In the tech space it is very common to see headlines fixate on valuations.
It drives clicks and is obviously of great interest in the market as one indicator of a business’ growth trajectory.
But it can cause founders and management teams to focus unduly on simple calculations in their spreadsheets and cap tables, poring over what they are (mathematically) ‘giving away’, rather than how the detail of the deal terms will determine how that deal unfolds for them.
First, let’s recap a couple of key concepts.
A company’s pre-money valuation is its valuation before the investment is made. This is often contested, with founders wanting it to be greater and investors more cautious.
This dynamic occurs because, on the face of it, the pre-money valuation directly informs what percentage of shares in the company the investment will represent (and therefore what percentage of shares in the company the founders must relinquish to the investors to secure the money).
Founders and incumbent shareholders want to minimise their dilution from investment round to investment round while investors don’t want to overpay for their investment.
Meanwhile, the company’s post-money valuation simply adds the amount of the investment that is made to the pre-money valuation and is helpful in working out a simplistic percentage participation post-deal.
Whilst the ‘waterfall’ is exactly as the name suggest – how the money available via profit distributions and on a winding up or exit fills each shareholder’s metaphorical bucket before flowing to the next shareholder’s bucket lower down.
And it is working out and modelling the waterfall across the investment rounds that is critical here rather than the simple maths and headline percentages.
It is accepted that investors will look to secure (via a combination of share classes) a variety of beneficial rights. This is entirely reasonable as a concept and the quid pro quo for them taking the risk in investing.
But the impact of these beneficial rights on the waterfall and what is left for founders at the end can be startling and founders must ensure the correct balance is struck to avoid being left empty-handed.
I’ve set out below some deal terms that we have seen over the past year or so. They’re unlikely to all occur in a deal but serve to illustrate the cautionary nature of this piece and why it’s vital to pay attention to the detail.
Deal terms
First, investors will want preference shares that carry a liquidation preference, meaning that the investor gets paid out to a specified level before other shareholders if the company is sold or liquidated.
This level may be what they put in, but it may factor in a return from the outset. This is what goes to the investor before anything is available for other shareholders so pay attention.
The investor will also likely seek to secure a fixed dividend on their preference shares which may be cumulative in nature (such that if the company fails to pay a dividend in one or more years they accumulate regardless and are paid out when the company is able to do so).
This will further increase the investors’ return, potentially at the expense of other shareholders on exit. Make sure this is understood.
Then the investor will seek to participate in the growth of the company over and above their preferred return by holding ordinary shares. Entirely reasonable if the liquidation preference is fair.
But some particularly aggressive investors may also look for their preference shares to be added to their ordinary shareholding for these purposes, which inflates their growth participation and should be resisted.
And finally, in PE-backed deals you may even see something called a dividend recap which is a US-style mechanism requiring a company to take on debt to pay a dividend to shareholders which effectively loads the company up with debt while getting cash to the shareholders (primarily, you’ve guessed it, the investor).
What it means is when the investor is long gone on their exit, the company continues to carry the debt. Again, to be resisted.
In summary, only by looking through and working out the waterfall can a founder or management team ascertain what is left in the post for them and other shareholders.
Check the percentages, check the deal terms, model the waterfall and use experienced advisors as early as you can and before term sheets are signed.