KAUFMAN, J.

DRAFT July 11, 2012

The Trade-O Between Valuation and Participation Cap

Jonathan Kaufman July 11, 2012
Abstract During the negotiation of a venture capital investment, there are many factors which can counteract each others nancial eects. Two prominent factors are valuation and participation cap. each of these can have a significant eect on the nancial outcome of all shareholders. Venture capital investors and entrepreneurs can have eective intuition regarding the nancial path the company may take (i.e. what the eventual nancial exit may look like as well as what additional nancing events may be required before reaching an exit). Where intuition evades most investors and entrepreneurs, however, is in the realm of how these factors quantitatively aect the nancial outcome to specic classes of shareholders. A good understanding exists regarding the direction that such factors can have on an outcome, but not the size. This paper quantitatively describes the counteracting exit eects of what could be the two most important factors (valuation and participation cap) during a typical sequence of company nancing events, demonstrating a method for gaining a company-specic quantitative understanding in an important area where intuition can be evasive. This method can be applied to help guide a venture capital investment negotiation toward solutions that successfully serve all parties as the company progresses and encounters additional nancing and exit opportunities.

Since there are a multitude of nancial factors in any venture capital nancing event, the counter-balance of these factors can create a challenge during the evaluation of various options or scenarios. This paper present a relatively concise example of the counter-balance between two important factors: valuation and participation cap. We demonstrate how determining the optimal combination for any of the shareholders requires an more than just an intuition of how the company can nancially perform. Since the interplay of nancial factors can be complex, a nancial modeling of such scenarios is also required. Here we present an example of combining an intuition of nancial performance with modeling to demonstrate how such decisions can be approached. The process (though not the specic trade-os) can be generalized to a broad range of situations, as well as the perspectives of holders of various classes of securities.

KAUFMAN, J.:

DRAFT July 11, 2012

Suppose you are one of four co-founders of a biotech company, each having 1 million shares of common stock. The company has a technology, but no capital yet to start operations. You would like $10 million to get started, and conveniently you have the following three oers for a $10 million Series A investment. Scenario 1: $4 million pre-money valuation, non-participating preferred Scenario 2: $8 million pre-money valuation, with a 2X participation cap Scenario 3: $12 million pre-money valuation, with a 3X participation cap To make matters simple, lets suppose that $10 million is all you need to feel condent that you can sell the company for twice the post-money valuation of the middle oer (i.e. about $36 million) within a year or so. Given these expectations, which of the three oers should you like best? Even though your intuition may be good for knowing what the company can be worth, it can be much more dicult to predict which combination of investment factors would be best. All other factors being equal, a higher valuation is better for existing shareholders. However, in this case, the higher valuations do come with increased levels of participation before being required to convert. How will you decide? Maybe a rst step could be to calculate what the payout would be for the expected $36 million exit. The largest pay-out per share of common stock (which is approximately $4.00 per share) is scenario 2, the investment corresponding to the $8 million pre-money valuation with a 2X participation cap.1 Does this mean that scenario 2 is the best option? The exit payout may not be exactly $36 million, it could be signicantly higher or lower. Lets face it, the expected exit on a venture deal can be dicult to predict. Maybe calculating the pay-out distribution over a range a exit values will shed more light. Such payout functions can be obtained by methods recently described1 , and are shown in gure 1 for each of the three investment scenarios. Clearly, scenario 1 is least favorable. The relative advantage between scenarios 2 and 3 is however a bit more dicult to discern. If the general instinct of the founders is that the company could very likely sell for considerably more than $60 million, then scenario 3 could be the better bet. However, this expectation would imply a huge variance on the expected return. The downside of scenario 3 versus scenario 2, at the expected return point, is not very large. Most importantly though, is that scenario 2 is a the high end of a zone of indierence at an exit value of $36 million, meaning that, the series A shareholder receives the same aggregate $20 million in proceeds if
1 For scenario 2, with an exit value of $36 million, the aggregate payout to the Series A investors is in the range where its participation is capped at $20 million, leaving the remaining $16 million to be distributed to the 4 million shares of common stock. 1 Kaufman, Jonathan, Contingent Payout Functions for Firms with Capped Participating Preferred Stock (June 26, 2012). Venture Projections Working Paper, June 26, 2012. Available at SSRN: http://ssrn.com/abstract=2080715 or http://dx.doi.org/10.2139/ssrn.2080715

KAUFMAN, J.:

DRAFT July 11, 2012

10 9

Scenario 3

per share common ($)

8 7 6 5 4 3 2 1 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 74

Scenario 1 Scenario 2

exit ($M)

Figure 1: Pay-out per share of common stock as a function of exit value for each of
the three investment scenarios.

the exit is for a lower amount, such as $30 million. Therefore, shareholders of common stock consequently risk the Series A investors acceptance of a lower exit valuation. This zone of indierence is more easy to identify in gure 2, which illustrates the aggregate payout to all security holders for scenario 2. However, what should
aggregate proceeds to security($M)
41 35 30 25 20 15 10 5 0 0 10 20 30 40 exit value ($M) 50 60 70 74 Series A zone of indierence

Series A Common

Figure 2: Series A zone of indierence in scenario 2 ranges between exit valuations

from $28 million to $36 million.

also be apparent is that there is a similar zone of indierence for the Series A investors in scenario 3, albeit at higher range of exit values (from $54 million to $66 million). So maybe scenario 2 remains the preferred choice, since it oers the common stockholders the best per-share return in a range of reasonable exits. But what happens if the company needs to issue more equity before reaching an exit? Suppose we assume the possibility of a $20 million Series B nancing event at a $36 million pre-money valuation and the same participation cap multiples

KAUFMAN, J.:

DRAFT July 11, 2012

as in the respective series A round (i.e. assume precedent), and similarly an expected exit valuation of twice the post money valuation (i.e. $112 million). Scenario 4: $10 million Series A having an $8 million pre-money valuation with a 2X participation cap, followed by a $20 million Series B having a $36 million pre-money valuation with a 2X participation cap. Scenario 5: $10 million Series A having a $12 million pre-money valuation with a 3X participation cap, followed by a $20 million Series B having a $36 million pre-money valuation with a 3X participation cap. Would this have a signicant impact on the relative merits of the Series A nancing scenarios? Figure 3 shows the resulting per-share payout to common stock. Viewed from the perspective of the common stock shareholder, scenario
23

per-share to common ($)

20

Scenario 5 Scenario 4

15

10

0 0 20 40 60 80 100 120 140 160 180 200 220 240

exit valuation ($M)

Figure 3: Comparison of per-share payout to common stock after the Series B nancing event.

5 (which corresponds to scenario 3) is best. Again, especially if a higher than expecting exit valuation is a possibility. The eects on the Series A shareholders are expectedly in the opposite direction, as shown in gure 4. The Series A investors in scenario 5 is adversely aected by the consequential higher participation cap of the Series B investment. Thus, for the Series A investor to rationally oer scenario 3 (rather than scenario 2), they would have to anticipate signicantly participating in the Series B round and/or presume that they would not be setting a precedent for the following Series B participation cap. Its also possible that not all parties in the negotiation are adequately modeling the future (not to say what we have done thus far is complete). Suppose an information asymmetry exists and that the founders have conducted the modeling, but not the Series A investors. It could thus be prudent for the founders, if oered scenario 2, to suggest that they believe in the value of what they are doing and would prefer to take a higher valuation in exchange for offering increased down-side protection to the Series A investors, knowing that

KAUFMAN, J.:

DRAFT July 11, 2012

100

aggregate payout to Series A ($M)

90 80 70 60 50 40 30 20 10 0 0 20 40 60 80 100 120 140 160 180 200 220 240

Scenario 4

Scenario 5

exit valuation ($M)

Figure 4: Comparison of per-share payout to Series A preferred stock after the Series
B nancing event.

the downside protection does not adversely aect the founders once the following round of nancing is taken into account. However, making this supposition would of course require a bit more modeling to obtain a fuller understanding of the relative eects of all factors involved. This being said though, probably more than a glimpse of technique is shining through in the present example. What would happen if scenario 3 was not an available option, but there is an alternative (scenario 6) to consider, which has a $10 million pre-money valuation with a 3X participation cap. Scenario 6: $10 million Series A having a $10 million pre-money valuation with a 3X participation cap, followed by a $20 million Series B having a $36 million pre-money valuation with a 3X participation cap. Figure 5 shows the outcome to common stock on a per-share basis not considering the eects of a Series B investment. These two scenarios seem a bit more dicult to decide between, then the equivalent decision associated with gure 1. Figure 6 shows the corresponding eect after the Series B investment (at the same terms as described above). Here again, the two remaining scenarios are more dicult to distinguish, but perhaps the option with the higher valuation (and participation cap) remains the best option for the founders. We also see that we may be getting close to a relative equivalence between two investment options with counter-acting factors, such that we can learn, within a specic context, how much of a valuation increase the founders may be willing to sacrice in exchange for a reduction in a participation cap multiple.

KAUFMAN, J.:

DRAFT July 11, 2012

10 9

per share common ($)

8 7 6 5 4 3 2 1 0 0 10 20 30 40 exit valuation ($M) 50 60 70 80

Scenario 2

Scenario 6

Figure 5: Comparison of two Series A investment scenarios: $8M pre-money valuation

with 2X participation cap, and $10M pre-money valuation with 3X participation cap.

23

per-share to common ($)

20

Scenario 5 Scenario 4

15

10

Scenario 6

0 0 20 40 60 80 100 120 140 160 180 200 220 240

exit valuation ($M)

Figure 6: Payout per share to common stock after considering eects of Series B investment, including an option for a Series A investment at a $3M pre-money valuation and a 3X participation cap.