We’ve been running a brief series of VC Insights focussed on valuations. So far, we’ve covered an approach to valuing the business itself. We’ve then adjusted for loans, options and other claims to end up with the equity valuation, which drives what percentage the investor gets.
That’s all fine when there’s a clear division between lender and shareholders. But what about an investor who combines the two roles?
Incidentally, from the investor’s point of view, this post might equally be subtitled “what price did we just pay?”
What’s the problem?
In a previous post, we gave the example of SaaSco’s funding round. The first and most uncomplicated scenario was an investment of £1m for a 20% vanilla equity stake. That makes for an easy calculation of the post-money valuation: it’s £1m / 20% = £5m.
The complication comes when the investment is structured and, for example, consists of tranches of both vanilla equity and a preferential instrument such as loans, or when a participating exit preference right attaches to the equity. For the angel investor, by the way, we should note that many preferential investment instruments such as loans and preference shares will not qualify for EIS relief.
The issue is that the investor is looking to make a return from the package of all the individual components of their investment. They will write one cheque but might be given two or more instruments in return. The lawyers and accountants will book a nominal value for each component, but in a composite deal of this nature, it is quite likely that these nominal values will not allocate the economic value properly between the two or more components of the investment.
A simple example would be the following case:
- an investment in SaasCo of £1m denominated as zero-interest unsecured loan repayable only on exit;
- accompanied by an extra 20p for 20 shares of a 1p nominal value each;
- held alongside 80 shares held by the founders.
The investor just paid 20p for a 20% stake so the post-money valuation of the equity is theoretically £1. Plainly that’s nonsense.
Equally however, SaasCo’s equity isn’t necessarily worth the £4m that would result from treating the loan as equity (£1m / 20% minus £1m). That is not least because we only got to the £5m in the first place by treating the loan as though it was equity. So there should be no deduction for the loan. But in reality that loan continues, stubbornly, to exist. We could go in circles. There’s no logical way of accounting for it using this analysis.
So how does the investor assess their entry price? How do the founders work out what the last round just valued their business at?
Do we even need to work out an entry price?
The truth is that you probably don’t really need a headline valuation, but it might help. There are plenty of investment analysis tools that don’t need you to work out a single entry-price – internal rate of return or just a cash-on-cash appraisals, for example.
A single headline price does, however, help provide a simple rule-of-thumb analysis for comparing different offers. Investors can then instantly compare structured versus unstructured alternatives. Founders can more simply compare offers from different investors with varying structures. “Investor X is 12% off investor Z in terms of headline price, but there’s no debt to worry about, and they don’t require five board seats”.
What we need is a mechanism for converting potentially complex investment structures into that single headline price – the vanilla equity equivalent. We just made this phrase up, but let’s make it sound special, and call it the “VEE”. In fact, to give it a chance of featuring in a gullible PhD student’s thesis, how about V ™ ?
Headline valuations in a structured investment – finding the V ™.
The following is a methodology that we find helpful in working out the V ™. If so inclined, you could develop a really sophisticated model, but our guiding star in this series of posts is to find simple, workable techniques that offer insights but don’t aspire to misleading precision. The only “known fact” in early stage investment is, after all, that nothing is certain.
The return from a structured investment is generated by the combination of different instruments. In the SaaSco example, the loan provides more chance than an equity investment of returning its capital, but it offers no yield and no upside. In contrast, the equity offers upside but is riskier, as it sits further down the capital stack. SaaSco is an early stage company with a poor covenant. No bank would make a zero-interest unsecured loan (or any loan) to SaaSco. The investor knows this, but reckons that the high risk of non-repayment, and the certainty of a poor return (as there is no yield) is offset by the equity share which they acquired for a few pennies, which has massive albeit highly uncertain upside.
So the economic underpinning of our analysis is therefore the value-shift between the day-one £1m value of the loan and the 20p nominally allocated to the equity shares.
We have a couple of known variables in the SaaSco example: the total sum invested (£1m) and the equity percentage acquired by the investor (20%). There is no readily-available figure for how much of the £1m should, in economic terms, be allocated to the loan or the equity. Quite possibly (in fact almost always) even the investor will not have had a figure in mind. Let’s see if we can do better – starting off by finding a valuation for the loan. That way we can infer a valuation for the 20% equity stake. Then we can work out the value of the 100%, which is SaaSco’s V ™.
Let’s have a stab at that loan valuation. What we know is it pays no yield, redeems for £1m but only on an exit (and in practice only when the value of SaaSco at that point is more than £1m) , and has no security. If SaaSco fails, and the exit is a liquidation, it’s safe to assume that the recovery will be zero. Let’s hazard a guess that in scenarios when SaaSco limps to the finishing line, the investor recovers half their money. And excellent exits yield a 100% return, because the loan is at the front of the queue.
Back in our first valuations post, we assumed that SaaSco had a fabulous exit in 15% of scenarios. Now let’s further assume that SaaSco fails utterly 50% of the time, and the remaining 35% of outcomes see it limping to some sort of exit. Earlier in this series, we also assumed that any exit would happen on average 5 years from investment, and we were seeking a 15% internal rate of return or better.
Let’s plug those assumptions into Excel:
What this analysis tells us is that a risk investor should, theoretically at least, be happy to pay £162k to buy the £1m loan today. They would be acquiring the chance to double their money over the next five years, collecting an average £325k after an average 5 years, but in most scenarios routinely waving goodbye to the £1m.
£162k market value compared to a £1m face value – sounds like a heavy discount? Whilst it’s not the main point of this post, it’s worth re-emphasising that loans into very early stage companies usually don’t get paid back. When they do, it’s so far in the future that the risk-adjusted discount rate takes a knife to the remaining net present value. Angels and venture investors might think they are having their cake and eating it, but the cake may turn out to be just a small macaroon.
Back to SaaSco. £1m was invested. The economic value of the loan = £162k. So, the equity must represent the remainder of the £1m, being £838k. That got the investor 20% of SaaSco, so SaaSco’s vanilla equity equivalent or V ™ is £838k / 20% = £4.2m post-money. In a vanilla equity deal, the £1m as pure share capital would take not 20%, but £1m / £4.2m = 23.8%.
Taking the analysis further, this suggests that any investors or founders who accepted the various assumptions would be ambivalent between:
- £1m invested as a loan with 20% of the equity subscribed at a token amount; OR
- £1m invested as pure equity taking a 23.8% stake.
Of course there are plenty of other considerations beside valuation, not least that loans represent a hideous overhang if SaaSco struggles, and they set the scene for future funding rounds (“if they got loans, so will we”), or inter-investor bust-ups (“why should we invest to support your loans?”).
As soon as you add any complexity into an equity investment, you can lose sight of what the deal means, and what it’s worth. Calculating a vanilla equity equivalent valuation can give clarity, and allow both founders and investors to work out just what price they’re agreeing to.
Partner, DSW Ventures (and inventor of the V ™)