One Way to Solve the Pre-Money Valuation Conundrum

Let’s make something perfectly clear; I’ve made some ridiculously stupid investment decisions.  I’ve also made some which in hindsight appear to be genius (buying SLV leaps over a year ago, for example).  When structuring deals where our own capital was at risk, we’ve structured some poorly, and others far more astutely.

I console myself with the fact that nobody’s perfect. I’ve always been a proponent of paying my dues in the real world, rather than inside the confines of some institution filled with academics who typically have little to no experience in the business world. Although I’ve tried both the academic as well as the “jump in and swim” technique, I’ve certainly gained far more from the latter and can honestly say that much of the former has been dangerous. As such I’ve learned a lot from each and every deal I’ve put together. One of the things I would like to discuss today is structuring an investment in a company where accurately valuing it is problematic if not impossible.

When investing in a small company that is in its early stages, whether it be a startup or simply a small company raising capital for expansion, I’ve often come across difficulties in valuing the business. This is especially so when revenues are non-existent or minuscule.

As an aside, my friend Kuppy wrote an outstanding piece on this theme when valuing small caps (not startups necessarily). I highly recommend you check it out here.

What I should pay, and what my slice of the equity should be are naturally core questions, and at the heart of every investment decision.

Obtaining any reasonably accurate valuation for a business that has no revenues is almost impossible. It’s like expecting Paris Hilton to solve a quantum physics problem; It’s not possible (unless she’s smarter than she appears – which may be the case). When a company has some tangible assets that it owns there can be a value placed on such assets, but typically there are multiple other factors which cannot be accurately valued. I personally place a large amount of value on the founders, CEO’s and management, and their requisite experience, and will not invest in any company where management is not superb, no matter how good everything else looks.

Unfortunately, the problem of valuing a business is still not as simple as just becoming comfortable with management. Clearly then, getting an accurate valuation on such a business is challenging at best, and how you structure the funding is difficult until you have a reasonably accurate valuation for the business.  It’s a Catch 22.

So what do you do when you see real value in a small business? You want to invest, everything stacks up, you know how much capital is required to achieve the desired outcome, but you struggle to know how much equity you should expect in return for your capital.

Enter the convertible bond.

I would much rather be issued debt, and have the ability to participate in any future seed rounds that take place than try to figure out what percentage of the company I am going to receive.

With the convertible note I also get to reduce my risk of private equity coming in further down the line and arguing the valuation lower or even diluting my stock with additional capital raises… Eduardo Savarin anyone??

Because it’s an attractive structure for many deals, let me briefly explain how a convertible note works. As the investor you receive a promissory note with a conversion feature. The conversion feature is the mechanism whereby your debt will convert to equity upon a certain predetermined event. This conversion should be automatic so as to negate any voting of the board.

Example:

You invest $100,000 and use a convertible note with the predetermined event being an automatic conversion on a qualified financing of say $1M.

* You invest $100,000;
* The Business issues you a convertible promissory note for $100,000, this note is automatically converted on a qualified financing of $1M with a conversion discount of 20%;
* The Business closes a qualified financing of $1M of preferred stock with a venture capital firm at a price of $1 per share;
* The conversion is automatically triggered and the convertible debt is now received as equity at a share price of $0.80;
* You receive 125,000 shares of preferred stock and the note is canceled.

It’s common to have the note converted at a discount to the equity on the aforementioned predetermined event. In this fashion the convertible note is priced in the same way that government debt is priced, which is to say at a discount to par value.

In addition to the aforementioned conversion feature I like to have a second, let’s call it default trigger, for either conversion and or re-payment of the loan. There is no sense in agreeing to a promissory note with a conversion feature which doesn’t allow for time, since you want to mitigate the risks of the particular event not taking place or being delayed beyond a reasonable time frame.

I prefer a trigger event based on a time-line for certain achievements being accomplished (in addition to a trigger event for conversion of debt to equity) for the full repayment of the loan. Ultimately this may take the course of restructuring of the debt with differing interest terms and more security, or a payout based on a third party valuation.

There is much more to say about this, and we will do so in a free report on Angel investing that we are in the process of putting together.

Stay tuned and have a great weekend!

“Don’t marry for money. You can borrow it cheaper” — Scottish proverb

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