British, and by extension European, startups often talk heatedly about valuations. But across the pond where they’ve been doing this for many years, the talk is usually about how any deal is structured. Sean Glass, founder of Pikum!, has now founded a startup on both sides of the Atlantic, and lays it all out in a guest post.
I was at the Always On Media conference in New York last year, when one of the speakers on a panel about M&A and exit activity made a very sage comment. He said “You name the price, I’ll name the terms – I guarantee I’ll win every time.”
When talking to first time, early stage entrepreneurs about raising money, often the piece that I find they are most interested in is how a valuation will be agreed upon – and how to get it as high as possible. It’s amazing how often this comes up at entrepreneurial workshops, panels, and networking events. In fact, one London VC and I thought that it might be worthwhile to create a handout that said “Forget valuation – 0% of 0 is 0”. Worry about how you’ll make the business work so you can raise money, and a good valuation will take care of itself.
The truth is, when you do get to a term sheet, valuation is important, however the terms are equally, if not even more important. Although there are many key terms, liquidation preference and participation are terms that are probably the most important to understand as they may severely affect the entrepreneurs outcome.
Liquidation preference guarantees that investors get X times their investment prior to any money going to common shareholders in a distrubtion. A great post as to why investors want liquidation preference (and why they’re fair) can be found here:
Participation (or participating preferred) enables the investor to receive both their liquidation preference and their % allocation of the remaining funds to be distributed. Brad Feld discusses the concept and gives a concise description here:
The reason that liquidation preferences and participation matter is that they may affect how much you make when you sell your business as much or more than the pre-money valuation you negotiate. This is particularly true if the business is very successful, but not a “10 bagger” [A 10-bagger means that for every $1 of investment made, the VC fund receives $10 back when they sell their stake (either selling the company to someone else, or after an IPO). 10-baggers are pretty rare].
Let’s look at a couple scenarios based on the idea that you are raising a $5 million series A and targeting a $15 Million Pre-Money valuation (you’ve built a lot so far right?). We’ll then look at how the founders and employees do if they accept the terms offered.
One mythical VC, who we’ll call Simple Terms Ventures, thinks your valuation is high and offers $5M with a 1X liquidation preference, non participating.
Their competitor, Liquidation Preference Capital, thinks your valuation is high, is willing to go to $10M pre-money if you accept a 3x liquidation preference.
Meanwhile, in the office across the road, those Our Terms Fund guys are willing to go with your valuation, however they want a 3x liquidation preference and participation.
Two years after your series A, you get an offer to sell the company for $60 million (3x on your targeted post money for Series A – nice job). How did you do?
You accepted Simple Terms Ventures Proposal
You get $30MM which is shared by common shareholders. Simple Terms gets 3x / 2 years, a really solid return. What if you’d received an offer price of more or less? Here’s the return to common versus total acquisition price would play out at different prices. The key is that as long as the company is sold for more than $5 million, common shareholders will get 50% of each dollar over that threshold.
You Accepted Liquidation Preference Capital’s Proposal
At a $60 million exit value, common shareholders receive 66% or $40. Because you negotiated a better pre-money, you’ve made more money. However, it’s important to note that you had to sell the company for more than $15 Million to get anything.
You accepted the terms from Our Terms Fund
At a deal price of $60 million, you got out $33.75 million, better than the low simple valuation, but worse than the valuation without the participation term. Additionally, again it was important that you sell for at least $15 million to make anything, and from that point, what you make is lessened as investors get the $15 million out first, then their pro-rata share of the remainder.
What’s the right path?
The answer is, like most things with a startup, it depends. Many entrepreneurs and VC’s prefer simple, clean terms where both sides do equally well as the value of the company grows. Other entrepreneurs prefer the higher valuation and larger upside that can be obtained by accepting liquidation preferences of 2-3X or more (and then delivering a huge exit). The key to is understanding that when you’re raising money, it’s not just the valuation, but also the terms that count.