Three Basic Rules: Dilution, Dilution, Dilution

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.


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What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

The Entrepreneur’s Shares: A Balanced Approach To Founder’s Equity

Guest post by Daniel I. DeWolf, Evan M. Bienstock, Samuel Effron, and Ilan Goldbard – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

When accepting money from outside investors, entrepreneurs are generally asked to give up some degree of control over their start-up, exchanging equity in their company for cash. In an effort to minimize the control they relinquish, upon formation of their company entrepreneurs can grant themselves equity that comes with special rights. These rights, such as special voting privileges or guaranteed board seats, allow founders to maintain control of their company in spite of a dwindling ownership percentage. They may also include special rights that make it possible for a founder to cash out some of his equity prior to an IPO or other exit event.

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Term Sheets: Important Negotiating Issues

Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies “one demand registration at the issuer‘s expense, unlimited piggybacks at the issuer‘s expense, weighted average antidilution,” it saves time not to have to spell out the long-form edition of those references.

Important Negotiating Issues

Entrepreneurs who are in the process of effecting a venture capital financing for their start-up or emerging companies will negotiate with one or more venture capital firms on a number of fundamental and important issues. These issues are generally initially set forth in a “Term Sheet” which will serve as the basic framework for the investment. It is important that the company anticipate these issues and that the Term Sheet reflect the parties’ understanding with respect to them.

The following are some of the more important issues that arise:

  • The Valuation of the Company. While valuation is often viewed as the most important issue by the company, it needs to be considered in light of other issues, including vesting of founder shares, follow-on investment capabilities by the venture investors, and terms of the security issued to the investors. Significant financial and legal due diligence will occur and entrepreneurs should ensure that their companies’ financial projections are reasonable and that important assumptions are explained. Venture investors will consider stock options and stock needed to be issued to future employees in determining a value per share. This is often referred to as determining valuation on a “fully diluted” basis.
  • The Amount and Timing of the Investment. Venture investors in early stage companies often wish to stage their investment, with an obligation to make installment contributions only if certain pre-designated milestones are met.
  • The Form of the Investment by the Venture Investors. Venture investors often prefer to invest in convertible preferred stock, giving them a preference over common shareholders in dividends and upon liquidation of the company, but with the upside potential of being able to convert into the common stock of the company. There are strong tax considerations in favor of employee-shareholders for use of convertible preferred stock, allowing the employees to obtain options in the company at a much reduced price to that paid by the venture investors (a pricing of employee stock options at 1/10th of the price for preferred stock is common among Silicon Valley companies). Often times, venture investors will seek to establish interim opportunities to realize a return on this investment such as by incorporating a current dividend yield or redemption feature in the security. [Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.]
  • The Number of Directors the Venture Investors Can Elect. The venture investors will often want the right to appoint a designated number of directors to the company’s Board. This will be important to the venture investors for at least two reasons: (1) they will be better able to monitor their investment and have a say in running of the business and (2) this will be helpful for characterization of venture capital fund investors as “venture capital operating companies” for purposes of the ERISA plan asset regulations. Companies often resist giving venture investors control of, or a blocking position on, a company’s Board. A frequent compromise is to allow outside directors, acceptable to the company and venture investors, to hold the balance of power. Occasionally, Board visitation rights in lieu of a Board seat is granted.
  • Vesting of the Founders’ Stock. Venture investors will often insist that all or a portion of the stock owned or to be owned by the founders and key employees vest (i.e., become “earned”) only in stages after continued employment with the company. The amount deemed already vested and the period over which the remaining shares will vest is often one of the most sensitive and difficult negotiating issues. Vesting of founder stock is less of an issue in later stage companies. Another issue with the founders can arise if the VC insist that the founders lock-up the issuer‘s representatives and warranties. Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. [Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders.
  • Additional Management Members. The investors will occasionally insist that additional or substitute management employees be hired following their investment. A crucial issue in this regard will be the extent to which the stock or options issued to the additional management will dilute the holdings of the founders and the investors.
  • The Protection of Conversion Rights of the Investors from Future Company Stock Issuances. The venture investors will insist on at least a weighted average anti-dilution protection, such that if the company were to issue stock in the future based on a valuation of the company less than the valuation represented by their investment, the venture investors’ conversion price would be lowered. The company will want to avoid the more severe “ratchet” anti-dilution clause and to specifically exempt from the anti-dilution protection shares or options that are issued to officers and key employees. It is also sometimes desirable from the company’s perspective to modify the anti-dilution protection by providing that only those investors who invest in a subsequent dilutive round of financing can take advantage of an adjustment downward of their conversion price, a so-called “pay to play” provision. If the formula states that if the number of shares in the formula is “broadest” based, this helps the common shareholder. [If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.]
  • Pre-emptive Rights of the Investors to Purchase any Future Stock Issuances on a Priority Basis. The company will want this pre-emptive right to terminate on a public offering and will want the right to exclude employee stock issuances and issuances in connection with acquisitions, employee stock issues, and securities issuances to lenders and equipment lessors.
  • Employment Agreements With Key Founders. Management should anticipate that venture investors will typically not want employment agreements. If they are negotiated, the key issues often are: (1) compensation and benefits; (2) duties of the employee and under what circumstances those duties can be changed; (3) the circumstances under which the employee can be fired; (4) severance payments on termination; (5) the rights of the company to repurchase stock of the terminated employee and at what price; (6) term of employment; and (7) restrictions on post-employment activities and competition.
  • The Proprietary Rights of the Company. If the company has a key product, the investors will want some comfort as to the ownership by the company of the proprietary rights to the product and the company’s ability to protect those rights. Furthermore, the investors will want some comfort that any employees who have left other companies are not bringing confidential or proprietary information of their former employer to the new company. If the product of the company was invented by a particular individual, appropriate assignments to the company will often be required. Investors may require that all employees sign a standard form Confidentiality and Inventions Assignment Agreement.
  • Founders Non-Competes. The investors want to make sure the founders and key employees sign non-competes.
  • Exit Strategy for the Investors. The venture investors will be interested in how they will be able to realize on the value of their investment. In this regard, they will insist on registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions. The company will need to consider and negotiate these rights to assure that they will not adversely affect any future rounds of financing.
  • Lock-Up Rights. Increasingly, venture investors are insisting on a lock-up period at the term sheet stage where the investors have a period of time (usually 30-60 days) where they have the exclusive right, but not the obligation, to make the investment. The lock-up period allows the investors to complete due diligence without fear that other investors will pre-empt their opportunity to invest in the company. The company will be naturally reluctant to agree to such an exclusivity period, as it will hamper its ability to get needed financing if the parties cannot reach agreement on a definitive deal.

Form of Term Sheet

Term sheets are intended to set forth the basic terms of a venture investor’s prospective investment in the company. There are varying philosophies on the use and extent of Term Sheets. One approach is to have an abbreviated short form Term Sheet where only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and not be hampered by argument over side points. Another approach to Term Sheets is the long form all-encompassing approach, where virtually all issues that need to be negotiated are raised so that the drafting and negotiating of the definitive documents can be quick and easy. The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage and, if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal. The disadvantage of the long form approach from the venture investors’ perspective is that it may tend to scare away unsophisticated companies.

Lagniappe Terms:

The Charter: (Certificate of Incorporation) is a public document, filed with the Secretary of State of the state in which the company is incorporated, that establishes all of the rights, preferences, privileges and restrictions of the Preferred Stock.

Accrued and unpaid dividends are payable on conversion as well as upon a liquidation event in some cases. Most typically, however, dividends are not paid if the preferred is converted.

PIK” (payment-in-kind) dividends: another alternative to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

“Opt Out”: For corporations incorporated in California, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock. The purpose of this provision is to “opt out” of DGL 242(b)(2).

Preferred Stock: Note that as a matter of background law, Section 242(b)(2) of the Delaware General Corporation Law provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.

The per share test: ensures that the investor achieves a significant return on investment before the Company can go public. Also consider allowing a non-QPO to become a QPO if an adjustment is made to the Conversion Price for the benefit of the investor, so that the investor does not have the power to block a public offering.

Blank Check Preferred: If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.

Redemption rights: allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.

Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders. Note that Founders/management sometimes also seek limited registration rights.

Registration: The Company will want the percentage to be high enough so that a significant portion of the investor base is behind the demand. Companies will typically resist allowing a single investor to cause a registration. Experienced investors will want to ensure that less experienced investors do not have the right to cause a demand registration. In some cases, different series of Preferred Stock may request the right for that series to initiate a certain number of demand registrations. Companies will typically resist this due to the cost and diversion of management resources when multiple constituencies have this right.

Break Up Fee: It is unusual to provide for such “break-up” fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).

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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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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.