This post is by Jeff Carter from Points and Figures
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Valuations of companies are consistently on the minds of both entrepreneurs and investors. As an angel, I want to know where I am investing early and the progression of the valuation of the company. I worry about valuation but don’t count my chickens before they are hatched. It’s all paper until I ring the cash register. As an entrepreneur or employee of a startup, I want to know how much I own, and what that ownership is worth. As a VC I worry about both of the above with the additional responsibility of going through an audit and reporting back to my LPs the financial valuation of the firms the fund invested in along with what their investment is theoretically worth today.
I feel for the entrepreneur mindset. Equity is never greater for them than at the start of the company. 100%. As soon as they take a paid advisor, investor they will never own 100% again. I always tell entrepreneurs I invest in that at the end of the day I want them to own a huge island and I just want to be able to buy a Porsche 911 that I can fit in.
Again, it’s all New Orleans Jackson Square voodoo until the cash register is rung.
However, you can totally screw up a company in its initial round if you don’t do things right. Rule of thumb is that you sell 20% of the company at each funding. But, rules of thumb can be broken but you need reasons to break them.
Each round of financing needs to be just right. Entrepreneurs need enough equity to have the financial incentive to build a blow out company. Investors need to have a meaningful stake so they can pay themselves and investors. The math is unforgiving.
What happens when you run into a company where the math is screwed up, yet there is a business still to be had?
Perhaps the company raised a bunch of money, did some pivots, and finally has a business but the original investors own way too much of the company so the entrepreneur doesn’t have an incentive to build it. Perhaps founders left the firm leaving dead equity on the cap table.
There are lots of ways to deal with this but I think it helps to use an emotionally intelligent process to figure out how to deal with it because no two situations will be exactly alike. You have to spend time getting to know the field and lay a lot of groundwork out before you really dig in and write a check.
The first thing to do is check in with the management team. Find out if they have the will and determination to follow through and build a company. If they do, you can start to sort things out. If you find that they don’t, or that you will have to add and subtract new management (re-engineer the management team), there isn’t any hope. If I was an investor in a deal like this, I’d figure out how to sell the company to realize something in return or just shut the company down. Every investor can tell you about Zombie’s in their portfolio. They rarely come back from the dead.
If the management is solid, figure out what their equity stake is. Do a waterfall at the last valuation or at the new projected valuation based on a realistic new investment. Take that number to the management team and show it to them. If they are still on board, proceed. If not, revert.
If they are on board, you have to figure out the round. The next step is to talk to existing investors. Figure out what is motivating them. This is an emotionally intelligent conversation. Guide it. Really dig. You will uncover a lot. Will they support you, or are they going to fight you? Where do they want to exit? Where they want to exit makes a huge difference. If that doesn’t jibe with the management team or your exit number, you need to have a long conversation about that. If it can’t be agreed upon, you are going to have problems.
Now that everyone is on board, you can figure out the round.
The first part is easy. You know where the company wants to go and the resources that it will need. Burn rate times months and that lets you know the raise.
The hard part is the mechanics. There are several options:
- Recap the company. Cram down original investors. Bring in new capital.
- Fresh capital layered on top of the existing cap table, but take care of the management team will need a big refresh of the options pool to give them incentive. That’s dilutive to investors.
- If the company has cash flow, or is sitting on cash, the company can buy back equity from existing investors?
- Increase the compensation of the management team to above market to compensate for their loss of equity.
- Can the management team invest themselves to buy equity?
- In the age of crypto, is an ICO that is non-dilutive a possibility?
- Is there any breach of contract that can be enforced where you can claw back equity?
- Are there any options packages out there that can be clawed back, or are there employees that are leaving/left the company where they have to exercise vested options or lose them?
- If there are dead investors on the cap table, are they willing to sell equity to active investors?
It is never an easy situation. This sort of thing should only be done if you are going to try and create a really blow out unicorn style company because even at small percentages of equity, the dollar numbers become very meaningful.
Of course, if you put discipline into corporate finance from the get go, you can avoid a lot of these kinds of situations.