Valuation issues with early equity finance

Abstract

The need to finance startups generates the effect of equity dilution. By dilution we mean the decrease in founders’ ownership of the startup due to the company issuing new equity. An important issue with early equity financing is that a larger number of total shares outstanding has a dilutive effect on the ownership and control of existing shareholders. A critical parameter that determines the magnitude of dilution is the value at which new investors agree to participate, the so called pre-money valuation. As early valuations usually happen with little or no credible financial performance history data, the upshot is a conservative low valuation which aims to protect investors. Unfortunately, if not done properly, such investor protection comes at a substantial cost and control loss to the entrepreneur. One method that to some extent mitigates the risk of such an early low valuation is to finance by convertible bonds. Convertible debt is a hybrid security between common stock and plain vanilla debt, that investors buy with the intention to convert the debt to equity at some later date. The key benefits to consider is that convertible debt financing often avoids some of the difficult valuation issues, and that debt is senior to equity in the event of liquidation. In reality though, for early startups with little or no liquidation value this is not particularly valuable