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Why Valuation Isn't Nearly As Important As You Think

     

Understanding how much your business is worth is definitely important. Valuation is a key financial indicator throughout the life of a business, but particularly during fundraising rounds or a potential M&A deal. However, too many companies obsess over valuation as if it is the ONLY deal term that matters, and this simply is not the case. Here are other financial aspects of a deal that can be just as important and must be taken into consideration:

Liquidation Preference

During fundraising, potential investors will no doubt want to include a liquidation preference to protect their investment. However, not all liquidation preferences are created equally. The preference proposed is extremely important because it can actually undermine the apparent value of the company. Thus, this must be examined in the context of the valuation to ensure your company is getting a fair deal.


In general, a non-participating preference is the best option. This gives investors preferred stock, allowing them to recoup their investment in the event of a liquidation (whether bankruptcy, a sale, or otherwise). The preferred stockholders are given back the money they invested plus any applicable dividends before common stockholders are given their proceeds, and nothing more. This scenario is better for the company than a participating preference or even a capped participating preference, both of which afford the investors rights as preferred stockholders AND common stockholders.


In those situations, the investors receive their initial investment plus dividends before proceeds are distributed to the common stockholders, and then also receive the proceeds divided among the common stockholders, although in the capped scenario this is at least limited to a certain amount. Thus, your company clearly needs to evaluate the liquidation preference that potential investors are seeking to avoid excessive erosion.

Anti-dilution

In addition to liquidation preference, investors often demand an anti-dilution provision to protect their investment in the event that stock shares are sold at lower prices down the road than the investors initially paid. It usually results in the investors having convertible preferred stock, which is stock that is converted from preferred to common at an adjusted price in light of the price decrease, although there are other ways that investors may seek this adjustment.


It is obvious why investors want to protect their investments, especially venture capitalists who are more likely to make riskier investments. However, companies must ensure that they carefully review any such proposed provision, as it could have a substantial impact on the company’s future value.

Pay-to-play

This type of provision may be a company’s bargaining chip for agreeing to liquidation preferences and anti-dilution protection. In essence, the prospective investors are agreeing upfront to participate in later fundraising rounds or risk losing the preferential provisions they managed to negotiate. This may still be a viable option for some companies, but considering that it is harder to get funding now than it was a few years ago, some investors may not even entertain the idea. Nonetheless, companies must be willing to think creatively, and of course look far beyond valuation, when negotiating with potential investors to iron out the best terms possible in light of the economic climate.

Employee or Option Pool

An employee or option pool has become pretty standard for startups, especially those that are bootstrapping the business. To entice talent, it is important to have an attractive compensation package and offering employees stock options when cash is not available for hefty salaries helps sweeten the deal. Plus, if your company plans to seek venture capital funding in the future, having such a pool will likely be a requirement. Venture firms often ask for fairly large option pools, at a minimum 10 to 20%, essentially to dilute founder ownership while allowing the investor to retain its full share.

 

But, to offset some of this dilution, your company should try to negotiate a higher pre-money valuation, which is just the valuation before the venture capital infusion. Although this may seem circular since it goes back to valuation, it shows the overall importance of the option pool requirement and particularly the size of it. There are usually a lot of incredibly confusing terms proposed during venture capital funding, and thus items like this, which appear to be primarily beneficial to a company, are often misunderstood or overlooked.

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