Valuation has always been one of the key stumbling blocks in the negotiating process between capital sources and companies. This has never been more true than in the current environment, where newly public internet companies with limited revenue and no earnings achieve market capitalizations of Fortune 500 companies. While valuation has always been as much art as science, these very visible successes have made the valuation process in the private equity markets a less methodical exercise than in the past. It is now very common to see wide differences of opinion between the founders of an internet or new media start-up and a Venture Capital (VC) or other potential capital source. If the parties can resolve the difference, there will likely be a deal. If not, it will be back on the money trail for the company and perhaps a missed opportunity for the investors. The parties should be aware that there are various possibilities for crafting a solution to bring the parties together.
Pre- and Post-Money Valuation
Underlying every financing is an express or implied valuation. Valuation can be thought of in terms of "pre-money" valuation or "post-money" valuation. Sophisticated parties will typically negotiate the pre-money valuation of the company up front, recognizing that it will drive the economics of the transaction. The negotiation might, for example, consist of the founders arguing for a valuation between $5 and $10 million based on their view of the current climate for new internet start-ups or, if the company is in a traditional business or is already achieving revenue, some multiple of projected revenues for the year. This value, if accepted, has been established before taking into account the new investment and thus is the pre-money valuation of the company. A VC that wants to invest $1 million in a company with a pre-money valuation of $10 million would purchase 10 percent of the shares of the company outstanding prior to the issuance of shares to the VC. On a post-money basis, the VC will hold approximately nine percent of the outstanding shares of a company with a post-money valuation of $11 million.
Even parties who do not speak specifically in terms of pre-money valuation determine a pre-money valuation when they decide on the price and percentage of the company to be sold. A founder who decides to give up 25 percent of his company for $250,000 has given his company a pre-money valuation of $1 million and a post-money valuation of $1.25 million. It is important, however, to think about the transaction in terms of pre- and post-money valuation to understand who will bear the dilutive impact of the investment itself. For example, in the case above, if the founder has given up 25 percent of his company on a post-investment, rather than pre-investment, basis, he will have achieved a pre-money valuation of only $750,000 and a post-money valuation of only $1 million. If the founder had intended to establish that his company was worth $1 million prior to the investment, the shares issued to the investor should have constituted 25 percent of the company prior to the investment, and would have constituted only 20 percent of the outstanding shares following the investment. This dilution issue is a relatively common oversight by start-up companies and, unless caught early in the process, may become difficult to address after several meetings or rounds of negotiation with an investor.
No Right Answer
The first thing to note about the valuation process is that there are no hard and fast rules to follow. While VCs are familiar with the process, entrepreneurs often ask for a formula by which they can determine the right price or how they can check on the validity of the reasoning behind a valuation proposed by the investor. It needs to be understood that although there are some customary methodologies and trends that change from time to time, the valuation discussion is an arms-length negotiation with each side free to raise whatever factors it deems relevant to support its view.
One mistake often made by start-up and early stage companies is to argue for a valuation that is unreasonably high. Although the market may be large and the business may be in a "hot " area, going in at a very high valuation will make the negotiations more difficult and may set the company up for failure. Companies that convince initial investors to buy in at a price that cannot be supported down the road find that a second round of investment cannot be obtained at the same or better price. When the company is forced to due a "down round," or round priced below the previous round, it will have disappointed its first-round investors, who may refuse to lend further support to the company. In addition, the founders may face greater dilution than they otherwise would have faced due to anti-dilution rights of the first-round investors that will be triggered by the cheaper second-round investment. For these reasons, it is often better for founders to be reasonable in the early rounds of financing. If feasible, the tradeoff should be to take less money at the lower price, show an increase in value through performance and obtain a better, and supportable, valuation in the succeeding rounds.
If the parties are unable to reach an agreement on valuation there are several alternatives that can be considered. It should be noted at the outset that each of the alternatives discussed below needs to be evaluated with respect to potential tax issues in light of the specific transaction.
Staged Closings
One means to resolving a valuation disagreement is to provide for multiple closings of the investment. An investor may be willing to risk a portion of the amount being asked to be invested up front, but unwilling to put in the whole amount at the proposed valuation. In this case, the purchase agreement can provide for an initial closing of, for example, 50 percent of the total amount proposed to be invested. The agreement could then provide for an additional closing of the remaining 50 percent to occur before a specified date based on the company's achievement of milestones. These milestones would be negotiated between the parties and would constitute the thresholds that the investor feels are required to merit each remaining portion of the investment. Depending on the stage of the company, the milestones might relate to stages of product development, the hiring of a CEO, the issuance of a patent or copyright, new customer contracts, revenue levels or, for more developed companies, levels of operating income. In internet companies, milestones can relate to the beta stage of a website, a targeted number of subscribers to a service or a strategic deal with a portal company or other strategic partner.
A variation on staged closings is to provide for variable pricing at the different closings based on performance against milestones. The purchase agreement can provide that the initial purchase price will be reduced or increased for the subsequent closings pursuant to a formula tied to performance. In this case, the investor will be applying projected values of the company based on the company's performance against the milestones with a view to maintaining a purchase price level that will result in a targeted internal rate of return (IRR) for the investor. While this may capture a more accurate measure of valuation, this type of structured pricing can add a level of complexity and resulting cost that needs to be considered in light of the size of the transaction.
While staged closings can offer the investor the opportunity to mitigate valuation risk and are often utilized in venture financings, they have certain potential disadvantages. First, they can leave the company undercapitalized since the company receives only a portion of the investment up front and entrepreneurs often underestimate cash requirements. In addition, they can add transaction costs due not only to more complex negotiations, but also as a result of multiple closings requiring delivery of legal opinions, officers' certificates, stock certificates and other closing documentation. Notwithstanding these drawbacks, the staged closing structure is often the easiest way to circumvent a valuation roadblock.
Warrants
Another approach to solving a valuation problem is to issue warrants that can be used to acquire a greater percentage of the company based on a company's actual results. In this case, an investor might agree to the pre-money valuation proposed by a company, but only if the investor receives a warrant to purchase additional shares of the company as a hedge. The warrants would become exercisable if the company fails to perform according to plan or an agreed-upon set of milestones. The warrant could also be structured so that it would become exercisable to varying degrees based on such performance criteria. The exercise price of the warrant is another variable. The exercise price could be nominal, priced at the initial closing purchase price, at fair market at the time of exercise or could be floating until set based on performance against milestones. Again, the goal of the investor will be to structure the warrant so that the return on the shares originally purchased together with the warrant shares will result in the targeted IRR.
If the investor is unwilling to accept the company's valuation even with the foregoing warrant coverage, another possibility is to issue warrants to the founders to adjust value. In this case, the agreed-upon valuation for the closing would be the investor's valuation, and the founders would receive warrants that would let them acquire more shares if the company achieves the agreed-upon milestones.
Preferred Stock Conversion Ratios
The most common investment security in private placements is preferred stock which converts at the option of the holder into common stock. Preferred stock will also customarily have a liquidation and dividend preference over common stock, "full ratchet" or weighted average anti-dilution protection, certain voting rights and possibly a redemption feature which becomes effective after a specified number of years. One of the ways valuation can be addressed is through the conversion feature of the preferred. Typically, preferred stock will initially convert on a one-for-one basis at the time the preferred is issued. In the event of anti-dilution protection on a "down round," the conversion ratio will automatically adjust so that each share of preferred stock will convert into more than one share of common stock. This mechanic serves to offset the lower priced issuance by increasing the preferred holder's ownership percentage in the company.
The same mechanic can be used to address a valuation issue. Assume a founder believes his company should be valued at $10 million and a VC thinks the company is worth only $7 million. The VC is willing to invest $1 million, so at a $10 million pre-money valuation the VC would end up owning 9.1 percent of the company and at a $7 million pre-money valuation the VC would end up owning 12.5 percent of the company. The VC concedes that if the company were able to recruit the CEO the founder has predicted will join within three months, the VC would agree to the $10 million valuation. One approach to resolving this difference would be to sell the VC a 12.5 percent stake on a post-investment basis but provide that the conversion ratio of the preferred stock will be adjusted to result in a lower number of common share equivalents if the CEO joins within the specified time frame. There are many possible variations on this theme. For example, the conversation ratio might have three different possible settling points based on the achievement of various milestones. The conversion ratio might not be set at all until some period of weeks or months in the future when milestones can be measured.
In general, when using conversion ratios as a way to address valuation issues, intervening events, such as a sale of the company, must be taken into account. A decision will have to be made as to the proper conversion ratio if the company hasn't had time to achieve the designated milestones. This might be addressed by pegging the ratio based on the price at which the company is sold. The parties must also decide whether other rights attendant to the shares, such as voting rights or preemptive rights can be exercised according to the initial conversion price. In the case of a minority investment where voting rights may not be important, it may be agreeable to suspend the voting rights until the period for the conversion ratio adjustment expires. Finally, the attorney must be careful not to create a taxable event for the investor. Starting with a lower conversion ratio and adjusting it upward may create a tax problem since the adjustment might not qualify as an exempt form of anti-dilution adjustment under the tax regulations.
Protection on Liquidity Events
Another way to offer investors protection when valuation cannot be agreed upon is to provide that on a sale of the company or the redemption of the investor's shares, the investor will be entitled to receive an amount which gives the investor a specified annualized IRR over the period of the investment. This can be accomplished through the deemed liquidation and the redemption provisions of the preferred stock charter. Here again, tax analysis will be important since redemption rights at a premium to what an investor paid for its shares can be treated as a deemed dividend. This may result in the realization of taxable income over the periods prior to redemption at a time when the investor has received no liquidity with which to pay a tax obligation.
These are some of the more common ways companies and investors can reach common ground on valuation. It will always be important to weigh the advantages of adopting one of the approaches discussed above against added cost and complexity, and the parties will often do best by meeting in the middle and avoiding a more complex structure. However, there are cases where the gap cannot be bridged absent some creative structuring.