When representing clients in private equity transactions, we notice that founders / owners and possible investors frequently differ on the (pre)money valuation of the underlying company; the founder believes his business is worth more than the investor is willing to offer. Still, at the end of the day, both parties wish to close the deal. How to crack this nut ?

Why do valuation gaps exist?

First of all, let’s get a better understanding as to why ‘valuation gaps’ exist. Usually, the owner has high expectations of the future performance of his company; he perceives that his company has a lot of unrealized potential. The investor on the other hand is willing to purchase or invest capital into the company, but not at the perceived valuation, which, to the liking of the investor, is too much staked on future developments of the company.

Assuming Harvey Specter is not around and both parties remain in the trenches, you could consider proposing the following ‘bridges’, currently in sway:

1. Staged Closings;
2. Warrants (opties);
3. Preferred Stock Conversion Ratio’s; and
4. Protection on Liquidity Events

In this article we’ll tackle nrs. 1 and 2. In a couple of weeks, nrs. 3 and 4 will be dealt with.

Bridge 1: Staged closings

A staged closing provides for an investment into a company in multiple tranches (two or more), subject to fulfilment of certain targets/milestones (such as revenue levels, new business, product development or the filing of a new patent). So how does it work?

A first tranche of the investment is valued at an acceptable initial (pre)money valuation for the investor and owner.

1. If certain pre-agreed milestones are met, the second tranche will also be invested by the investor as share premium (in Dutch: agio), thereby increasing the initial valuation to that of the perceived value by the owner.
2. However if the pre-agreed milestones are not met, the second tranche will not or only partly be invested by the investor, without any further shares to be issued to the investor, thereby not or only slightly increasing the initial pre-money valuation.

Alternative: despite the fact that pre-agreed milestones are not met, the second tranche will still be invested by the investor. However, the investor will receive additional shares in the company against the initial pre-money valuation, increasing the investor’s overall stake in the company (while the founder suffers dilution).

Pro’s:

• the valuation gap is bridged;
• the valuation will be based on actual, realized return of the company. This reduces the risk of overpaying by the investor;
• staged closings offer a ‘gap stop’ for throwing ‘good’ money after underperforming companies.

Con’s:

• discussion could arise whether the milestones are met or not. Please find some useful tips in our conclusion below.
• if the conditions for the 2nd tranche are not met, the company will be undercapitalized, which will be to the detriment of all stakeholders, including the investor. In this light, most certainly an additional cash-call from the company will arise, which could be a cause for agitation between the shareholders.

Bridge 2: Warrants

An investor who buys into the unrealized potential of the company against owner’s higher valuation, can protect his downside by structuring a call option for a certain % of the ordinary shares (at par value) from the owner. The way this works is as follows:

1. The call option becomes exercisable by the investor if the company underperforms or does not meet pre-agreed milestones.
2. If the call option is exercised, the investor increases its shareholding in the company, while the founder’s stake decreases. As a result, the initial (higher) valuation decreases. In general the goal of the investor will be to structure the warrant so that the return on the shares originally received + the warrant shares will result in the targeted IRR.

Alternative: if the investor does not invest at the higher valuation set by the owner, the owner can protect his downside by structuring a call option for a certain % of the ordinary shares from the investor. The call option becomes exercisable if the company performs on target or meets the pre-agreed milestones. If the call option is exercised, the shareholding of the investor is decreased, while the founder’s stake increases. As a result, the initial (lower) valuation increases.

Pro’s:

• the valuation gap is bridged;
• very straight-forward;
• the warrant could be “hived-off” to other investors.

Con’s:

• discussion could arise whether the milestones are met or not.

Conclusion and recommendations

There you have it; two useful bridges that might help move deals forward when parties cannot agree on the value of the company. To minimize discussions ending up in litigation the milestones should be well documented, objective and measurable. For instance, use crystal clear definitions of the milestones (for instance EBITDA and synergies); insert a simple example of how the milestones will be calculated and have an accountant check the arrangement to see if it makes any sense to him. Furthermore, it is imperative for investors to stipulate clauses to which they are in a position to check, control or influence the milestones.

Keep a close eye on our next series of articles in which we will deal with the two other bridges helping our clients to close valuation gaps: ‘Preferred Stock Conversion Ratio’s’ and ‘Protection on Liquidity Events’.

Oh goody !