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4 ways that you can use to get the investors to invest at the valuation you want (by risk sharing)

One of the hardest things for an entrepreneur, pitching and negotiating with investor, is to get the investors to accept the valuation that you find perfectly reasonable.

You want a high valuation meaning that you get to keep as much as possible of the company and the investor wants a low valuation meaning that he gets as much as possible of the company.

There are ways through which you can get the investor to agree to meet you at a higher valuation – we are talking mechanisms where you risk share in different ways relating to the development of the valuation, i.e. if the higher valuation that you are arguing for turns out to be true or not.

Before we begin...

Before we kick of we should stress that we assume that the valuation that you are pitching is based on solid facts and assumptions, we are NOT talking about tricking an investor into investing into an inflated valuation and a company without honestly disclosed merits and facts. We are talking about ways to get the investor to accept your higher valuation based on it having a legitimate base.

Non of the below are uncontroversial and it is important that you fully understand the different results each option could lead to for you and your company. 

You put your money where your mouth is.


 1. You can do a convertible

A convertible can be seen as a hybrid between a loan and equity. Instead of having to agree on a valuation here and now the investor and the founder agree on a structure whereby the investor commits to convert its loan against shares in the company at the next larger funding round. The conversion will then take place to the valuation that is set at that future funding round where you assume that you will be able to attract other investors and through them participating you get a better confirmation of the market value of the company. Given that the first investor will take an additional risk by investing prior to the other investors and earlier in the company journey, the investor will typically get a pre-determined discount of e.g. 25 % as well as interest on the loan up and to the conversion point.


What happens if you fail to raise money in a future funding round one may ask. Unless the company goes bankrupt, you often have a pre agreed fall back valuation or valuation mechanism under which the convertible will convert. Or have the convertible remain as a loan instead of turning it into shares.


2. You can provide the investor with anti-dilution protection 

Another way to give the investor more comfort to invest here and now, and to accept the higher valuation you are arguing for, is to offer an anti-dilution protection.


Highly simplified this means that if the company does not increase in value, but rather decreases until the time of the next funding round. The investor will get to recalibrate its price per share, by getting a number of additional shares to compensate for the dilution.


A simple example of an investor friendly example is where the investor bought 10 0000 shares for SEK 100 each (in total investing SEK 1 000 000). If the company raises money in a subsequent round at the price per share of SEK 50 then the investor would get extra shares as if he/she had used the entire investment to buy shares for the lower price (i.e. the lower valuation that occurred after he/she invested). In this case the investor would be entitled to 10 000 extra shares.


Investment: 1 000 000

Price per share: 100

Number of shares received: 10 000

Later funding round at a lower valuation, price per share: 50 SEK

The investor 1 000 000 / 50 = 20 0000 and he only got 10 000 so he is entitled to another 10 000 Shares.


If you and the company prove your case and the next funding round occurs at a higher valuation as was expected then the first investor will not get any additional shares.


A tip for you as an entrepreneur, if you are to offer an anti-dilution, make sure to limit it in time and also, you can limited to only apply on “quailifed” funding round. This means that you set a bar so that the investor does not have the right at any tiny funding round/new share issue that you do.


3. You can offer preference shares to the investor

You will typically have common shares – one type of shares in the company from the start. You can however offer the investor preference shares – another share class as a way to tip the scale and get the investor to say yes to your company and your valuation.


Preference shares are shares with particular economic terms connected to them. Most typical the preference shares will have a better right than the common shares to the proceeds of the company in a liquidity event. And what do we mean by a liquidity event? This can be a sale of the company, liquidation of the company or even a bankruptcy (although you should except little to nothing as a shareholder even if you hold preference shares). They can also have a better right to dividends.


Most often the better right is caped to the investment, so that the investor gets his investment back before you or anyone else has a right to any monies from the company.


Example: The investor has invested 10 million at a post money valuation of 100 million. He demands and gets preference shares. That investors ownership in the company will then be 10 %, so if the company is sold for only 20 million the investor would, if he had common shares with the rest of you – be 10 % of 20 million which is 2 million – he will thereby make a loss of 8 million. However since the investor holds preference shares, he has a right to the full 10 million and the rest of you will only have a right to the other 10 million. So even though you hold 90 % of the company you only have a right in relation to 50 % of the monies it sold for. Also note, that the one holding the preference shares can be entitled to have his share of the remaining 10 million (that is 10 % of that part of the cake) depending on how you structure the preference share rights (this is so called participating preference shares, the other option would be so called non-participating preference shares).


4. You can offer the investor warrants in combination with the shares 

As a way to get the investor to pull the trigger and invest in your company now – and at the valuation you propose – you can offer the investor the opportunity to to deploy a portion now and a portion at a later date but at a pre determined valuation. This is done by firstly issuing shares at the valuation you propose, and then to issue warrants with a strike price that (often) corresponds to the price paid for the shares. 

In practice, this means that the investor gets the opportunity to wait and see if the valuation is correct - or even low - before he deploys all of his potential investment in the company. In order to ensure that the options serve their purpose these kinds of structures - sometimes called second closing option, are given a relatively short duration, often 6-12 months and rarely beyond the next funding round. 


Example: 

An investor invests 10 million at a post money valuation of 100 million. The investor is also given warrants that entitle the investor to invest an additional 5 million within 6 months. If the company grows according to plan the investor will likely use the opportunity - not least if you, during the warrants duration period, fundraise to a value of 150 million. 


Summary 

The rational for all of the above is that the investor gets an additional beneficial right/option that will relate to the companies performance, and that premiers him/her for taking the additional risk by investing early and at an unsecure valuation. 


Important!

The devil is in the details. Non of the structures above are uncontroversial and you as an entrepreneur should make sure you, in full, understand the specific terms and conditions of your deal with the investor. You should plot out best case, and a worst case, scenarios to make sure you get the full picture of what results the structure could end up leading to for you and your company! 


Non of the above should be seen as legal advice but only general and thought provoking insights. If you have questions feel free to reach out on DM or katarina.strandberg@stgcommerciallaw.com 


More articles: www.stgcommerciallaw.com 


Stockholm, 2024-07-15

Katarina Strandberg 

Before we begin...

Before we kick of we should stress that we assume that the valuation that you are pitching is based on solid facts and assumptions, we are NOT talking about tricking an investor into investing into an inflated valuation and a company without honestly disclosed merits and facts. We are talking about ways to get the investor to accept your higher valuation based on it having a legitimate base.

Non of the below are uncontroversial and it is important that you fully understand the different results each option could lead to for you and your company. 

You put your money where your mouth is.


 1. You can do a convertible

A convertible can be seen as a hybrid between a loan and equity. Instead of having to agree on a valuation here and now the investor and the founder agree on a structure whereby the investor commits to convert its loan against shares in the company at the next larger funding round. The conversion will then take place to the valuation that is set at that future funding round where you assume that you will be able to attract other investors and through them participating you get a better confirmation of the market value of the company. Given that the first investor will take an additional risk by investing prior to the other investors and earlier in the company journey, the investor will typically get a pre-determined discount of e.g. 25 % as well as interest on the loan up and to the conversion point.


What happens if you fail to raise money in a future funding round one may ask. Unless the company goes bankrupt, you often have a pre agreed fall back valuation or valuation mechanism under which the convertible will convert. Or have the convertible remain as a loan instead of turning it into shares.


2. You can provide the investor with anti-dilution protection 

Another way to give the investor more comfort to invest here and now, and to accept the higher valuation you are arguing for, is to offer an anti-dilution protection.


Highly simplified this means that if the company does not increase in value, but rather decreases until the time of the next funding round. The investor will get to recalibrate its price per share, by getting a number of additional shares to compensate for the dilution.


A simple example of an investor friendly example is where the investor bought 10 0000 shares for SEK 100 each (in total investing SEK 1 000 000). If the company raises money in a subsequent round at the price per share of SEK 50 then the investor would get extra shares as if he/she had used the entire investment to buy shares for the lower price (i.e. the lower valuation that occurred after he/she invested). In this case the investor would be entitled to 10 000 extra shares.


Investment: 1 000 000

Price per share: 100

Number of shares received: 10 000

Later funding round at a lower valuation, price per share: 50 SEK

The investor 1 000 000 / 50 = 20 0000 and he only got 10 000 so he is entitled to another 10 000 Shares.


If you and the company prove your case and the next funding round occurs at a higher valuation as was expected then the first investor will not get any additional shares.


A tip for you as an entrepreneur, if you are to offer an anti-dilution, make sure to limit it in time and also, you can limited to only apply on “quailifed” funding round. This means that you set a bar so that the investor does not have the right at any tiny funding round/new share issue that you do.


3. You can offer preference shares to the investor

You will typically have common shares – one type of shares in the company from the start. You can however offer the investor preference shares – another share class as a way to tip the scale and get the investor to say yes to your company and your valuation.


Preference shares are shares with particular economic terms connected to them. Most typical the preference shares will have a better right than the common shares to the proceeds of the company in a liquidity event. And what do we mean by a liquidity event? This can be a sale of the company, liquidation of the company or even a bankruptcy (although you should except little to nothing as a shareholder even if you hold preference shares). They can also have a better right to dividends.


Most often the better right is caped to the investment, so that the investor gets his investment back before you or anyone else has a right to any monies from the company.


Example: The investor has invested 10 million at a post money valuation of 100 million. He demands and gets preference shares. That investors ownership in the company will then be 10 %, so if the company is sold for only 20 million the investor would, if he had common shares with the rest of you – be 10 % of 20 million which is 2 million – he will thereby make a loss of 8 million. However since the investor holds preference shares, he has a right to the full 10 million and the rest of you will only have a right to the other 10 million. So even though you hold 90 % of the company you only have a right in relation to 50 % of the monies it sold for. Also note, that the one holding the preference shares can be entitled to have his share of the remaining 10 million (that is 10 % of that part of the cake) depending on how you structure the preference share rights (this is so called participating preference shares, the other option would be so called non-participating preference shares).


4. You can offer the investor warrants in combination with the shares 

As a way to get the investor to pull the trigger and invest in your company now – and at the valuation you propose – you can offer the investor the opportunity to to deploy a portion now and a portion at a later date but at a pre determined valuation. This is done by firstly issuing shares at the valuation you propose, and then to issue warrants with a strike price that (often) corresponds to the price paid for the shares. 

In practice, this means that the investor gets the opportunity to wait and see if the valuation is correct - or even low - before he deploys all of his potential investment in the company. In order to ensure that the options serve their purpose these kinds of structures - sometimes called second closing option, are given a relatively short duration, often 6-12 months and rarely beyond the next funding round. 


Example: 

An investor invests 10 million at a post money valuation of 100 million. The investor is also given warrants that entitle the investor to invest an additional 5 million within 6 months. If the company grows according to plan the investor will likely use the opportunity - not least if you, during the warrants duration period, fundraise to a value of 150 million. 


Summary 

The rational for all of the above is that the investor gets an additional beneficial right/option that will relate to the companies performance, and that premiers him/her for taking the additional risk by investing early and at an unsecure valuation. 


Important!

The devil is in the details. Non of the structures above are uncontroversial and you as an entrepreneur should make sure you, in full, understand the specific terms and conditions of your deal with the investor. You should plot out best case, and a worst case, scenarios to make sure you get the full picture of what results the structure could end up leading to for you and your company! 


Non of the above should be seen as legal advice but only general and thought provoking insights. If you have questions feel free to reach out on DM or katarina.strandberg@stgcommerciallaw.com 


More articles: www.stgcommerciallaw.com 


Stockholm, 2024-07-15

Katarina Strandberg 

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