Why Founders Need to Consider More than Valuation
- Which factors are important for founders to consider other than valuation
- Why the details of a transaction have important bearing on the dynamics of a future partnership
While valuation is certainly the most top-of-mind item when receiving offers from prospective investors, founders need to pay attention to more than just the proposed purchase price.
Other important questions that a founder should consider include:
- Are the non-financial terms of the offer fair to me as a founder?
- Does the investor’s strategy and culture fit well with my company and goals?
- How does the structure of my rollover equity compare to the investor’s?
Read on to learn more about how founders should think about the above questions.
Are the non-financial terms of the offer fair to me as a founder?
Whether or not a proposed investment is a good move for founders will depend on the details of the offer—even when the valuation appears attractive. Particularly in non-buyout transactions, an investor might propose several protective provisions whose implications won’t be clear to the average founder.
For example, if an investor proposes veto and approval rights designed in a way that gives the investor complete power in the operational decision-making of the company, you may lose control as a founder even if you retain a majority ownership in the business.
As such, founders need to be mindful of the potential downsides of non-financial details, even when tempted to base their decision solely on valuation. If founders aren’t careful, the details could negatively affect the dynamic of a partnership or a future exit.
Does the investor’s strategy and culture fit well with my company and goals?
Because you’ll be in a partnership with the investor post-close, you want to ensure that the investor’s approach and attitude toward the business align well with your own.
Some questions you should ask yourself include:
- What kinds of resources does the investor have access to?
- How hands-on is this investor with the companies it invests in?
- Do they have a playbook and does that playbook align with my business?
- Are they focused on organic growth or growth through M&A?
- If an investor joins my board, will their personality align well with our executive team?
- Do we have a shared vision for where this company can go?
- Am I confident this investor can help me realize a return on my rollover equity?
There’s also the question of legacy. A couple questions to consider:
- What is the investor’s reputation for carrying on a company’s culture?
- What tends to happen to the company’s employees after a company is acquired by this investor?
Each investor will have a different attitude towards an acquired company, its culture, and its employees. If these aspects of your business are important to you post-transaction, ensure you find an investor aligned with your preferences, regardless of valuation. To do so:
- Ask for and follow up on references
- Engage with many firms so you have exposure to a wide range of personalities
Note that this insight applies to both the investment firm as a whole as well as the partner who you will be working with. The firm may have one style and reputation, and the partner another.
How does the structure of my rollover equity compare to the investor’s?
To participate in future upside, founders will often opt to retain (or "roll over") some of their equity when selling their business.
Naturally, a founder who chooses to do so may feel more attracted to an offer with a higher valuation because on paper that rollover equity is worth more. What founders often fail to consider is that the security structure of their new equity may be unfavorable when compared to the investor’s security structure. If so, the economic payout to the founder from subsequent exits may not reflect their percentage ownership in the company.
As an example, if your company were valued at $100M and you rolled $25M, the investor would pay $75M in cash for your business and you would retain 25% of your equity. (For simplicity, we’re assuming no cash, debt, or other adjustments, though this scenario is unlikely.)
Given you now own 25% of the business, you might assume that your take-home percentage of a subsequent exit should be around 25%. But given the security structure, it may be much less.
Consider if your investor’s equity were participating preferred securities with a 1x liquidation preference. In this case, if your company later sold for $200M, by nature of the security structure, the investor would first receive 1x their original investment ($75M), then 75% the remaining balance ($125M x 75% = $93.75M) for a total of $168.75M or 84.3% of the purchase price. In effect, the founder receives $18M less than what they might expect based on equity ownership.
Designing a Process That Gives You Choices
When selling your business, the best approach you can take as a founder is to run a competitive process with multiple buyers. Having multiple buyers (especially ones who see the business from different angles) gives you optionality and leverage to negotiate valuation and other key terms to improve your overall outcome.