is confident in achieving a business forecast (and justifies the valuation of the start-up based on such growth) which an investor may view as overly optimistic. However, such warrants would be less appealing to investors of start-ups at risk of insolvency, as the warrants could become worthless if the start-ups undergo liquidation.

(e) Anti-dilution protections

Investors may also incorporate or strengthen anti-dilution protections in investment documents to protect the value of their investment in the event of a future down round, which is a financing round where shares are issued at a valuation lower than in previous financing rounds.

In Singapore, it is common for investment documents to provide for anti-dilution provisions based on a broad-based weighted average formula that takes into account a number of factors (including the price and number of shares issued in the down round and the total outstanding shares) when adjusting the conversion price of the preference shares held by the existing investors. The Shareholders’ Agreement in the VIMA 2.0 Suite includes a broad-based weighted average formula as the default option.

Other adjustment methods used in the market include a narrow-based weighted average adjustment formula and a full ratchet mechanism. These provide more robust anti-dilution protection for investors, and accordingly, are much less palatable to founders compared to a broad-based weighted average adjustment.

Note that anti-dilution adjustments may be subject to pre-agreed exclusions or waivers. For example, investors may be asked to waive the anti-dilution adjustments when a start-up needs to secure emergency funding from new investors in a down round.

4. Conclusion

Bridging the valuation gap of a start-up requires founders and investors to find common ground on their perceptions of the startup and its potential, a task that is made more difficult in a challenging fundraising environment. However, the use of the tools described above can help to bridge the gap and facilitate the closing of an investment.

About the authors:

Lip Kian Ang is a partner in Morrison Foerster’s Singapore office. Ranked as a Leading Individual in Singapore for Startups & Emerging Companies by Chambers Asia-Pacific, he represents international funds, multinational corporations and financial institutions in large cross-border private equity, venture capital, mergers and acquisitions, real estate and fund transactions.  His work spans a wide range of industries including real estate, fintech, life sciences, technology and fast-moving consumer goods. He is a member of the VIMA 2.0 working group.

Mark Tay is an associate in Morrison Foerster’s Singapore office. He represents multinational corporations and investors in venture capital transactions, private equity transactions, restructurings, other commercial, general corporate advisory, and regulatory matters, as well as on the formation and operation of private equity funds, venture capital funds, real estate funds and other alternative investment products.

Yong Wei Tan is an associate in Morrison Foerster’s Singapore office. She represents global, public and private corporations on venture capital, mergers and acquisitions, private equity and other corporate matters across Southeast Asia.

With contributions from Thomas Chou, Alfredo Silva and Katrina Tsoi of Morrison Foerster.

Disclaimer: This article is intended for general information only. It is not intended to be, nor should it be, regarded as or relied upon as legal advice. Readers should consult qualified legal professionals before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising. Neither the Singapore Academy of Law nor any of the VIMA 2.0 working group members or contributors takes any responsibility for the contents of this article.