Increasing Your CompanyÕs Value
(eighteenth
in a series)
Back in the fourth week of this series, I walked you through my view of the valuation process. This week weÕll talk about ways that you can influence that process to your companyÕs benefit.
First, letÕs recap some of the points in the prior article.
What is your company worth? ItÕs worth whatever someone is willing to pay for it. Valuation is more an art than a science. In my experience, valuation falls into a range of values. ThereÕs some number below which an entrepreneur will not accept an investment. Similarly, thereÕs some number above which an investor will walk away.
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Since investors want to maximize their return on investment, the valuation they are likely to propose will be toward the low end of the range. That number is not going to change materially in one-on-one negotiations. My guess is that increasing it 20% is at the outside of what you might be able to achieve.
The only way that I have seen to increase valuation significantly (by orders of magnitude) is to have competition, or credible perceived competition, for your deal.
LetÕs revisit the original case. [The following characterizations are more caricatures, than reflections of actual behavior. You would never allow your company be this vulnerable. No investor would be as devious as the one described. These are extremes for the purpose of making point, É. or are they?]
You have been pursuing an investment from any source for months now. It has taken forever to get even one investor to come the point of preparing a term sheet and giving you a specific valuation for your company (as well as all the other terms and conditions do that impact your interpretation of the valuation). You are running out of cash, or have already done so and youÕre running on fumes. You need to do a deal, and you need to do it soon.
You take a look at the term sheet and your jaw drops. The valuation the investor has put on your company is only a fraction of what you believe your company is worth. You express your dismay and ask how that can be. The investor will cite other investment transactions with which he is familiar (and may have actually done) and explains the similarities and differences of your company relative to these other companies. He pulls up a spreadsheet on his laptop to demonstrate to you that by taking the projections in your business plan and making what he claims to be prudent adjustments to them, the results can be analyzed in the context of an exit and return potential. The valuation is a simple case of analysis and calculation. Numbers donÕt lie.
As you fight back tears (or your urge to punch him, depending upon how you react to surprises), he closes by telling you that he had to really go to bat for you with his partners because they thought the value should be even lower. ÒIn fact,Ó he warns you, ÒOne said that there were better deals in the prospect list and that we should pass on your altogether!Ó
The investorÕs message is: Be thankful youÕve got a deal. DonÕt screw around, or the deal might fall through.
How can you respond? Can you go to another source of funding? [Not the way IÕve built this hypothetical case.] Can you appeal the investorÕs sense of ÒfairnessÓ? Can you/should you convince yourself that a smaller percentage of the bigger pie is better than 100% of a small pie (or no piece, if the company fails)? Are you willing to crater your company on a Òmatter of principleÓ?
Quite simply: Who has the power? I hope that itÕs obvious that virtually all the power resides with the investor. Why would an investor increase a valuation that he has already justified to himself, his partners, and now to you, as ÒfairÓ?
Now, letÕs look at the same deal, but in this case, youÕve read all my columns. YouÕve got yourself surrounded by a group of professionals and mentors who have helped you level the playing field. You are aware of the pitfalls of being forced to do a deal when you are only talking to one investor and you are about to run out of money.
Being sufficiently forewarned, you have done the following:
You have resisted the urge to increase your burn rate. You have avoided being desperate for cash.
Ideally, you can maintain a cash neutral level of operations, if necessary.
You have developed a strong relationship with at least one large firm that Ògets itÓ and wants to work with you.
You have carefully chosen to pursue investment from potential investors who qualify as being ÒgoodÓ investors for you and two are close to offering independent term sheets.
Now, who has the power? You!
In my mind, this scenario is optimal for an entrepreneur seeking funding:
Two potential financially motivated investors
A potential strategic partner (they can play the role of wild card in that many strategic partners can offer very generous valuations if they invest)[ThatÕs not always a good thing, but weÕll save that discussion for another day.]
You can walk from the deal.
It is not easy to pull this set of options together, but it is worth trying to.
Even when youÕve positioned things this way, you can screw it up and end up with nothing. If any of the parties thinks they are being Òplayed,Ó they are likely to withdraw immediately. In turn, the investment community is small enough that the rumor mill will spread that news like wild fire. Your honesty and integrity will be called into question. The whole house of cards could come falling down.
One company I know had but together the following:
An interested financial investor
A potential investment from a strategic partner
A potential investment from a company looking for diversification
An agreement among existing investors that they would provide bridge financing if it became necessary
The company preferred the financial investor in terms of its potential impact on the ultimate exit, but only if the terms of the deal were acceptable. Each of the other alternatives was viable, with positives and negatives. The company was willing to go in any of these directions. Each had a sense that the company had alternatives, but did not know the details or identity of the other possible players.
After setting these dominoes up, the company was able to extract a term sheet from the financial investor. The prior round of financing had been done at $1.75 per share. The term sheet came in at $1.25 per share! The company was not pleased, to say the least. The investor was told that while the company would like to work with it, these terms were not attractive. The company did not reject the term sheet, but the investors knew that the company was not happy.
The companyÕs management quickly put the other options in play. They explained to each of the potential corporate investors that it had received a term sheet from an investor and that if they wanted their interests to be considered, they needed to put their offers in writing, which they did.
Things went round and round for a while, with each party walking gingerly. Feelings were being hurt. Egos were getting bruised. Each potential investor had withdrawn from negotiations at least once. The knots in the stomachs of the companyÕs management were the size of watermelons. Finally, there was a sense that each party, including the company, was about at its limit, and the possibility of the deal falling apart was increasing.
The company told each investor that it was going to hold a board meeting and that it would make a decision at it. By this time, the financial investor had increased its offer to $1.80 per share, claiming that an ÒupÓ round was generous.
The board meeting was called into session and discussion ensued. Phone calls were made to each potential investor to clarify certain points and to determine if any were willing to improve their offers. There was some movement by each, but nothing significant. The board was still interested in the financial investorÕs deal, but was split on whether the terms were going to be acceptable. A final call went out to each investor. They were each told the concerns the company had with each deal. The potential investors were told to make their final offer. By this time, the companyÕs attorney was having these discussions as the involved parties might have had trouble maintaining a dispassionate tone on the phone.
Cutting to the punch line, the financial investors offered $3.00 per share which was acceptable, and that deal closed. The progress made in those last few hours probably added about $20-30 million to the exit value of the existing investors and management.
You need to begin preparing for these discussions TODAY.
A key factor in negotiations is the relative power of the participants.
Being able to walk from a deal is very powerful.
The first-time entrepreneur needs to plot a fund raising strategy in advance and execute against that strategy.
If at all possible, avoid having to do a deal with only one investor.
Creating the perception of competition, if no firm alternatives exist, can be used effectively, if necessary, but such posturing can also backfire. Think through the consequences of your actions and make sure you can live with a worst case outcome.
BE HONEST AT ALL TIMES!
Build a network of mentors, advisors, professionals, and entrepreneurs who have Òbeen there and done that,Ó particularly in your market space. They already have the battle scars. They will have awareness of recent transactions and valuations.
As a first-time entrepreneur, you do not need to put yourself at the mercy of the investment community, but itÕs your job, not theirs, to prepare yourself to engage in valuation discussions when you are seeking capital.
Frank Demmler (fd0n@andrew.cmu.edu) is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (http://web.gsia.cmu.edu/display_faculty.aspx?id=168)