December 18, 2019 // Entrepreneur Valuation isn’t Everything I was in South Carolina recently attending VentureSouthâs annual Summit when managing director Matt Dunbar, speaking to the crowd about valuation, said a phrase that I have heard repeated frequently throughout my career in finance as it relates to dealmaking: You can choose the valuation as long as I can choose the rest (specifically, structure). Focusing on Valuation So why do so many entrepreneurs focus so much time and thought on their companyâs valuation in the lead-up and negotiation with investors? Part of it is certainly rational. Assuming the entrepreneurs are also equity shareholders in the company, it makes sense that a higher valuation means, at least on paper, the entrepreneurâs net worth is greater as well. And for most, making money in the long term is at least somewhat of a factor for endeavoring to build a company. Competitive spirit also drives some of the valuation discussion – why should we not be viewed as the same, if not better, than similar companies in our stage, industry, sector or region? Itâs ok to be proud of the baby that you have created and are nurturing. The Investor Angle Investors, however, are in the business of acquiring and de-risking assets, with the understanding (and hope) that these assets will deliver returns at or above their risk-adjusted initial expectations. How do they de-risk? There are a variety of levers to be pulled, and simply put, valuation is just one of them. Yes, if an investor negotiates a lower valuation on the front end, there is now a greater opportunity for price appreciation and upside than there would have been otherwise. However, structuring can provide even more protection for investors. Remember this – professional investors will almost always only purchase preferred equity in a company, making their investment immediately more senior in the capital stack to the entrepreneurâs and employeesâ common stock. What does this mean? In any liquidity event (sale, merger, bankruptcy, etc.), they get paid their share of proceeds first. To compound this, many investors negotiate liquidation preferences as well, meaning that in the same sale or merger, the investors get ALL of their invested money back first (and sometimes 2x or more!) before the common stockholders get anything. That is just one type of investor protection among many, including PIK (paid in kind) interest on the preferred equity, which accumulates and increases the value of the investment. Doing a little back of the napkin algebra, one can see how valuation matters a lot less in a sale for the entrepreneurs when the investors have structured to their liking. Too High too Early Another issue with getting too far out in front of your skis with valuation – especially in the early stages of your companyâs growth? If you are valued too high too early, you create unrealistic future expectations for your company assuming you plan on raising capital in again in the future. Remember, your investors want a return, and that means growth. Investors are generally savvy, and if you canât back that up growth, youâll be stuck between a rock and a hard place with finding new investors to keep you going. Usually, this means a dreaded âdown roundâ, where your current investors take a haircut on the price of their shares (they can generally anticipate dilution, but have little patience for price decline). Down rounds can also signal that the management team cannot execute. And in more cases than not, it signals the beginning of the end of the business, and certainly as a high growth venture. So get smart on valuation (more on that next time), but remember, itâs not everything. If you would like to learn more about capital visit our Connect to Capital page or connect with us to learn more about how CED can connect you to resources.Â