Bill Daniels, a cable tycoon, was a consummate deal maker. I never had the honor of meeting Bill, but his reputation in the industry has stood the test of time as have some quotes that have been attributed to him. My Partners, some of whom had the great pleasure of knowing and doing business with Bill, are fond of one such quote:
You set the price and I’ll set the terms.
From what I am told, Bill understood the interaction between pricing and structure better than most. The essence of the quote is that pricing and structure are inextricably linked; you cannot fully understand the valuation of the deal without fully understanding each of its elements.
Often, I find that entrepreneurs overemphasize pricing (the pre-money valuation) and under-value structure. This is understandable. The pre-money is “a number”. Being a number, it is easy to understand, requires little interpretation and is easy to communication.
Yeah, we got the venture guys to pay-up with a $(fill in the blank) pre-money.
The pre-money valuation of a deal lends itself to soundbite marketing and entrepreneurial chest-thumping. By driving pricing up, the entrepreneur can bring a big number back to his/her existing investors and Board, thereby validating what the entrepreneur has accomplished. This is all well and good; I’m all for entrepreneurs doing their fiduciary duty and battling to maximize pricing on the behalf of their existing investors. But a focus on pricing completely ignores the other half of the valuation equation, structure.
Unfortunately, in my experience, entrepreneurs over-value a high pre-money price and undervalue structure. Take the example of a $10 million last institutional growth capital round. Lets say the Company is choosing between a convertible preferred structure priced at a $20 million pre-money and a participating preferred structure with a $30 million pre-money. The chart below shows the payout to the new investor from this structure (the bottom axis is exit value, the left axis is $ returns to new investors. I’ve posted the full spreadsheet here.
This is an overly simplistic example, but I think it shows the interplay between structure and pricing very well. Notice that the returns for both structures diverge at the $10 million mark; this is the level at which the liquidating preferences of both structures are paid back. The difference is that the standard convertible preferred structure does not begin participating again until it is advantageous to convert and that happens only when the post-money valuation of the round is exceeded ($30 million). The participating instrument however begins to participate immediately after the liquidation preference is paid back. Although the participating instrument owns less of the company, it returns more than the standard convertible preferred structure all the way up to the $90 million exit value, where the structures are equal. The participation feature acts as a return accelerant at lower levels of exit valuation.
Why is this important? For me, the goal of pricing and structuring a new investment is to get a fair deal that maximizes the alignment between new investors, existing investors and management. By “fair”, I mean that it provides my limited partners with an expected return on capital invested that is commensurate with the risk of the investment. Getting to the right risk-adjusted return is a matter of both pricing and terms. When entrepreneurs try to push the pre-money valuation higher, investors have no choice but to respond with structural return “kickers” like participation features. In the scheme of things, a participating feature is a mild structural advantage for new investors; I’ve seen much worse (multiple liquidating preferences, performance based ownership ratchets, etc.) But even a participation feature can create a disconnect between the interests of existing investors/management and new investors. In this case, the participation feature may lower the new investor’s exit threshold, creating an incentive to sell earlier than they would otherwise. Caps and catch-ups can help to remedy this, but add another layer of complexity. And in my experience, complexity is rightly to be avoided because it often results in unintended consequences.
The point is that entrepreneurs should understand that valuation is matter of both pricing and terms. You cannot understand one without the other. The goal of alignment will always favor a simpler structure at a fair price. Unfortunately, in practice, things are never quite that straightforward.