Fundraising 101: Valuation of Start-ups – Some Key Considerations

MoFo Singapore partner Lip Kian Ang, and Singapore associates Mark Tay and Yong Wei Tan, recently authored an article titled “Fundraising 101: Valuation of Start-ups – Some Key Considerations,” which was published on the Singapore Academy of Law’s Singapore Law Watch as part of a series of articles contributed by members of the Venture Capital Investment Model Agreements (VIMA) 2.0 working group.

The article highlights the importance of valuation to a start-up and its business. For instance:

• Proportionate ownership stakes: The valuation established during a start-up’s fundraising round determines how much ownership stake an investor gains in exchange for its investment, and correspondingly, how much ownership stake the founders must relinquish. This dynamic heavily influences the bargaining power of both founders and investors during the negotiation of fundraising terms.
• Employee recruitment and incentivization: A start-up’s valuation can serve as an important recruitment tool as a high valuation could indicate a robust business model, healthy prospects, and/or the financial capacity to pay wages and other expenses – all of which are key factors for prospective employees. The start-up’s valuation is also an important consideration in equity incentive plans which are commonly incorporated in start-ups’ remuneration packages to attract and incentivize employees.
• Modelling, planning and decision-making: Valuations are integral to the business modelling, operational planning, and strategic decision-making of a start-up.

However, a valuation gap could arise for various 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.

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.

• Convertible instruments: Founders can raise funds through convertible instruments instead of issuing shares in the start-up, thereby postponing the determination of the valuation until a later stage.
• Staged closings: Under this approach, the investor does not contribute the entire investment amount upfront; instead, payments are made in installments contingent upon the start-up achieving pre-agreed milestones indicative of an increase in valuation.
• Valuation adjustments: Founders and investors may also agree initially to a higher valuation proposed by the founders, contingent upon achieving specific pre-agreed milestones, key performance indicators, or financial results to maintain that valuation. 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.
• Warrants: Founders and investors can also bridge the valuation gap by using warrants issued by the start-up, which grant rights to purchase additional equity in the company. These warrants may include provisions that allow them to be exercised at a discounted (or nominal) price if the start-up fails to reach specific milestones.
• Anti-dilution protections: Investors may also incorporate or strengthen anti-dilution provisions to safeguard the value of their investment in case of a future down round, which occurs when shares are issued at a valuation lower than in previous financing rounds.

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.

With contributions from partners Thomas Chou, Alfredo Silva and associate Katrina Tsoi.

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