Reality, as most investors now know, is often not pretty. It can be painful, humbling – even crippling. But a good reality check can often inspire creative solutions even for what appear to be the toughest of problems.
In private equity, this painful down round reality has been shared by VCs, founders, and portfolio company employees alike. In response, some venture capitalists have tightened up term sheets, adding what appears to some as unreasonable demands.
But, contrary to popular belief, VC’s don’t set all the rules when it comes to valuation and terms. Because we take our cue, literally, from the public markets – and since public company market valuations are down (nearly 90% in many cases) – private company valuations have been sliced commensurately. It’s a haircut across the board, and nearly everyone must now learn to wear a new look
The good news is that the new reality has led us to creative solutions when raising new money for our companies. One of our recent deals, Talaris Inc., is a case study in how to bring all players to the table in a creative and rewarding way. Talaris, a 2 1/2-year-old Web services applications company based in San Francisco, has a solid management team in place, two major customers, and is in the process of deploying its first product over the next three months. It’s one of our fund’s expected “winners,” as opposed to others just limping along in this market environment.
Yet, Talaris, which had previously raised $15 million in two prior rounds, still needed to close a C round of $12 million to help it reach profitability. It’s very well positioned in a rapidly expanding new Web services market, but its valuation was still at the mercy of public market conditions, conditions which have left even solid companies like Ariba and Ciena, trading at 5% of market highs.
For our own private Web services or communications equipment companies, this new valuation reality is a shock – the psychological impact of which cannot be underestimated. Even for the most grounded and dedicated entrepreneurs, destruction of valuation can’t help but make them wonder why they’ve worked so hard to try and build great companies in the first place.
Yet, creatively, a haircut to share price can often be offset simply by issuing a large amount of new stock prior to a deal, while making sure ownership dilution is at least kept in check. If price itself can be set aside – and the previously all-important step-up in valuation discarded – equity ownership can become a great driving force in keeping companies alive and moving forward. With Talaris, we increased the pool of employee stock options by 15 million shares, providing total employee ownership of the company, post deal, of 25%.
While there’s nothing new about issuing more stock in subsequent rounds in order to raise additional capital, issuing enough to keep all major stakeholders at a certain level of equity ownership – and understanding their needs going into the negotiating process – sets a new a pivotal benchmark in how to structure equity-focused, rather than valuation-focused, deals. As a result, we simply looked 18 months into the future and asked ourselves how much stock it would take to keep existing employees at reasonable dilution levels. Likewise, we factored in how much additional stock would be required to compensate new hires while maintaining the equity stakes of existing shareholders and satisfying ownership requirements of a dedicated new VC partner: Bluestream Ventures, a firm with offices in Menlo Park, Calif., and Minneapolis.
By asking this question before a term sheet was offered, and leaving price-per share out of the equation for the moment, all players could share in deciding reasonable equity stakes. Sure, when valuation was set, the price per share was low. But who cares? The new reality is about creating a capital structure that provides for adequate resources and sufficiently aligns key stakeholders, ensuring that all VCs, entrepreneurs, management and employees buy in to any new deal, accepting additional equity in lieu of a lower price per share.
Granted, there may be a potential danger that even additional stock may not compensate management and employees for the liquidity preferences sometimes granted to new investors. In the case where there are too many preference dollars ahead of common shares in the event of a liquidity event, it is possible that common stock may not see any return. Yet, even under this scenario, we would try to creatively add additional terms delineating specific carve-outs of about 10% of the sale price (in the case of a liquidity event) to give to employees while further incentivizing them to commit to the company’s success.
Of course, there’s no perfect solution to every problem. One would be surprised at the number of management teams who choose to not go along with a dilutive financing round (while increasing number of employee shares to compensate). In these instances, the sticking point is an overly heavy focus on pre-money valuation as a barometer of success.
Unfortunately, management teams who take this stance often do not get a second look from new investors, and if they are portfolio companies they probably won’t receive follow-on capital. As an alternative to taking outside money, these management teams would rather take dribs and drabs from willing insiders and other angels to maintain the price at the prior round’s valuation. This strategy not only raises insolvency risk, but it often is financially irrational because the same dollars could be used in a pro rata investment in a bigger, market-priced round, reducing financing risk.
Although entrepreneurs often worry that they may be taken advantage of when it comes to resetting valuation, we’re committed that they not be taken advantage of. Deals are priced in line with public company comparisons. This is true for even the best companies with great products and expanding revenue streams. If public companies are trading at 2 times future 12 months revenue, comparable private companies are (at best) being priced the same way.
Yet, by significantly adding shares to the capitalization table, pre-deal, entrepreneurs and investors are at least working together once again. In fact, the only losers in the new market reality are those shareholders who choose not to participate in subsequent rounds. In these cases, the reality is that the price per share has taken a hit and shares have become diluted. Put another way, by looking out for all participating players pre-deal – and by this I mean employees and entrepreneurs in particular – we and they get to stick around and at least play the game another day.
Ravi Chiruvolu is a general partner with Charter Venture Capital, a Palo Alto, Calif.-based firm with $400 million under management. Chiruvolu has been a VC for four years and specializes in enterprise software and software infrastructure deals.