In negotiating a startup investment there’s always a tension between the startup and the investors in placing a value on the equity in the deal. The entrepreneur is pushing up the valuation pointing to the opportunity in the deal while the investor pushes the valuation down pointing to the risk.
Most view valuation as a single number that can never be changed. This is one reason why there’s so much discussion around it as once you set it, there’s no changing it.
Or is there a way of changing it based on the results?
Performance-based valuation puts a new spin on valuations. The valuation can change based on the short-term outcome. Achieving the expected outcome earns the expected valuation. Missing it, means a lower valuation.
For example, you are investing in my company and I want a $10M valuation and I’m forecasting $3M in sales in the coming 12 months. In performance-based valuation, you agree to those numbers but add a clause that says, if you don’t reach the $3M revenue number in 12 months, then the valuation on the deal comes down from $10M to $7M. This puts the onus on the entrepreneur to hit the target or as the investor would put it “earning the target.”
This aligns the price of the equity with the short term results. I say “short term” because it’s going to be difficult to apply this to the final exit outcome as valuation on the current round needs to be set before pursuing follow on rounds.
It’s a useful tool to set the equity and takes some of the “discussion” out of the process.
Hall T. Martin is the founder of TEN Capital and a builder of entrepreneur ecosystems by startup funding through angel networks, funding portals, syndicates, and more. Connect with him about fundraising, business growth, and emerging technologies
