Valuation. The magic word supposedly related to the current price tag of a company. Is it so, though?
I remember it as it was yesterday. In 2007, in my own startup, we received a Term Sheet with stellar valuation. It was so high, that we were blindfolded for the other “legal language”, such as … liquidation preference. “That’s not important, we’re not gonna liquidate our company and even if it does go down the tubes, two times zero is zero anyway,” I recall us thinking.
Liquidation preference is, however, related to any “liquidation event”, which – surprise, surprise – includes exit of the business as well. Then those stakeholders with higher liquidation preference are higher in so called “liquidation waterfall” and are entitled to get not just what their then-current shareholding is, but what their liquidation preference says. Only after they are fully satisfied, remaining proceeds are distributed to others.
Not long ago I’ve seen a startup signing a Term Sheet with $5 investment at a whopping $50m post money valuation. Competitive bids came at around $30m. The catch was, that there was “participating 3x liquidation preference” fine print in the seemingly better Term Sheet. The “participating” word is even another slyness. It means that after such investor gets his 3x investment, he still participates on the pro-rata distribution. With the more usual and fair “non-participating”, the investor can choose to get either liquidation preference, or pro-rata distribution. So, in practical terms, what can happen:
The company gets sold at $100m: Investor gets his 3×5=$15m a then 10% of $85m, i.e. total of $23,5m (23.5%) for his 10% stake. Compared to the investor, who’d invest at $30m without these “features” (who’d get 5/30*100=$16.7m), he receives 40% more, although his stake was 66% smaller (!). And now imagine things do not go so well and the company gets only sold at $15m: The 10% investor gets everything and founders get nothing.
Do you still consider the valuation as the most important part of a term sheet?
In the coming weeks we will elaborate on other twists relating to high valuations. Have you heard of full-ratchet anti-dillution protection? Or the lock up your company would face if things do not go so well and you would need to raise a downround? Or consequences of different conversion times of convertible notes? We’ve been there and learned the hard way. We are aware that we won’t be liked by other investors, as we are uncovering their dirty practices. But we are and always will be on the founders side.
Stay tuned 🙂
I remember well the fights with my parents over tidying up my room. I mean, is that really necessary? Organised things are for dumbs, smart guys can navigate in chaos!
Over time, I found out I can avoid this boring task when there is nothing to clean. Everything can be put back to place after I stop using it. And this simple principle works great everywhere. When I do it right at first, I don’t have to get back to them.
It’s even more important in business. Your goal is to build a successful business, and you may want to have an option to sell it in the future. It won’t help if you know, how to navigate the chaos. The investor wants to be able to navigate it itself. Each missing contract, IP or makeshift arrangements will be grounds to hammer the price down. And cleaning the mess during the due diligence is nerve wracking and sometimes even impossible.
Do I know, where and how all my contracts are organised? Do I have that code from a friend covered with IP assignment? Is my accounting showing real accruals and aging of A/R? … Anywhere where I can be tempted to cut a corner and have a temporarily easier way, I should ask myself – if I was an investor, what would I say to this? Well, I rather work overtime to do it right. Because cleaning sucks.
One of my best business rules is 2x ASAP, a.k.a. “As Soon As Possible & As Simple As Possible”.
Imagine two beach bars: at one, you may select one of five main courses. Costs for the operator are lower and service is way faster. Everyone is happy (except 2% customers, who always complain). Compare to a bar with 60 main courses selection. It will take 20 minutes at least for each customer to make an order. It will cost a fortune to handle the complexity in the kitchen. And because it will also take longer to prepare, you will only be able to serve about a half of the potential customers. What’s better?
We are seeing this all the time with our portfolio companies. They come up with a genius idea, but then they fine tune it for so long that it becomes a monster. Typically, a price list. Instead of a price for a service, we read through many exceptions, bundles etc that all make perfect sense alone, but together it is almost impossible to get it right. And implementing it takes soooo long that the world is different by then.
Customers are no rocket scientists. They hate studying complicated proposals. Their attention span is short and if they are overwhelmed, they leave. Focus on 90% of them and make the decision simple. And do it now.