News – General corporate and securities matters
26 January 2016
Valuing Tech Companies – a difficult Matter
Much controversy has surrounded the so-called ‘subprime unicorpses’, a derogatory term for ‘unicorns’ (private technology firms valued at over one billion dollars), undergoing a significant negative valuation adjustment in the case of a sale or Initial Public Offering. The list keeps on growing: Dropbox, Square, Groupon, Good Technology, LivingSocial, …
Such crystallisation of the fair value – the price at which a transparent market or an independent third-party values such companies – often leads to a substantial distortion between the position of common shareholders (founders, employees and initial investors) and the position of professional investors (venture capitalists and hedge funds). In such event, the latter acquire additional shares in order to align the value of their investment with the fair value or receive almost all sale proceeds. As a result, the common shareholders will receive much less than their percentage stake in the capital.
We are regularly faced with similar situations and would like to take the opportunity to formulate a few recommendations for entrepreneurs as well as investors, aspiring to align the interests of both. After all, substantially overvalued companies are rarely succesful on the long term.
Given the popularity of and focus on technology firms, we notice that many entrepreneurs often compare themselves to such unicorns, aspiring to obtain the highest possible valuation from investors. Some investors will agree to such high valuations, but will usually deploy complex financial instruments which disassociate the investment conditions from the valuation.
It is certainly customary for investors to demand a preference mechanism protecting at the minimum their basic investment. However, we also see examples of mechanisms requiring the repayment of three to four times the investment amount prior to all shareholders, including the investors, being able to participate in the proceeds on a pro rata basis.
The same applies to the so-called anti-dilution protection, which essentially entitles investors to additional shares without compensation in the event of a future capital increase at a lower valuation. In this respect it is common to provide for a correction taking into account the size and valuation of the dilutive round. However, there are also cases where a full-ratchet to the price of a next round or IPO occurs with detrimental impact on the common shareholders.
This almost always happens in the event entrepreneurs and investors have a fundamental different assessment of the valuation. We always advise entrepreneurs to lower their valuation expectations in exchange for balanced investment conditions offering an acceptable level of protection for the investors.
An alternative option is to spread the total funding over separate rounds whereby only the required capital is raised in every tranche. This permits to raise additional funds in a next growth stage at a better valuation (with less dilution). In the long run the first backers, entrepreneurs and employees will benefit from such strategy and receive a portion of the proceeds approximating their percentage stake in the company.
Founder and employee interests
In return investors should also take full account of the interests of entrepreneurs and employees. Focusing only on the maximization of their own returns, without due regard to the interests of entrepreneurs and employees, is likely to have detrimental effects for the investors in the long run.
Professional investors do not run the company on a daily basis and are dependent on the motivation and success of the entrepreneurs and employees. Corporate transactions (an IPO, a financing or a sale) at a value much below the valuation of the most recent financing will distort the relative proportions and cause dissatisfaction and probable departure of key persons.
The public market or buyer will, however, always require such key persons to remain on board and motivated, providing entrepreneurs and management substantial leverage in negotiations. This often leads to difficult discussions between investors and entrepreneurs concerning the distribution of proceeds. If these negotiations fail, it is unlikely for a sale or IPO to be successful, and in the most dramatic cases likely to lead to litigation.
An investment balancing the interests of the shareholders by applying a realistic valuation with reasonable investment terms is of crucial importance.
Michel Akkermans, serial entrepeneur, investor and director.
David Dessers and Pieter Capiau, partners at Cresco, legal advisor of Belgian technology entrepreneurs, start-ups and investors.
* Free translation opinion published in De Tijd – 23 January 2016