Architecting valuations (building a house of cards)

In a day and age of valuations as  score card there are in some cases extraordinary efforts being made to forcefully make certain milestone valuations happen (100m, 500m, 1bn etc).

The right way to make a high(er) valuation happen is of course to have someone just pay that price with fair and appropriate growth / later stage financing terms. Lots of companies can pull that off – even to the point where new later stage investors are just getting common stock.

But that is not what is going on in many cases. This is what’s going on:

New later stage investor: “Hey so I don’t think your company is worth $500m; maybe $200m – BUT if we can agree that I can get a 2x liquidation preference on my $50m and a full ratchet I would be ok with it. You should be fine with it because you told me next round will be $1bn+  – so we both win. You get your $500m valuation now, you don’t get a lot of dilution and I know I’ll make a safe 2-3x.”

Basically this means the new later stage investor will still make a 2x return if the company is sold as low as for $100m (!). And later stage investors typically are aiming for just a 2-3x. So the headline valuation nearly doesn’t matter – they’re happy to meet your milestone if they can generate their required returns through other terms (liquidation preferences and full ratchets) + some extra upside if the the company moves beyond the milestone valuation.

Now the bet that is not being made any more here is this: “I think the company is worth X today and I am going to price it exactly as that. I think it can be worth 3X in Y years – that’s the upside / risk profile I’m taking”.  Basically the scenario above is close to pure financial engineering (although you do have to believe the company could be sold for $100m). It’ hedge fund style, not venture funding. It’s very different; I’m not saying it is necessarily a bad thing always.

This approach is working well for some companies. Maybe it’s OK – we’re all adults. Everyone’s knows what they are getting in to. However, in more than enough cases I am sure it will turn out to be a horrific house of cards on the way down.

  • John Smith

    Great post. In the example above, I’m curious how the calculation changes if we are talking about a $100 million IPO and not a $100 million sale. In that case, wouldn’t the preferred shares convert to common, implying that the VC will take a hit?

    • Ciarán O’Leary

      Usually there are all kinds of rights, hurdles, voting mechanisms etc to decide on an IPO. So there is still plenty of room to say “ok we’ll IPO, BUT…”