Valuation is for suckers

by Kamal Hassan

I was at an otherwise excellent talk last night by a top Silicon Valley lean start-up guru (Bob Dorf). However, while talking about preserving value for entrepreneurs when you take funding, he said: “it’s all about the valuation”.

This is one of the most dangerous myths out there. It’s NOT “all about the valuation”, it’s “all about the terms”.

What does this mean? Let me tell you about a conversation I had one hour after the talk.   I was talking to an entrepreneur, recently moved to Canada, who was looking for financing for his business. He told me the tale of woe of what had happened in his past two businesses. In one business, his substantial holding of, say, 500,000 shares got reduced to 25,000 shares, through a series of steps that all revolved around deal terms (the issuance of a dilutive round of shares; a forced loss of already vested shares because he didn’t want to work for an acquirer; etc). Note: all of these stories are from the entrepreneur’s point of view … I am sure the investor has good reasons for what they did.

In the second case (here in Toronto, I’m sad to say), he signed a ‘no-shop’ clause with an ‘investment banker’ who promised to get him financing. The investment banker kept stringing him along for three months, and then finally, when the entrepreneur tried to get out of the deal the banker said he couldn’t (‘terms’), but he would extend him a $1,000,000 loan himself. After advancing the first $100,000 of the loan, the banker froze all further payments (pointing to a clause in the agreement – more terms), and then proceeded to use the terms of the agreement, and a threatening letter by one of Canada’s top legal firms, to effectively take over the company for peanuts after it had signed its first major client.

This entrepreneur had lots of shares in both companies, i.e., he got his financing in both cases at great valuations. He got screwed and ended up with very little because of the terms of the deal.

I have seen this happen over and over again, in my own experience, and in that of other entrepreneurs I know. Let me share three tips:

1. It’s best to avoid debt: if you take debt, understand that the debt holder has a cheap and easy way to own 100% of your company: they simply need to ask for repayment of the loan (if the terms of the debt allow it), and if you can’t pay, they take the company. This happened to the other entrepreneur (and to me in one case – where I took a loan from a government fund that I didn’t expect to ever call the loan – and they did). Think three times before taking the debt, and be sure you understand if/when/how you can be asked/forced to repay it. It’s best to avoid debt.

2. It’s best to avoid preferred shares: if you have different classes of shares, understand that this can give very different incentives to different shareholders, and you may end up fighting or forced to do things which are against the interest of your class of shares. A friend of mine went through this: a late angel investor got preferred shares in his company. After a longer/harder slog than expected they had just started to get their sales working, and they got a lowball acquisition offer from a major multinational, which would leave the common shareholders with almost nothing … but which would let the preferred shareholder get his money back. The preferred shareholder was tired of the long hard fight, picked the acquisition (and browbeat the board into acquiescing). The common shareholders got virtually nothing.

3. It’s best to avoid staged investments: the story of the debtholder who only advanced $100,000 of the promised $1,000,000 and then didn’t pay the rest is very common. I know another entrepreneur from Eastern Europe who met all the conditions for release of their second tranche of investment from a top-tier VC, but didn’t get the second tranche because of ‘changing market conditions’. As the CEO said, what was he going to do, take the VC to court? That’s a losing proposition: not only do you ruin your own reputation (CEOs who sue their investors aren’t popular), but the VC knows you’re almost out of money (typically) and can’t possibly keep the company alive long enough to maintain the lawsuit. Instead, take in whatever money you agree to now, and agree to give them some sort of priority on a follow-on round that you will fill on meeting certain milestones. This will keep you focused, and remind you that you can’t count on their money … because whatever it says in the contract, you probably can’t (unless you do really well, and people want to throw money at you – the topic for another post).

Many other clauses matter as well… and they and the strategy to take are the topic for other posts.  Just remember: it’s all about the terms. Valuation is for suckers.

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