"Don't Overvalue Pre-Money Valuations "

by Michael Bain and Joshua Fox, WilmerHale Venture Group

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When companies receive competing term sheets, the decision regarding which term sheet to accept may seem clear - the term sheet with the highest valuation. However, pre-money valuation is only one of several important economic terms in a term sheet.

Assume that a company receives two term sheets and investors will purchase preferred stock for $5 million. The pre-money valuation is $10 million in Term Sheet 1 and $7 million in Term Sheet 2. Because Term Sheet 1 includes a higher pre-money valuation, it looks better for existing stockholders - following the financing, preferred stockholders will own 33% of the company under Term Sheet 1, but will own about 42% of the company under Term Sheet 2.

	Term Sheet 1	Term Sheet 2
Ownership Percentage of Preferred Stockholders	$5 million invested _________________________________= 33.33% $5 million + $10 million invested pre-money valuation	$5 million invested ______________________________= 41.67% $5 million + $7 million invested pre-money valuation

 

However, depending on the other terms, these numbers can be misleading. So, companies should carefully consider the other economic terms when deciding whether a term sheet is really as good as it looks.

Liquidation Preferences . Preferred stockholders typically receive proceeds from a liquidation, including a sale of the company, prior to any distributions to common stockholders. Typically, this "liquidation preference" equals 1x the preferred stockholders' original investment. However, sometimes there is a "multiple" liquidation preference, which entitles the preferred stockholders to a payment of some multiple of their original investment. Such a provision can change the economics of the financing greatly.

For example, assume that Term Sheet 1 (with the higher pre-money valuation) includes a multiple liquidation preference of 2x and Term Sheet 2 includes a liquidation preference of 1x. The following table shows the amounts that each class of stock would receive upon a company sale for $10 million.

	Term Sheet 1 ($10 million Pre-Money Valuation)	Term Sheet 2 ($7 million Pre-Money Valuation)
Preferred Stockholders	$10 million liquidation preference ($5 million x 2)	$5 million liquidation preference
Common Stockholders	$10 million total sale proceeds -   $10 million in proceeds to preferred stockholders =   Zero for Common Stockholders	$10 million total sale proceeds -   $5 million in proceeds to preferred stockholders =   $5 million for Common Stockholders

Because of the multiple liquidation preference in Term Sheet 1, common stockholders receive nothing, whereas under Term Sheet 2, they receive $5 million.

Of course, if the company is sold for a much higher purchase price, all of the preferred stock would simply convert and none of these liquidation preferences will matter, right? Not necessarily. If the preferred stock is "participating preferred stock", the preferred stockholders get their liquidation preference no matter what.

Participating Preferred. Participating preferred means that after preferred stockholders receive their liquidation preference, they share the remaining proceeds with common stockholders. Assume that both term sheets provide for liquidation preferences of 1x, but Term Sheet 1 calls for participating preferred. The amounts to be received by each class of stock upon a company sale for $20 million are as follows:

	Term Sheet 1 ($10 million Pre-Money Valuation)	Term Sheet 2 ($7 million Pre-Money Valuation)
Preferred Stockholders	$5 million (liquidation preference) + 33% of $15 million (participation) =   $9.95 million	Preferred would convert and share ratably with the common. Preferred holders receive $8.34 million (41.67% of $20 million)
Common Stockholders	$10.05 million	$11.66 million

 

Because the preferred stock in Term Sheet 2 is non-participating, common stockholders would receive 8% more under Term Sheet 2 than under Term Sheet 1.

If companies must accept participating preferred, they should negotiate a "cap" on participation, which provides that after preferred stockholders receive a specified amount of sale proceeds (expressed as a multiple of their liquidation preference), common stockholders receive the remaining proceeds.

For example, assume both term sheets have a $10 million pre-money valuation, $5 million investment, 1x liquidation preference and participating preferred stock. However, Term Sheet 2 has a 2x cap on participation. A company sale for $30 million would result in the following distributions:

	Term Sheet 1	Term Sheet 2
Preferred Stockholders	$5 million (liquidation preference) +   33% of $25 million (participation; no cap) =   $13.25 million	$5 million (liquidation preference) + $5 million (participation) =   $10 million (2x cap)
Common Stockholders	$16.75 million	$20 million

 

The cap in Term Sheet 2 improves the position of common stockholders by $3.25 million.

Accruing Dividends. Sometimes, a dividend "accrues" on preferred stock (typically at 6% - 8% per year) even if the board has not declared one. Accruing dividends are paid upon a company sale, thereby increasing the amount paid to preferred stockholders. Assume a company closes a $5 million investment with a 1x liquidation preference and 8% per year accruing dividend. If the company is sold four years later, preferred stockholders will receive $1.6 million (8% of $5 million times 4) as accruing dividends in addition to their $5 million liquidation preference prior to any distributions to common stockholders.

Option Pool . The size of the option pool is often negotiated in a financing and is typically dependent on the company's hiring needs. Management often seeks a larger pool because the cushion provides them with greater hiring flexibility. However, that flexibility comes at a cost that is not borne by all parties equally.

When calculating the per share price of the preferred stock (pre-money valuation divided by the number of shares outstanding prior to the financing), investors typically treat the entire pool as outstanding. This results in a lower per share price for the preferred stock and more preferred shares being issued. In other words, the existing stockholders absorb 100% of the dilution from the new option pool. If all of those shares are not ultimately issued, the effect of the unused "cushion" is the same as if the pre-money valuation were lower.

Anti-Dilution Protection. Anti-dilution protection means that the conversion ratio of preferred stock is adjusted if additional securities are issued for a price below the purchase price paid by the preferred stockholders. The result is that additional shares of common stock are issuable upon conversion of the preferred stock, translating into higher ownership percentages of the company by the preferred stockholders on an as-converted basis.

"Weighted-average" anti-dilution protection is more favorable to existing stockholders because adjustments to the conversion ratio are designed to take into account the dilutive impact of the down round. In contrast, "full-ratchet" anti-dilution provisions simply reduce the existing conversion price to the price per share paid by new investors without regard to the actual dilutive impact (e.g., the price may be low, but the amount of money and shares involved could be minimal).

Be careful not to accept a term sheet simply because it has a high valuation. This increases the risk that a future financing will be a "down round", thereby triggering anti-dilution adjustments. Instead, companies should plan for rational increases in valuation each round, reducing the risk that a "down round" will occur and making the company more attractive over time.

Conclusion

In evaluating term sheets, companies should consider all of the economic terms proposed. The term sheet with the highest pre-money valuation may look the best, but looks can be deceiving.