Article by Natalia de la Figuera – Co-Founder and COO of GENESIS Biomed

• Before carrying out any investment round, it is essential to first quantify the start-up/spin-off’s need for cash.

• Once the need for cash has been identified, one of the most critical aspects of this process is to establish the valuation of the company prior to the funding round.

The creation of a start-up or spin-off is an arduous and complicated process. But if setting up a start-up or spin-off is already a major achievement, it is even more important to survive in order to ensure that the product development reaches the degree of maturity necessary for exit scenarios to appear. These exit scenarios, understood as those in which the entire investment is recovered, are normally the acquisition of the spin-off by a company or the arrival of the product on the market. But until this exit scenario is reached, the spin-off or start-up will need successive rounds of investment from Business Angels, Family Offices or Venture Capital and leverage with public funds to obtain the necessary capital inflow to meet all the costs and investments of the company (personnel costs, investments in tangible and intangible assets, etc.) and thus allow progress in the development of the product. In order to carry out an investment round, there are two key elements to be determined:

1. The Cash Need to determine the value of the Investment Round

Before carrying out any of these investment rounds, it is essential to first quantify the start-up/spin-off’s cash need over the range of time it considers necessary, in order to reach the milestones that will allow it to reach the acquisition or market launch scenario. For instance, let’s take the example of a spin-off/start-up developing a healthcare product, and the company quantifies that it needs 4 years with a cash requirement of 10 M€ to achieve it. The company may decide to raise this capital through two rounds of investment (including public funds): a first seed round that allows it to obtain a prototype of the medical device during the first year for a value of 1-2 M€ and a second round (series A) of 8-9 M€ that allows it to carry out clinical validation and CE marking in the following years. Continuing with this example, the company may find it necessary to close a subsequent round to provide it with resources that can help it obtain FDA clearance and commercial activity to gain market traction and be more attractive to potential acquiring companies.

2. Valuation

Once the cash need has been identified, one of the most critical aspects of this process is to establish the valuation of the company prior to the financing round. This value determines the relationship between the founders and the investors, as well as the long-term prospects of the company. Understanding the importance of a correct valuation and its implications is vital for any entrepreneur.

To estimate the value of a company before receiving new external investment (pre-money valuation), a series of factors must be considered, such as growth projections, market share, technology, IP protection strategy, management team, among others. Once this value is determined, the negotiation process begins, in which a final valuation will be closed that will determine the percentage of equity to be allocated to new investors, with existing partners being diluted accordingly.

For example, if a company has a pre-money valuation of 8 M€ pre-money and considering that the cash requirement study has identified the need to inject 2 M€, the new valuation (post-money valuation) will be 10 M€ and the investors will own approximately 20% of the company.

The valuation of a company therefore sets a baseline for the expectations of both parties: entrepreneurs and investors. Too high a valuation may raise unrealistic expectations about the company’s growth and make successive funding rounds more difficult; while too low a valuation may overly dilute the involvement of existing founders and partners, which may discourage their commitment. It is essential to find a balance that ensures that founders retain sufficient shareholding to remain motivated, while offering investors an attractive return. Therefore, establishing a proper valuation prior to a financing round is crucial for the long-term success of a company.

There are several methods to determine the valuation of a company prior to financing. The most common are:

• The Comparables Valuation Method: This method involves comparing the company with similar companies that have recently been valued or acquired in the market. It is a useful approximation but may not reflect the particularities of the company in question.
• Discounted Cash Flow Method: This approach is based on projecting the future free cash flows of the company and discounting them to a present value using a discount rate. If cash flows are not available, an approximation can be made by using instead the Total Net Revenue calculated from the sales forecast for the period under study, and applying the Operating Margin.
• Venture Capital Method: This method is based on calculating the pre-money valuation of the start-up based on the terminal sales value of the company and the expected return of investment over a time horizon of 5-8 years, depending on the length of the company’s life cycle.

Therefore, the cash need and valuation are the two elements that will allow sizing the scope of the Round or successive Rounds that the company needs to reach the exit scenario. Entrepreneurs must approach this process with a mixture of realism and ambition. This is the only way to align the interests of all parties involved and to establish a solid foundation for growth and achievement of the planned goal.