With and without VCs, differences in valuation
I want to present my approach on how to deal with difficulty of contracting the value of the company with VCs. They know what they are talking about and if you don’t know much about finance, your counter arguments are going be weak. And, as a result, you are going to undersell your company.
Today, I want to analyse a common statement used by VCs that they can use to increase his slice of the cake: “The value of the company without me is nothing! My €200.000 are half of the value of the company so the company is only worth half without me: I want half of the shares.” Entrepreneurs often have difficulty correctly appreciating this statement, which on a financial basis is wrong.
My approach to deal with contracting the value of your company is based on the M&A (Mergers and Acquisitions) theory, which highlights the idea that a company has two values. The first is the standalone value, the value that it has without the VC or the value that the company is worth before entering the VC office. The second value is the merged one. We can think about investments as a merger with a company that has no activities but a lot of cash. This merger creates a combined value that is larger than the sum of the two values separated. The difference between these two values is called synergy. Differently put, the synergy is the present value of all the future cash flow improvements that the merged company will obtain and that were not obtainable by the two separate entities.
Now, let’s think about an example. Our company, FinancialKickOff, is worth €100.000. This value takes into account all the capital constraints and the probability of bankruptcy without any external funding. Suppose now we are seeking an investment of €50.000: €25.000 to improve our cash position (and reducing the probability of bankruptcy) and €25.000 to pay someone to translate our website in Chinese so that also small entrepreneurs in China can benefit from our advice.
Now, suppose we do not have synergies: what is the value of the company after the merger? It is €150.000. The share of the merged company that belongs to the VC is 33% (€50.000/€150.000) and we are left with the 66%.
Now, suppose we do have synergies: first the Operational Synergy and second, the Financial Synergy. We can calculate the value of the synergy in two ways. First, calculate the value of the merged company and subtract €150.000 from it. Second, compute the value of the synergy in itself. In the end the two methods are the same thing and their explanation is left to future articles. So which are the synergies here?
- Operational Synergy: The investment allows us to improve the website and the present value of this improvement is supposed to be €50.000 (€25.000 of net present value)
- Financial Synergy: The €25.000 on our bank account lowers the probability of bankruptcy, also lowering the discount rate of our future cash flows. It also allows further positive NPV investments and keeps other options open. For simplicity, the new €25.000 in the bank increases the value of the merged company by €40.000 (net present value of €25.000).
So, the merged company is now worth €150.000 + €25.000 + €15.000 = €190.000. The sum of the values plus synergies. We are sitting on €190.000. The total value of the synergy is €40.000. Now we are talking about numbers! And we can see that the statement of the VC does not make sense.
What is the percentage of equity to give away to the VC? The denominator of the fraction is 190k. The VC is actually discussing its percentage in the merged company but we are not selling FinancialKickOff: are selling FinancialKickOff plus €50.000 plus the net present value of the improvements we are going to make. The numerator of the fraction has to be at least €50.000: this is what the VC has invested. Next question: how to divide the synergy between the VC and us?
The division of the €40.000 can be bargained and it depends strongly on the bargaining power of the two parties. That is to say that if you have contacted 2000 VCs and only one showed some interest, you should better let him take the synergy. In this case the percentage becomes €90.000/ €190.000 or about 47%. However if your product is popular and VCs are standing in line to help you out, you can keep all the synergy for yourself and give away only €50.000/ €190.000 or 26% of the company. Remember this has to be at least €50.000 as it was what the VC invested.
The calculations in this article are highly simplified and, in practice, having two valuations (yours and the VC’s) that do not differ for more than 50% is already a good. However the framework is important because it allows you to have a counterargument and not to be overwhelmed by the numbers. Also, some interesting unresolved questions remain which should be kept in mind:
- What are the synergies a VC can bring to my company?
- How to calculate the value of the standalone and the merged companies?
- How is risk affecting my valuation?