The higher the valuation, the better?
When would maximizing the company’s valuation be beneficial for the Founders — and when could it backfire?
Company valuation is naturally one of the most contentious points of discussion in financing rounds. In the process of raising funds, a large number of entrepreneurs are trying to maximize the value of the company, in order to minimize dilution as much as possible. Valuation, however, is but one of many economic factors and not necessarily the most important to consider in connection with financing rounds. In addition, a valuation that’s too high could become a double-edged sword down the road. For example, investors may object to the sale of a company at a valuation that represents too low of a return on their investment, which may make it difficult to sell the company for what could be a very attractive price for the entrepreneurs. In addition, negotiations in investment rounds raise equally important issues, which sophisticated founders will often opt to trade for some “valuation” points.
Valuation as a “Double-Edged Sword” — a Real Life Example
Following its initial two rounds, which were based on a typical valuation for startups, a certain company, which was able to generate significant value for its activities and attract great interest from potential investors, took advantage of the opportunity and demanded a pre-money valuation of $90 million. The eager investors agreed to invest $ 10 million (which, of course, resulted in $ 100 million post-money), so that the investors received 10% of the company’s shares and the three entrepreneurs were left with about 20% of the company.
Two years later, the company received a purchase offer for $ 200 million (let’s not forget that higher-value exits are very rare in Israel — not more than a handful per year). In such a deal, Round C investors could earn $ 20 million, or 200% their investment. As we all know, VCs do not take the risk involved in technology investments just to earn 2X on their investment — it simply does not justify the risk and does not offset the other investments in companies that did not do as well, which the VC must write off. The investors demanded (as they were entitled to do pursuant to the investment documents) that the company decline the purchase offer and continue to create value in order to obtain a better offer. Today, several years later, no better bids have come, the company’s situation is not as good as it used to be (and that happens even to some of the most promising companies) and the entrepreneurs, who could have received $ 40 million if the deal was good for their investors, are now concerned that their life’s work will go down the drain.
Now let’s assume that the company was willing to raise based on a company pre-money valuation of $ 50 million (or $ 60 million post-money), which would give the new investors 16.66% and let’s assume that the entrepreneurs were diluted to 17.5% (the rest of the dilution would have been absorbed by the previous investors). Here, for the new investors, a sale of $ 200 million would reflect a value of 333% their investment. Much more attractive for them, while the entrepreneurs would have received $ 35 instead of $ 40 million — a little less, still a lot, and in any case much, much more than nothing.
So, what else matters?
Other points such as those outlined below, often do not receive the same time and attention as the valuation point, but are just as important (and at times even much more):
Board Composition
Founders are often too quick to agree to an investor majority or a tied board, overlooking the fact that this could, in effect, result in handing over control of the company. The Board is the corporate body that calls the shots on matters such as M&A, investment rounds, firing and hiring executive level officers (including the CEO), the company’s strategic direction and much more, so to control it means to control the company.
Veto Rights
Investors often have valid concerns that can only be addressed through balanced veto rights over fundamental decisions such as change of the company’s core business or interested-party transactions. However, investors will at times also request veto rights that go far beyond basic matters and could significantly affect management’s power to direct the company’s affairs. Many Israeli ventures “sold” themselves without understanding that they were doing so because, by granting veto rights to investors who had their own agenda, they significantly restricted their power to decide on key matters. This point is particularly sensitive with respect to strategic investors. Such investors will oftentimes be more interested in the company’s technology and their own ability to use it (or to stop competitors from using it) than in the financial outcome of their investment, which in turn means that they would at times be in conflict of interests with other shareholders. It follows that granting excessive veto rights to strategic investors could be very problematic.
Liquidation and Distribution Preference
Most investors will expect to receive their money back before other shareholders participate in the distribution of the proceeds of any M&A or dividends. That is fair enough, however, such preference can at times come in more aggressive forms (such as “participating liquidation preference”) that would result in the investors receiving a return reflecting a percentage far higher than their holding percentage (which, of course, means that the founders will be receiving less than their ownership percentage).
And, therefore…
Many of the entrepreneurs who led successful enterprises were able to rise, at their testing moment, above the basic instinct of maximizing value and to trade it for the overall picture and the company’s mid and long-term future. Below are some rules to keep in mind to ensure that an investment round will be a positive jumping point for your company and not an obstacle to its development, but first to reiterate…
It is important to recall that the financial picture is complicated and must not be viewed solely through the narrow perspective of valuation alone.
It is important to negotiate multiple points simultaneously.
Negotiations process could be conducted far more effectively when a venture has certain points to trade in exchange for others. For that reason, it might be a good idea to discuss, for example, the terms of the liquidation preference in conjunction with valuation and not after it has already been agreed.
Get the best advisors you possibly can.
As an entrepreneur, you will almost always have less experience in negotiating investment rounds than the VC with whom you negotiate. Good and experienced advisors, who are familiar with market standards and trends, could help you offset such disadvantage. This is true for any venture at any stage — top-tier service providers in the tech world are presently available also for early-stage ventures, so you really have no reason to compromise.
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Tomer Shani is a partner in Meitar’s Corporate and Securities Group. Meitar is the largest law firm in Israel, and Israel’s leading international law firm. The firm represents some of the world’s largest multinational corporations in corporate, commercial and litigation matters, in Israel and abroad.
Tomer represents private and public technology companies, venture capital funds and individual entrepreneurs in a wide range of business transactions including mergers and acquisitions, venture capital investments, private debt and equity offerings, strategic investments, joint ventures and strategic collaborations, technology licensing, and distribution and marketing arrangements.
