We see executives make this mistake over and over, so we found it important to bring this point up again: Your company’s post-money-valuation is not the same thing as your company’s valuation (as much as you would like it to be). We’ve discussed in other blog posts on why these valuations are different, but in short, your post-money-valuation is determined using a flawed calculation which assumes Preferred Stock and Common Stock are the same thing, which they aren’t.
We see this scenario often:
- A company raises a $50M Series C at a $300M post-money-valuation as it gets ready for hyper-growth, issuing 16% new shares of Preferred Stock at $5 / share. The company has 60 million shares after the issuance of 10 million shares of Preferred Series C.
- They approach their smaller competitor ("Target") and offer them a $6M acquisition (as part of their growth strategy).
- In doing so, they offer the Target 2% of fully diluted shares ($300M post-money valuation * 2% = $6M).
- Both parties agree and sign docs, which states that the buyer will give the seller 1.2M shares of Common Stock, and everyone is “happy”.
- But what the Seller fails to realize is that the Common Stock is actually “worth” ~$2 / share, not the $5 / share of the Preferred Stock (given the risk profile of the buyer). And thus, the seller should have demanded 3M shares ($6M / $2 per share = 3M).
By leaving 1.8M shares on the table, the seller has cost themselves millions of dollars and is getting less than half of their planned acquisition price.
Most private-to-private transactions are not all cash. They involve earn-outs, stock of the buyer, non-competes, licensing, etc. All of these factors are interchangeable if viewed through the right financial lens, and it will give the buyer or the seller the right tools in their arsenal to successfully negotiate a transaction.
The acquisition of a business can also be viewed as the purchase of some combination of assets that together are able to generate value as a going concern. As businesses have commingled parts, most acquisitions are viewed on the entirety of the business as opposed to the individual components and their intricate relationship to each other and to the buyer. A Purchase Price Allocation (“PPA”) is an exercise intended to identify what was actually purchased—all of the assets, both tangible and intangible, as well as any liabilities—and assigning a Fair (or Fair Market) Value to these various components.
In some cases, we have found that conducting a hypothetical PPA (as part of the marketing of the company) will provide insight into many aspects of the business that the parties might otherwise not have had, thus providing a buyer with an understanding of the value drivers behind the purchased business and not just the expected total cash flows. It’s one thing to fill a pitch book with marketing language and discussion of your valuable intellectual property. It’s another thing to have an independent view of the value of the key underlying intellectual property, demonstrating that your business offers identifiable assets to be leveraged by a specific buyer.
A valuation expert can often help you understand (and therefore negotiate) the terms that matter to you most and make sure you are able to get the deal that you need. We're here to help you think through how you can play your cards right in your upcoming transactions. Shoot us a note to firstname.lastname@example.org or schedule a call now.