After a Down Round: Alternatives for Employee Incentive Plans

*Excerpted from VC Experts Encyclopedia of Private Equity & Venture Capital


Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional optionsrecapitalizationsand retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.

Recapitalizations

If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

Antidilution Explained: Full-Ratchet and Weighted-Average Provisions

There are two principal ways to formulate antidilution provisions, capitalizing the terms to make it clear we are talking about the ones which have substantive bite—the “Full Ratchet” and the “Weighted Average.” Full Ratchet provisions are the real killers, at least from the founder’s point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares [1] is automatically decreased, that is, it “ratchets down,” to the lower price. [2] Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate.

Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding, the founder owns all the common, and the investors own all the preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at $ .50 per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at $.50. Suddenly the preferreds’ conversion price is $.50, the founder goes from 50 percent of the equity to under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at $.50. This is a harsh result, indeed. When a really dilutive financing occurs, say shares have to be sold at MO per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 9 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been “burned out” of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full Ratchet dilution. When venture capitalists are referred to as “vulture capitalists,” it is likely the wounded founders are talking about dilutive financings and a Full Ratchet provision. [3]

The more moderate position on this issue has to do with Weighted Average antidilution provisions. There are various ways of expressing the formula but it comes down to the same central idea: The investors’ conversion price is reduced to a lower number but one which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued; then the conversion price does not move much; if many shares are issued—that is, there is in fact, real dilution—then the price moves accordingly.

The object is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued. Thus, the starting point is the total number of common shares outstanding prior to the dilutive financing. The procedure to achieve the objective is tomultiply the old conversion price per share by some fraction, less than one, to arrive at a new conversion price; the latter being smaller than the former, the investors will get more shares on conversion and dilute the common shareholders (the founder) accordingly. The fraction is actually a combination of two relationships used to “weight” the computation equitably. The first relationship is driven by the number of shares outstanding, the weighting factor, meaning that the calculation should take into account not only the drop in price but the number of shares involved—the significance of the dilution, in other words. [Call the number of shares outstanding before the transaction—A.]

The fraction, then, takes into account the drop in price and expresses that drop in terms that can be mathematically manipulated with the first number to get a combined, weighted result. The relationship is between the shares which would have been issued for the total consideration paid if the old (i.e., higher) conversion price had been used versus the shares actually issued (i.e., the shares issued at the new price.) [Call these two numbers—C and D.]

The combination of these two relationships—number of shares outstanding and the comparative effect of the step down in price (expressed in number of shares)—is a formula:

((A + C) ÷ (A + D)) x Old Conversion Price

If the shares which would have been issued at the old (i.e., higher) price is (as indicated) the number in the numerator, the fraction or percentage will be less than one. This fraction (say 1/2 or .50) is multiplied by the existing (or initial) conversion price to obtain a lower conversion price, which means in turn that more shares will be issued because the conversion price produces the correct number of shares by being divided into a fixed number, usually the liquidation preference of the preferred stock.

It is open for theorists to argue about the fairness of that result, but the above formula has the advantage of economy of expression. If one wants to use a Weighted-Average antidilution formula, the above is one commonly used (albeit expressed in different terms).

There, are, of course, different ways of expressing the formula. In the case of warrants and options, for example, the contract is often expressed in terms of a specific number of shares obtained at a fixed exercise price. Simply adjusting the exercise price may mean that a holder gets the same number of shares but pays a little (or a lot) less. In such an instance, the trick is to continue the exercise price as is but to adjust upwards the number of shares resulting from exercise, which can easily be done by reversing the formula—(A plus D) divided by (A plus C).

The calculations get more complex, as rounds of financing multiply. If the investors in round one (holding series A preferred) enjoy a conversion price of $1, and the price for the round two (series B) investors is $1.50, and the round three (series C) preferred is convertible at $4 and there then occurs a dilutive financing at $.50, all the conversion prices are affected, but it takes a computer to figure out who is entitled to what number of shares, particularly since investors in the various rounds will tend to overlap. (In this connection, one occasionally encounters a formula which keys off accumulated dilution. Thus, in the example cited, and depending on the amount raised in each instance, only the series C preferred holders would get an adjustment in their conversion price; the earlier investors would hold fast because the Weighted Average price of all subsequent rounds, taken together, is above their price.)

There are a number of other confusions which can easily creep into the drafting of the section. For example, can the conversion price go up? The answer is ordinarily no, at least by virtue of cheap stock antidilution. Does the exercise price which is ratcheted down always mean the original conversion price or the conversion price immediately preceding the dilutive event? The answer can vary but usually the latter is meant. If the conversion price goes down from $10 to, say, $5, a subsequent round at $7 doesn’t budge it again. An adjustment in the conversion price is usually pegged to the issuance of cheap stock or the right to buy cheap stock, say another convertible or an option. If the option lapses, is the adjustment reversed? Ordinarily, no. Other dilutive events are referenced in conventional financing documents, including extraordinary dividends. Absent care in drafting, a distribution of cash or property can ratchet the conversion price down to a negative number.

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Confronting a Down Round

Guest post by Dror Futter, Rimon PC

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 focuses his practice on startup companies and their investors, and has worked with a wide range of technology companies. His fifteen years’ experience as in-house counsel includes positions with Vidyo, Inc., a venture-backed videoconferencing company, and New Venture Partners, a venture fund focused on corporate spinouts. Prior to that, Mr. Futter was Counsel to the CIO of Lucent Technologies, as well as supporting parts of its sourcing organization.

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.

Restructuring Liquidation Preferences

Guest Post by Eric Hanson-WilmerHale

Job candidates may choose to work for a startup to help build something new, to work in an environment that fosters and rewards creativity, or to get the thrill of climbing aboard a “rocket ship.” New employees rarely, if ever, guide the rocket ship’s trajectory, even though they often directly help determine it. And startup employees’ incentives usually skew heavily toward equity in the company’s option plan—rather than salary—even though these employees usually have no say in how the company’s fundraising activities will impact the eventual value and payout of the common stock held by the employees.

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