- October 26, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Valuing Anti-Dilution Provision In Venture Capital Transactions
A report yesterday in Business India mentioned that several startups would lose their unicorn status. For instance, India had 105 unicorns between 2018 and 2022, but we have 84 unicorns today. In addition, seven startups lost their valuations due to investor markdowns. Investors point out that the decline in unicorns is because of their high valuations that didn’t reflect their true potential. In this post, I provide insights on valuing anti-dilution provisions in venture capital transactions and how these protections offered to investors impact value and make non-unicorns look like unicorns.
How VC Values A Company
Let us take an example of a software company that has launched a gaming app. The founder owns 100% of the company and has no debt. In year 1, the company invested in R&D to develop an app, but it had no revenue.
At year 1, Revenues = 0
Expenses = $15 million
The startup needs additional capital of $30 million for customer acquisition expenses. Thus, the founder reaches out to a Venture Capital firm and pitches the following:
The founder is confident that the gaming app will quickly find customers and project $300 million in revenues at the end of 3 years. The VC is confident of the potential of the gaming app and wants to exit at the end of year three and applies an exit multiple (EV/Sales) of 3x.
Thus, in year 3, the value of the gaming app = 300*3 = $900 million.
As the startup is pre-revenue, the risk is higher. Thus, the VC assigns a target rate of return for this investment at 50% and discounts the startup value at the end of three years by 50%.
Target rate of return = 50%
Value today = $900/(1.5^3) = $266.67 million
Thus, the pre-money value of the startup = $266.67 million.
Post-money value = Pre-money Value + Cash Infusion = $266.67+$30 = $296.67 million.
Thus VC investment in Startup = $30/$296.67 = ~10%.
Thus, when the startup gives up a 10% stake, its valuation increases from $266 million to $296 million.
While the difference between pre-money and post-money valuation is clear, startup valuations add another layer of protection that becomes messy and complicated. Founders offer Venture capital protection against the downside risk of their investments, and this degree of protection can vary across deals.
For instance, if a VC invests $30 million, but in the subsequent round of capital raise, the value of the startup reduces from $297 million to $250 million; the investor in the subsequent round will get a better deal than the VC in the earlier round. To protect against this downside, the VC negotiates for a provision allowing its ownership stake to adjust for the lower value. For instance, if the value of the startup reduces by half, then the ownership stake of VC doubles. In the VC world, we call this adjustment a full ratchet. In some cases, the VC will receive partial protection and will not receive 100% protection.
However, we need to note that the ownership stake will change only if the startup wants to raise capital and thus is contingent on a capital event.
In reality, we state this protection in terms of price per share, where the price per share of the VC’s original investment is adjusted to reflect the price per share in the new capital-raising round. We can term this protection VC is getting as a put option on its investment. This protection works 100% when the startup’s value is between $30 million and $297 million. When the startup’s value declines below $30 million, the VC will lose the protection.
Let us value the put option or protection option, and to value this option; we have to assume the following:
- Probability of capital raise – The VC will get no protection if the startup does not raise additional capital. However, if the startup value declines dramatically, the founder has no alternative but to seek additional capital. Therefore, I assume the probability of capital raising at 90%.
- Expected Time to capital raise – We need to forecast the founder’s expected Time to raise capital. Assuming that it is 2022, when startups face losses, I assume that within 12 months, the founder will go for a capital raise.
- Degree of protection – I assume VC wants 100% protection on its investment.
As the founder operates in the software industry, I use the industry standard deviation of 72.4% as volatility. I use the risk-free at 3.3% (10-year US treasury bond)
When I input these assumptions in the Black-Scholes model, I value the put option at $7.07 million.
Unadjusted Value of Protection = $7.87 million.
Value of put option = Probability of Capital raisingUnadjusted Value of Protection = $7.8790% = $7.07 million.
VC Investment = $30 – $7.07. = $22.93 million.
VC ownership stake = 10%.
Post-money valuation = $22.93/10% = $229.3 million.
Pre-money valuation = $229.3 – $30 = $199.3 million.
The VC’s ownership stake increases from 10% to 13.08% (30/229.3 ).
When VC invest $30 million in the startup, the investor protection option inflates the startup valuation from $229.3 million to $297 million. Thus, when a startup raises more capital and offers an investor protection option, there is a more significant disparity between the intrinsic and the perceived value.
For instance, if I increase the probability of capital raise to 100%, the post-money valuation reduces to $221.46 million.
No Free Lunches
In the VC world, there are no free lunches. In my experience interacting with VC firms and founders, I find VC deals complex compared to valuing a matured company. I am not sure if it is by design or by accident.
Founders who use protection clauses defend this usage to protect against vulture capital investors who will strip the founders of their ownership stake when their startup value diminishes. However, I see the investor protection option as unnecessary, exposing founders to dangers.
At a fair price, the protection does not add any value. For instance, in our example, the founder can invest $30 million without protection and ask for a 13.08% stake or get 100% protection for a 10% stake.
The protection fails when the startup has to liquidate because its IP no longer adds value or its key employees leave the firm. Here, the startup’s value is zero, and the protection option does not work. Thus, 75% of the startups shut down despite the protection clauses.
Founders inflate the startup value by offering protection clauses and can negotiate for a higher valuation in the subsequent capital raise. Further, the protection option helps the founders run the business freely and without investor oversight. However, the founders must not offer too many bragging rights. For instance, I estimate the value of protection at $7 million, giving VC more than a 10% stake in return for a $30 million investment implying that the founder has given more ownership stake to VC than the investment it offers.
Further, when the founder plans for an IPO, the public market investors are unaware of the inside VC game. Public investors assume that the post-money valuation is the fair price to pay because they assume that VC firms are competent and must have priced the startup correctly. Thus, the startup looking for an IPO must disclose the details of the protective clause in its prospectus.
It is not wrong for VC firms to ask for protection from downside risk, but it can get detrimental when greed dominates investment decisions. Thus, the only winners in this game are the lawyers and consultants who make money by further complicating the VC deals. At the right price, the value of protection is zero, and when the price of the protection is high, the VC settles for a lower percentage of stake, and when the price of protection is low, the founders give up too much of ownership.
The fundamentals of business valuation are crucial, and VC must understand the business model. For example, if the VC overpays because they get downside protection, they lose out in the end. Similarly, founders who offer more significant stakes than they should by inflating post-money valuations regret their decisions in good and even worse in bad times.