In an earlier Blog – Part I of this series – I explained that as tempting as it may be for an entrepreneur to take money from an overzealous investor at a scary high valuation, in the long run the wise entrepreneur doesn’t take on an investor at price that doesn’t pass the blush test. Taking on investors at such prices today can make raising more money from more sophisticated investors in the future more difficult and often impossible. In this installment, my focus will be on a couple of other situations where judging an investment proposal solely by how high the face valuation is can be a mistake; other situations where sometimes less can indeed be more.
First, there is what I think of as the “Midas Touch” exception to the selling high is always best rule. This situation occurs when multiple investors offer different prices for a deal. Say, “C-List Ventures” offers a $5 million pre-money valuation while “A List Ventures” offers $4 million pre-money. Assuming for purposes of the example that both firms earned their place in the Venture Capital pecking order, there is a good chance the $4 million offer from A-List is the better deal, despite the lower price. Because in terms of form (reputation) and/or substance (real capabilities) the A-List firm is almost certainly bringing a lot more value beyond just capital to the deal than the C-List firm. Getting the right A List firm behind you can making raising the next round – or even getting to the exit – easier and more profitable (i) just because they are in the deal and/or (ii) because they have superior value add capabilities (networks, experience, etc.).
The Midas Touch exception can be tricky in application. Its not always certain that an A-List investor will bring more to a specific deal than a C-List investor (though reputation alone is almost always a plus). And value add distinctions are not always as big as “A-List” “C-List” examples might suggest: a particular C List firm might not have very broad capabilities, but may have just the exact such capability your deal needs. But the Midas Touch exception is very real, and entrepreneurs that don’t evaluate competing offers with it in mind can make big, unnecessary mistakes.
Besides factors relating to who is doing the bidding that can make a lower price a better deal for the entrepreneur/seller, there are complications relating to the deal itself. Call it the “Fine Print” exception. An offer at $4 million pre-money can be worth less than an offer at $3 million pre- money depending on the other terms of each offer. For example, if the $4 million offer includes ratchet anti-dilution protection, cumulative dividends and fully participating preferred stock, a $3 million offer with weak formula anti-dilution protection, no cumulative dividends and non-participating preferred stock might, in total, be the better deal despite its lower “face value.” The bottom line? You have to read – and understand – the often arcane details of a term sheet before you can place a discount (or premium) on the face value of the price offered.
Figuring out what your startup is worth is hard to do (though it helps to start at least with the notion that it is worth no more than a willing buyer will pay). Some offers are just too good: if not too good to be true, still too good to be accepted, as explained in the earlier post about the Over Zealous Investor rule. Others (the Midas Touch scenario) are difficult to compare because of differences in the value add metrics of the groups making the respective offers. And finally, the Fine Print exception illustrates how when it comes to valuation the devil can be and often is in the details. While the best investor is quite often the one that offers the highest valuation, that is not always the case. Sometimes less is better than more.