Jay Sachetti joined Jeff O’Brien, partner at Husch Blackwell and Dyanne Ross-Hanson, president of Exit Planning Strategies talked about the market for mergers and acquisitions, exit planning opportunities for companies that don’t end up for sale and how companies can maximize their eventual sale price during an early October panel at the first Upsize on Tap event at Summit Brewing Co. in St. Paul.
When the state Legislature passed a law requiring employers to provide paid leave and safe time for employees, Justin Bieganek started hearing differing details from friends, colleagues and peers.
In negotiations with investors, this question manifests itself as a combination of valuation and amount of investment.
The lower the value, the more of the company the investors will get for invested dollars.
Valuation is critical to both entrepreneurs and investors because it drives control and return at exit. Understanding the investor’s valuation process and perspective will help you close the valuation gap, perhaps to your advantage.
Investors, with some exceptions, invest to make money. They don’t invest because they like the management team or because they think the technology is cool. Those things help, but in the end, it’s all in the numbers: either it makes sense or it doesn’t. The potential return must reflect the time the investment would be outstanding and the relative risks involved.
The truth is, investor valuations are many times just gut estimates based on experience. If you understand the theoretical underpinning of the valuation calculations you will be in a better position to help your prospective investors realize that their estimate was off.
So here it is: Investors calculate the value of the enterprise prior to the proposed financing (known as the pre-money value) by determining a realistic exit value, based on industry comparables, and work backwards to determine how much of the company they will need to own to get their targeted return.
To do this investors make assumptions regarding future financings to come up with the percentage of the company they will likely own at exit. If that percentage does not reflect the targeted return, the deal doesn’t make sense.
For example, suppose an investor determines that a reasonable exit scenario for your company is $100 million in 5 years, it needs to invest $5 million in this round, and anticipates one more round of financing of $35 million at a pre-money value of $25 million from new investors. To make this opportunity even moderately interesting the investor would have to value your company at around $3 million, thus requiring you to sell more than 75 percent. In this structure the investor would receive a return on its $5 million investment of about $26 million, just over a five-times return.
Sure the numbers make sense, but what can you do to increase the value and keep more of the company? Focus on the projected exit scenario (when and how much) and the profile of future financings (pre-money value and how much).
Increasing the projected exit will have the greatest impact. Know the industry, recent transactions, valuations of public companies and how your company is similar to those with the highest valuations. You should be prepared to explain why your company justifies a higher valuation; perhaps its business model is different from comparables, perhaps there are no “good” comparables because your company is creating a new industry.
The amount and value of future financings will also have a significant impact on the value of your company. You must have a long-term financing strategy, showing each financing event, valuation, and milestone accomplished to justify the increase in value. Your financing plan should contemplate raising only enough money in each round as is necessary to accomplish the next business milestone that will increase the valuation (such as sales, FDA approval, working prototype).
Raising less money overall or raising money at higher valuations will increase the investors’ return on exit and thus justify an increase in pre-money value.
When you receive an offer from an investor it will likely be presented in terms of a price per share, not the overall pre-money value. The price per share is determined by dividing the pre-money value by the number of shares outstanding and the number of shares that could be sold upon exercise of options and warrants, as well as all shares in reserve for the employee stock option pool. This is generally referred to as outstanding shares on a “fully diluted basis.”
An interesting nuance in calculating the price per share is the practice of “baking in” a proposed increase in the number of shares reserved for issuance to employees. Investors often insist that the number of shares available for employees be increased as a condition to a financing. This increases the fully diluted shares outstanding and “bakes” the employee stock option pool increase into the pre-financing price per share. All the dilution caused by the increase is imposed on the pre-financing stakeholders.
The alternative is to increase the option pool after calculating the per share price. This spreads the dilution among all the stockholders following the financing. Here’s the difference:
1. Price per share with option pool increase after financing:
$10 million pre-money value/20 million fully diluted shares outstanding = $0.50 price per share.
2. Price per share with option pool increase before financing:
$10 million pre-money value/20 million fully diluted shares outstanding + 2 million option pool increase = $0.45 price per share.
Once you’ve worked through the numbers and agreed on a pre-money value, you’d think that would be the end of the valuation discussion, but it’s not. Investors generally insist upon a price protection provision that essentially reduces the pre-money value if the company later sells stock at a lower valuation.
There are two kinds of price protection: weighted average and full ratchet. Weighted average provides for a formula adjusted based on the relative price decrease and number of shares sold. Full ratchet antidilution reduces the price paid by the investors to the lower price paid by the new investors. Weighted average is very common and you should generally not be overly concerned about it. Stay away from full ratchet, if you can. If the investors insist upon full ratchet protection try to limit its duration to 6 or 12 months following closing.
While valuation is fundamental to every investment agreement and has a significant impact on how much of the company you’ll own, it’s not the only thing that matters. If fact, with properly structured founder vesting and governance provisions, you may be able to have a big piece of a big pie.
[contact] Kevin Spreng is a partner with Robins Kaplan Miller & Ciresi, the Minneapolis law firm: 612.349.0820; ks******@**mc.com; www.rkmc.com
