Multiple-Round Strategy

Written by: VC Experts Staff

Few, if any, start-ups survive to maturity on the basis of a single round of financing. It is in the nature of the venture-capital beast that companies consume cash in their early stages at unforeseen, sometimes alarming rates. Not only must products be developed, but in the classic venture-capital scenario, a new market must be penetrated and sometimes created. Digital computers, xerography, express mail, the Internet—these were not products developed to satisfy the public perception of existing demand. Rather, the existence of the product created—uncovered, if one prefers—the demand; necessity was not the mother of invention. Today it is difficult to see how humanity could get along without these staples. Nonetheless, no customers’ queue awaited computers until the computer was introduced and created the queue in the first instance.

Accordingly, the need of a start-up for frequent and regular infusions of cash is an imperative of the business, part of the culture of venture-backed startups. A sensible financing strategy focuses not only on the round on the table, but on the impact of subsequent rounds as well. Ultimate dilution of the founder will depend on the success or failure of the company in raising subsequent rounds at higher prices. In considering a given investor’s offer, the founder must make a judgment whether the investor has the staying power to support the investment in subsequent periods and will do so at a fair price. Leasing money, in other words, is a longitudinal process; it extends at least until the exit strategy is implemented.

If there is one single enemy encountered by a founder in a venture financing, it is investor indecision and delay. Founders contribute to the problem because they listen selectively, interpreting a politely worded “no” as an invitation to continue with the presentation. To induce investors to declare themselves, one strategy is to line up a lead or “bell cow” investor and hold a first closing, escrowing the proceeds of the offering until enough subscriptions are collected to round out a viable financing. The hope is to create some form of stampede among investors on the fence. At the least, an early closing will serve to freeze the terms and diminish niggling over minor points.

The first round is usually the most dilutive financing, because, obviously, it occurs at the moment of highest risk. Therefore, an intelligent founder will attempt to strike a balance in his first round between obtaining as much money as he thinks he’ll need to get to the next stage of development, but not so much that his equity is reduced to the borderline of triviality.

If it is assumed that later rounds will be less dilutive, then it is obvious that the first round should raise the smallest amount of money necessary to take the enterprise to the next round. On the other hand, if money is available, it could be a gross error of judgment not to take it, since the second round may (as it often is) be a good deal more difficult than anticipated, perhaps only because fashions change.

One old saw has it that a startup firm never has enough money, and there are anecdotes in sufficient number to illustrate that proposition. There is, however, contrary evidence, not only to the effect that the first round can be unnecessarily dilutive but that some companies are cursed in their early stages with too much money. For example, a dynamic manager may break away from a company he’s helped found and start the process all over again. Since venture investors are no less sheeplike than the rest of us, they extrapolate the past and assume that Mr. Genius can do it again. The founder takes a pregnant idea and money falls in his lap. He’s not worried about dilution in the first round because of the valuation he has been able to sell to the investment community. Forgetting the parsimonious habits of his youth, the founder then attempts to shorten the development process by doubling the number of sales and marketing people, putting on more technicians and so forth. He creates a monthly expense outlay, a “burn rate,” which is out of proportion to realistic expectations of the company’s development. When it comes time for a second round, the existence of a massive burn rate has inexorably postponed the date on when cash break-even will occur by a period which intimidates old and new investors. Only those who have gone through the process know how difficult it is, both logistically and in human terms, to make dramatic slashes in a burn rate. Unsympathetic landlords may refuse to take back the necessary space; firing people imposes separation costs as well as personal trauma.

In short, a higher-than-necessary burn rate is a bad sign, a red flag to the venture-capital community. Founders consistently complain the investors are starving them. Fed hand to mouth, they bemoan the opportunities missed for lack of capital; they cite the fact that venture capital is an early-entry strategy. As General Nathan Bedford Forest said, “Get there fastest with the mostest.” True in some instances, but the converse is equally likely, based on evidence of the past: Too much money equals potential trouble.

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Valuation And Pricing

Written by Joseph W. Bartlett/VC Experts Founder

When a founder determines it is worth his while to attempt to raise money for his concept, the basic issue becomes one of price. If, for example, the business needs $500,000 to get started, how much of the equity in that company should $500,000 in fresh cash command? A brief summary of common terminology will help illuminate the subsequent discussion.

The word “capitalization,” or its abbreviation, “cap,” is often used in pricing start-ups, with, on occasion, differing meanings. The “market capitalization” or cap of a company refers to the result obtained by multiplying the number of equity shares outstanding by some assigned per-share value. If it has been determined that a share of stock in the company is “worth” $10 and the company has 100,000 shares outstanding, then its market cap is $1 million.

The second use of the term has to do with the rate at which future flows are to be valued, a rate sometimes called the “discount” or “cap rate,” meaning that that flow of income is to be assigned a one-time value by being “capitalized.” Thus, elementary valuation theory teaches that one of the most reliable indicia of value to be assigned to a fledgling (or, indeed, any) enterprise is a number that capitalizes projected income streams.

In its simplest form, the question is what an informed investor would pay (i.e., what sum of capital would be put up) in exchange for a promise to pay him annually a certain sum of money. In working out the numbers, it is assumed that the investor wants his capital returned to him, plus a competitive rate of interest. The higher the assumed interest rate (deemed competitive with other investment opportunities), the higher the annual payments must be, given a fixed amount of capital invested on day one. Alternatively, a fixed amount and number of annual payments can be a given element in the formula; the assumed amount of capital to be invested (i.e., the discounted value of the future payments) is then derived, again as a function of the cap rate selected. As the assumed interest or cap rate goes up, the discounted value of the payment stream goes down; fewer dollars are required on day one to earn the investor, at the higher rate, the forecasted income flows.

Other common expressions are “before the money” and “after the money.” These denote ostensibly simple concepts, which occasionally trip up even the most sophisticated analysts. If a founder values his company at $1 million on Day 1, then 25 percent of the company is “worth” $250,000. However, there may be an ambiguity. Suppose the founder and the investors agree on two terms: (1) a $1 million valuation, and (2) a $250,000 equity investment. The founder organizes the corporation, pays a nominal consideration for 1,000 shares, and shortly thereafter offers the investor 250 shares for $250,000. Immediately there can be a disagreement. The investor may have thought that equity in the company was worth $1,000 per percentage point; $250,000 gets 250 out of 1,000–not 1,250–shares. The founder believed that he was contributing to the enterprise property already worth $1 million. For $250,000, the investor’s share of the resultant enterprise should be 20 percent. The uncovered issue was whether the agreed value of $1 million to be assigned to the company by the founder and investor was prior to or after the investor’s contribution of cash.

In whatever language he chooses, each founder takes on the chore of setting a preliminary valuation on the company for purposes of attracting outside capital. The principal point to be kept in mind is obvious but often overlooked. What the founder thinks the company is worth is largely irrelevant at this stage. The decision to go forward has been made, and his effort and resources have by now been pledged to the enterprise based on his expectations of risk and reward. When outside financing is being sought, the critical number is what the founder thinks the universe of investors will assign as value to the company. The founder’s personal valuation comes into play only if the investment community’s assigned value is so much lower than his expectation that he is forced to rethink the question whether the game is worth playing at all.

A number of interesting problems arise when the founder attempts to psychoanalyze the investment community to come up with a number that will prove attractive. In first-round financings there is often, and indeed ordinarily, no track record on which to be conclusive as to value. Moreover, existing assets-plant, machinery, equipment, accounts receivable–are seldom, if ever, meaningful in a first round.

There are almost as many methods of calculating value as there are world religions, since the questions are metaphysical in part and depend on the appetites of the observer. In one of the most common scenarios, a five-year forecast is prepared, the thought being that in the fifth year (assuming the projections are accurate) an exit strategy will be implemented; that is, investors will sell their securities for cash or the securities will become publicly traded, the equivalent of cash. It is usually assumed that the investors will realize their entire return upon implementation of the exit strategy; there will be no interim returns since all revenues will be retained in the business. The valuation formula most often used in connection with the forecast is relatively simple.

An investor plans to invest X dollars in the enterprise today for some to-be-determined percentage of the company’s equity. The projections predict the company will enjoy Y dollars of net after-tax earnings as of the day the exit strategy is accomplished; that is, the company is sold or goes public. The analyst then picks a multiple of earnings per share in order to hypothesize what the stock might sell for in a merger or an IPO. Since there is no way of forecasting that multiple, the next best strategy is to use existing multiples in the given industry. What is the PE (ratio of share price to earnings per share) of companies in comparable fields today? Let’s assume that multiple to be ten, meaning that the total market capitalization of the company immediately prior to the IPO will be ten times the net earnings for such year. The investor then picks that return on his investment that corresponds to the risk he deems himself encountering, taking into account the return on competing investments, again a subjective judgment. He may believe that he is entitled to a 38-percent compounded rate of return, which means, by rule of thumb in the venture community, that the company forecasts a “five-times” return; that is, the investor will get back, before tax, five dollars for every one dollar invested. If the investment called for is $250,000, then five times $250,000 is $1.25 million. If the company is forecast to be worth $10 million in Year 5, then the investor’s $250,000 should command 12.5 percent of the company in Year 1.

Of course, many of the elements of the formula are highly speculative, particularly the reliability of the company’s forecast. The method of taking that subjectivity (risk of error) into account is to adjust the rate-of-return target, or “bogey” or “hurdle rate” as it is sometimes called. If the investor thinks the forecast is suspect, one way of sensitizing the equation to his suspicion is to increase the rate of return target from, say, 38 percent to as much as, perhaps, a 50-percent compounded rate of return. If an adjustment has to be made to conjugate a rate of return much higher than 50 percent, then it’s arguable the investor should not make the investment in the first place. Because compounded rates of return in excess of 50 percent are so unusual, many investors feel it is unrealistic to predicate an investment on that kind of expectation. The power of compounding is enormous. Many neophytes inhabit fantasy worlds when they dream of investments continuing to compound at double-digit rates over an extended period.

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Confronting a Down Round

Guest Post by:  Dror Futter, Partner – McCarter & English LLP

The last few years have witnessed Unicorns become common and down rounds become scarce. Now the venture market is returning to a more normal state, which means more down rounds and fewer Unicorns.

If your venture is confronting a down round, you should not wear it as a badge of shame. In normal times, few ventures make an uninterrupted march up and to the right on the valuation curve. More importantly, if you are doing a down round, it still means you were able to raise capital. Although a down round will dilute your economics, no venture has ever died from excess dilution, the same cannot be said for lack of funds.

What is a “Down Round”

Simply stated, a “down round” is a round in which the pre-money valuation of a company is below the post-money valuation of its last round. As result, shares in the company purchased in a down round will be less expensive than those bought in the last round. Down rounds are never fun. To existing shareholders, it means the value of their investment has dropped and they will absorb additional dilution to raise the same amount of money. To venture investors, who report their illiquid holdings to their limited partners based on “mark-to-market” principles, it almost inevitably means a write-down of the carrying value of the investment. As a result, reported fund returns drop.

Down rounds are most common when a new investor enters the scene or most existing investors are not funding their pro rata. In addition to a lower valuation, funding terms of a down round are usually more investor friendly. Often shares sold in a down round will have a senior liquidation preference (i.e. they will sit above prior classes of shares in terms of priority for getting a return at exit), a participating preferred return (i.e. investor gets its investment back and sometimes a multiple of its investment back and then participates with common), dividends that are accruing and at a higher rate, and class-specific veto rights on multiple corporate decisions.

Why Do Down Rounds Occur?

There are several reasons why your company may be subject to a down round, including:

  • Your company failed to reach the financial and operational goals it set for itself the last time it raised money;
  • You did a particularly good job of selling your company at the last round and received financing at a favorable valuation. The down round may just be reversion to a more conservative valuation; or
  • Overall valuations have dropped in your sector or market-wide.

A down round, therefore, is not always a sign of a struggling company. However, even if your down round result from broad market forces, you will subject to the valuation drop, and likely many of the same unfavorable deal terms, as a struggling company.

What Can You Do to Prepare?

There are a few things a company can do that will help its down round proceed more smoothly.

1. Review the Corporate Charter and financing documents from prior rounds. Make sure you understand the rights of existing shareholders in a down round and have identified any relevant supermajority voting requirements and pay-to-play obligations. Also, identify all pre-emptive rights that existing shareholders have and the timetables they have to exercise. Down rounds are often Eleventh Hour fire drills and you do not want to be stymied by a multi-day notice period for pre-emptive rights.

2. If your shareholders have anti-dilution rights, make sure you have assembled a spreadsheet that will allow you to determine the impact of financings at various price points on the existing cap table. This will be essential information for the new investors as they determine the new pre-money valuation of the company. In some cases, new investors may require existing investors to waive their anti-dilution right as a condition of funding.

3. Down rounds are risky events for a company’s Board of Directors. This is especially true for a Board that does not have independent directors to provide an unbiased view on the fairness of the reduced share price in a down round. Shareholders who do not participate in the new financing and are significantly diluted may bring an action against the Board. To reduce this risk, the Board should shop financings to multiple investors and should document these efforts in writing. Also, the Board should conduct market research to fully understand market terms. If possible, the Board should seek to obtain the approval of non-participating shareholders and at a minimum, such shareholder should routinely be updated on attempts to find financing and findings on current market terms. The Board should also consider doing a “Rights Offering” where each existing shareholder is offered the opportunity to purchase its pro-rata piece the financing at the down round price, even those shareholders who do not have the benefit of a contractual pre-emptive right. Finally, a down round is a good time to make sure that D&O insurance is in place and includes adequate coverage.

4. Develop a communications plan for employees. Despite your best efforts, this is the type of information that often can get out there. Decide how you will position the down round to your employees. Since the dilution of a down round will also impact their options, consider whether some star performers should get option refreshes (i.e. a supplemental option grant to reduce the economic impact of the dilution).

One Final Word

Success lifts many boats. As a result, when a company is doing well and experiencing a string of “up rounds,” it is easy to gloss over different interests among shareholders and directors. A down round can create two or more classes of investors with very different economics. In the wake of a down round, it is important to be sensitive to this change, factor it into decision making, and develop a communications plan that addresses the potentially divergent interests of these shareholders.


Dror Futter, Partner, dfutter@mccarter.com

Dror Futter is a partner of the firm who brings more than 20 years of high tech and intellectual property legal and business experience to McCarter and its clients. Dror joined the firm as part of McCarter’s combination with SorinRand. Prior to joining SorinRand in February 2013, Dror was General Counsel to Vidyo, Inc., one of the nation’s top 50 venture-backed companies, where, among other things, he negotiated and documented sales agreements for both direct and indirect channels, purchase agreements, software licenses, service agreements, and strategic agreements in the US, Asia and Europe. Previously, he was a partner and General Counsel of renowned venture capital fund New Venture Partners LLC. While there, he helped to form funds, and advised multiple start-ups and corporate spin-offs in the information technology and telecommunications industries, as well as serving as the venture fund’s legal counsel. He also advised portfolio companies with respect to commercial, mergers and acquisitions, employment, Internet/ecommerce and intellectual property law matters.

Biography

McCarter & English LLP

McCarter & English, LLP is a firm of approximately 400 lawyers with offices in Boston, Hartford, Stamford, New York, Newark, East Brunswick, Philadelphia, Wilmington and Washington, DC. In continuous business for more than 170 years, we are among the oldest and largest law firms in America.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from McCarter & English LLP. This work reflects the law at the time of writing in September 2016.

Top 10 Mistakes Companies Make During Acquisitions

Guest Post by: Don Keller (Partner, Emerging Companies Practice in Silicon Valley, Orrick, Herrington & Sutcliffe LLP)

It used to be that when entrepreneurs started their companies, the idea of going public and making it big was on top of every founder or CEO’s checklist.  Nowadays, it seems that startups are constantly looking to build a great product that will attract the most users and then cross their fingers that the Googles or Microsofts of the world will acquire the company (or the team).  I gave a presentation yesterday at RocketSpace, an accelerator for seed-funded technologies in San Francisco, about best practices and top mistakes companies make during acquisitions. So for those of you who are interested in going down that route, here are some things to note as you prepare your company and team for the road to acquisition-ville.

1.  Founder Equity – Make sure founder equity is held in the form of shares, not options.  Shares allow founders to get all of the appreciation taxed at capital gain rates, whereas options typically result in the appreciation being taxed at ordinary income rates.  This can make a huge difference in the amount of take home pay.

2.  Protect Your IP – One of the biggest mistakes companies make in the early stages of their development, is not dotting all their i’s and crossing their t’s when it comes to protecting their intellectual property.  Make sure that when IP is involved, you work with a good lawyer to ensure that your IP is not owned by a former employer and that all of the IP has been properly assigned to the company.  The last thing you want is for your company to take off and then get hit with a notice that your IP is not actually your IP.

3.  Keep Your Options Open – To maximize your price, companies should leave themselves with alternatives to the buyers they are targeting.  You want to make sure that you’re not selling yourself short and putting all your eggs in one basket.  This does not make for a good negotiation strategy and is less likely to get you the best price.  If a buyer knows that you have only one alternative, the price will fall like a rock.

4.  What to Avoid Selling – Avoid selling the company for private company shares in a transaction that is taxable.  There is typically no market for private company shares so getting someone else’s private shares in an acquisition and having to pay tax on those shares, leaves you with an out of pocket cost and nothing to show for it other than some shares you cannot sell.  If the transaction is properly structured, the receipt of the buyer’s shares can be nontaxable (at least until you sell those shares) which is what you want.

5.  The Art of Negotiating – When negotiating on price, make sure you understand all of the adjustments to the price such as escrows, legal fees, balance sheet adjustments, and special indemnities.  Once you sign the 60 or 90 days no shop agreement, the buyer has all the leverage.  You don’t want to learn at that point that the price they said they would pay is before massive deductions.  It’s important to negotiate the terms right out of the gate so there are no surprises when it comes time to seal the deal.

6.  Open Source – Make sure you understand open source and how it’s used in your product.  Always double check to make sure that you have complied with the open source license terms.  It doesn’t happen often, but every now and then, this can be a deal breaker for buyers.

7. Keep Up with the Kardashians…I mean Housekeeping – Do not, and I repeat, do not wait until the last minute to catch up on cleaning your minute books and stock option pricing (409A issues).  It is important that your documents are maintained and updated on a regular basis.  If you wait until the last minute, it can create unnecessary headaches and disorganization.  The last thing a buyer wants to see is a company that can’t keep their documents up to par.

8.  Don’t Wait Until the Last Minute – Rolling over from #7, another important thing to note is that you shouldn’t leave the negotiation of employment and non-compete agreements until the last minute.  These are things that should be brought up as soon as discussions begin.  Time and again, these agreements are negotiated at the last minute with lots of pressure on the founders to sign and be happy.  Don’t let that be your situation.

9. Be Wary of Earn-Outs – Earn outs are a lawyer’s dream.  They almost always end in disputes about whether the buyer tried hard enough to generate revenue to meet the earn out thresholds.  Don’t count on any earn out payments and negotiate accordingly.

10.  Pay Attention to Your Board Members and Investors – It’s very important to listen to what your board members and investors are saying during this time.  You want to keep an ear out for biases for or against a sale and also take heed to strategic investor reactions to a sale.

There is no full proof way of being certain that by following the advice above, the road to acquisition will be an easy route.  However, best practices can provide entrepreneurs a clearer path and hopefully increase the likelihood of your company’s success.

About Don Keller:  Don is a Partner in the Emerging Companies Practice at Orrick’s Silicon Valley office. He advises emerging companies, public companies, venture capital firms and investment banks and has represented clients on more than 60 public offerings, 75 acquisition transactions and several hundred venture financings.  Don has worked on transactions for companies including Apple, Google, Oracle, and Rambus and represents clients such as eHarmony, OPOWER, and LS9, among many others.  For more information, you can visit his full biography.

Three Basic Rules: Dilution, Dilution, Dilution

Written by Joseph W. BartlettVC Experts Founder

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.

[1] Williams, “Community Development Venture Capital: Best Practices & Case Studies,” (Jan.2004)

Deal Terms: The Missing Piece of the Valuation Puzzle

The following is an excerpt from VC Experts Reference

There has been a good deal of elegant work done on the valuation of private equity securities and the issuers thereof – chiefly securities issued by early stage firms. The challenges are significant since the usual indicia of value are often not in place (e.g. revenues and net after tax earnings), particularly on a historical basis. Valuation is key to the pricing of various rounds of financing of an emerging growth company. The pre-money valuation, given the amount of the financing, yields the post-money valuation and, based thereon, the percentage of the company the investors in the round wind up owning. Thus, a pre-money valuation of $3 million and a $1 million investment equals a post-money valuation of $4 million, with the investors owning 25% ($1 million ÷ $4 million) of the company. The issue is how to arrive at the $3 million pre-money valuation.

The “venture capital method” entails ignoring the negative start-up cash flows, and estimating a hypothetical future terminal value for the company as of several (usually five) years in the future and discounting backwards, using a significant discount factor to take into account the unusual risks involved in early stage finance. The trick is to derive reliable projections based on some currently ascertainable indicia and evidence. The process aims to minimize the pure guesswork as much as possible, but is very difficult, given the lack of information. There is also future guesswork involved when one factors in the dilutive effect of future financings and speculates on the amount of dilution those financings will entail.

There are also other methods that VCs use to value early stage companies. The Discounted Cash Flow (“DCF”) method improves on the venture capital method by including all relevant cash flows for the company, and estimating a true cost of capital for the company. Comparators are often used, but perfectly comparable companies are hard to find, as are detailed financials, in the private equity space. A somewhat more sophisticated model involves the “option method”. The idea is that an early stage financing represents, in effect, payment for a call on future values. If the company fails (as many do), then the call is worthless, similar to a publicly traded option that expires out of the money. On the other hand the profit from a successful investment can be spectacularly well beyond anything a DCF analysis would suggest.

This article seeks to illustrate and highlight a significant oversight, in all the current methods–a piece of the equation that is routinely left out of conventional valuation discussions.

Take a typical conversation at the outset of the negotiation of a Series A Round financing. The discussion starts out with the issue of valuation. The entrepreneur and his or her advisors lay on the table a number, based on art as much as science, and suggest that the venture capitalist agree with it as the basis for further discussions. There may be, depending on the investment climate, a certain amount of discipline applied to the pricing of the deal if there is more than one potential investor. In such a case, the market sets the price of the security … i.e., the pre-money valuation. The fact is, however, that there is not much of an auction market for Series A Round securities. In fact, if a knowledgeable venture capitalist smells an auction, he or she will ordinarily pass and go on to the next opportunity, or team up with the competitor and make a consolidated bid.

The price, in other words, is usually left to naked negotiations between the buy and the sell side. The negotiation starts with the entrepreneur’s number, a different number comes from the VC, and the price settles somewhere in the middle. The final result is usually closest to the VC’s number since most VCs have a relatively good handle on what is going on the marketplace, what other firms are paying for investment opportunities. Moreover, ordinarily, there are fewer buyers than there are sellers and more deals than money. The parties agree on a price and then the negotiation segues to a discussion of deal terms. When the deal is finalized, the entrepreneur reports to his or her current shareholders that a pre-money valuation of X dollars has been secured.

My point is that this process, as described, puts the cart before the horse. The entrepreneur and the angels cannot understand the valuation number until they fully understand deal terms. Thus, the term sheet may recite a pre-money valuation of $10 million and, from the entrepreneur’s standpoint that may appear to be favorable. However, the $10 million stands up only if the new investors are buying common stock with their $1 million and standing pari passu with the existing shareholders. And, that is hardly ever the case.

Let us assume that the new investment is a convertible preferred stock. The new investors get their money back plus accrued dividends before the common shareholders i.e., the entrepreneur et al., get anything. And, let us assume there is at least a fifty-fifty chance the company will be sold for less than its post-money valuationi.e., $2 million vs. $4 million. Without doing the precise math, it is clear that the valuation, given that scenario, is not $3 million pre-money. Further, let us say that accrued but unpaid dividends are tacked on to the liquidation preference for purposes of the conversion calculation. If that dividend is 10% and the liquidation event is assumed to be four years away, the common shareholders are being diluted (even under a favorable scenario) automatically by 2.5% a year (the 10%dividend times the 25% interest with which the VCs start out).

Assume the VCs impose restrictions on the transfer of the entrepreneur’s shares, perhaps even reverse vesting. Under classic valuation theory, those restrictions eat into the current value of the common shares. Also assume the convertible preferred is in fact a convertible participating preferred, meaning that the VCs get their money back first and then they share in the proceeds as if they had converted. In most scenarios, i.e., those not involving a terminal value in the stratosphere, the participating preferred deal term negatively impacts the entrepreneur’s value significantly.

All this, of course, is well known. Savage Deal Terms in favor of the VCs have an individual and cumulative negative impact on both the pre- and post-money valuation of the company. What is remarkable is how little quantification work has been done on the impact of deal terms on notional valuations. It is true that the outcome of the valuation negotiation in a Series A Round gets underway does not ipso facto determine the outcomes of the parties. The parties do not see their investment posted on the score sheet until the liquidity event occurs, the price of that event matched with each participant’s percentage and, if applicable, the effect of various deal terms factored in. All relevant items determine the ultimate return on investment. If the company is sold or goes public, for instance, at a valuation of $500 million, the fact that the Series A investors get their $1 million back first is not a major factor one way or the other; if the terminal value is $5 million, on the other hand, the reverse is true.

In the above sense, the question of pre-money valuation has no definitive significance. However, since valuation determines the parties’ relative percentages, it is a critical number. And there is no reason why, under a variety of likely scenarios, the players should not have all the material information at their fingertips when the negotiations go forward.