Reading: Valuing Financing Alternatives

Now that we know how to value the various financing alternatives, we can go back to the actual deal terms to take a closer look at the deal valuation and, more importantly, the allocation of value between the founders and the investors.

In the preceding sections, we have engineered the example such that the deal valuation and pricing was fair. Put differently, we have made sure that the following holds:

• The various deal alternatives have the same value from the point of view of the investor (10 million)
• The deal is fairly priced, in the sense that the invested capital (10 million) corresponds exactly to the value of the securities that are issued to the investors (10 million).

These two conditions are rarely met in reality. To see this, let us go back to the initial example that we have considered in the chapter Offering Terms:

 

Issuer	Firm X ("Company")
Investors	VC Fund Y ("Investors")
Current Outstanding	8'000'000 of Common Stock (including reserved shares)
Amount of Investment	$6'000'000
Type of Securities	Series A Convertible Preferred Stock ("Series A Preferred" or "Preferred")
Number of Shares	6'000'000 shares of Series A Preferred
Price per Share	$1.00 per share of Series A Preferred ("Original Purchase Price")
Pre-Money Valuation	$8'000'000

 

• The numbers imply a post-money valuation of 14 million (pre-money valuation of 8 million plus investment of 6 million).
• The numbers also suggest that the current value of the Common Stock corresponds to the pre-money valuation and that the value of one share of common stock therefore is $1. Why? Simply because If the value of the firm before the investment (pre-money valuation) is 8 million and there are 8 million shares of Common Stock outstanding, the stock price should be $1.

 

It is important to understand that the latter calculation hinges on the assumption that the issue price of the Series A Preferred ($1.00 per share) is equal to the fair value of the Series A Preferred. However, if the fair value differs from the issue price, the two calculations will generally be wrong.

Most importantly, if the value of the Series A Preferred differs from it's issue price, the value of the firm's Common Stock will NOT correspond to the pre-money valuation of the firm!

 

Let's illustrate this with a simple example. Let us assume, for the moment, that the fair value of one share of Series A Convertible Preferred is $1.15 but that the investors can buy these shares at $1.00 (issue price). Under these assumptions:

• The investors receive a total value of 6.9 million [6 million shares with a value of $1.15 each].
• Given a post-money valuation of 14 million, the resulting value of the firm's common equity is 7.1 million [= 14.0 - 6.9], and not 8.0 million, as previously assumed.
• Given 8 million shares of common stock outstanding, the value of one share of common stock is $0.89 [= 7.1/8], and not $1.00, as previously assumed.

  

Because the investors can buy the securities at a price that is lower than the fair market value [$1.00 vs. $1.15], they  appropriate a total wealth of 0.9 million from the founders. Another way to see this is that, if the underpricing is $0.15 per share and there are 6 million shares issued, the total amount of "underpricing" will be 0.9 million [= 0.15*6]. The founders (more generally, the existing shareholders) pay for this underpricing.

 

Implications for Value Allocation

The crucial point to understand is that the issue price of a security does not necessarily have to correspond to its fair value. If there is a difference between value and issue price, the back-of-the-envelope calculation that we have conducted above to estimate the value of Common Stock (8 million) is generally wrong, and so is the assumption that the pre-money valuation corresponds to the value of Common Stock. 

 

But how can we tell whether the issue price is fair? We have to conduct our own valuation using the tools from the previous sections. To do so for our example, we have to make a few additional assumptions. Let us assume the following:

• There are no dividends
• The Series A Convertible Preferred has a 1x liquidation preference (6.0 million)
• The conversion ratio is 1
• The expected time to exit is 4 years
• The risk-free rate of return is 5%
• The volatility of the firm's assets is 40%.

  

Note that the assumptions about the deal terms (in particular the liquidation preference) would actually seem to be on the conservative side. A higher liquidation preference would imply that the following calculations become even more extreme.

With this information, we can use the tools from the section on convertible preferred valuation and find the following:

 

  

 Interpretations:

• The numbers imply that 6 million shares of Series A Convertible Preferred with a liquidation preference of $6.0 million and a conversion ratio of 1 have a value of 6.9 million today (based on all our assumptions).
• If the firm issues these shares at a price of $1 each, the investors receive 6.9 million worth of securities in exchange for their investment of $6.0 million.
• Consequently, the residual value of the firm's common stock is 14 - 6.9 = 7.1 million.
• With 8 million shares of common stock outstanding, the implied value of one share of common stock is only $0.88 (as opposed to $1.00).

 

Note that the implied value of one share of common stock would drop to $0.64 if Series A Preferred had a 2x liquidation preference.

 

These considerations imply that founders have to be extremely careful when trying to extract their own value implications from the term sheet:

• The temptation is to assume that the issue price of the new securities corresponds to the fair value of these securities.
• This temptation is often reaffirmed by the wording of the term sheet, which shows a pre-money valuation and a post-money valuation and therefore suggests that the value that goes to the new investors is the difference between the two valuations.
• However, following this temptation often (usually) leads to the wrong conclusions, and these conclusions often (usually) work against the founders! Put differently, the deal could look better to the founders than it actually is.
• To find out whether the pricing information is "fair," there is no way around a proper valuation. The tools discussed in this course section hopefully provide a valuable starting point.