Devaluing Valuations

By Paul Hynek G’90/WG’90, Founder of EZ Numbers

If you’ve been around the startup world long enough, you’ve most likely seen one or more investment deals go south after all the stars have aligned, simply because the investor and entrepreneur couldn’t agree on the valuation.

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I once had a deal agreed to with a VC. We had negotiated over months and we had the contracts drawn up and approved by both sides. They then encouraged us to buy another company as part of a larger overall roll up plan, so we did. Since we needed to give the founders of the other company some of our stock, we wound up issuing new stock. This diluted our VC’s ownership percentage below their 15% minimum threshold, so at the 11th hour (literally, this happened at 11:30 pm) they told us that we would need to cut our valuation in half. All of this because we bought the company they told us to buy. Since the effects of the acquisition of the other company hadn’t been spelled out, this caused us to walk away. You may say that this is really about ownership percentage, but it’s really the same thing as valuation.

Recently two new kinds of investment deals have been gaining popularity. The former is delays the valuation issue, while the latter makes it less important or completely irrelevant.

The first is convertible debt. Here the “investor” provides the agreed-upon amount of money, which gets recorded as debt. The initial agreement will specify the terms of the potential conversion to equity, which will often occur at the time of a subsequent equity round of funding. The valuation will be set automatically by the equity round, and typically the convertible debt investor will get around a 20% discount off the then-current valuation by virtue of having invested earlier.

The advantages of convertible debt at that you first delay, then automate the company valuation. At the point when the investor chooses to exercise their option to convert the debt to equity, all of the terms have already been agreed to.

The second method is revenue share. Here there is no debt taken, and no equity given. You pay an agreed-upon percentage of your Revenue, Gross Profit, or Operating Income. The advantages of revenue share are that if you make no money in a given period, you don’t have to pay anything. Often the investor will get their money back plus a premium of say, 20%. And for the investor, they often wind up getting made whole on their investment, plus some profit, far earlier than otherwise.

With revenue share deals, you completely sidestep the valuation issue altogether, unless, as commonly happens, you give an equity “kicker” in addition to the revenue share. In this case the company valuation is still relevant, but much less important because the investor is getting their money back independent of what the valuation is. VCs and larger angel funds don’t do revenue share deals as they’re looking for moon shot returns, but they do work for angels and friends and family who are more concerned with how long their money will be tied up.

If you’re raising money, think about convertible debt and revenue share. The less you have to negotiate your valuation, the more time you have to actually increase it.

Paul Headshot smBio: Paul Hynek WG ’90/G ’90 is the creator of EZ Numbers, software that makes financial projections for startups, and which has raised over half a billion dollars to date; an Adjunct Professor of Finance and Accounting at Pepperdine University; and a Partner in Avatron Smark Park—a new high tech theme park slated to open outside of Atlanta in 2018. He is a frequent speaker at technology and entertainment conferences.