For some companies the most important term in a term sheet is valuation. And that makes sense.  When raising capital the higher the valuation on your business, the more you keep.

But a  high valuation, or  perhaps more accurately an overly aggressive valuation, can be a double-edged sword.  It may lead to a more complicated investment that is difficult to value and an investor that is deeply imbedded in operations. Focusing too much on valuation may sabotage your ability to negotiate the best term sheet for your business.

To understand why I say this, you need to look at life from an equity investor’s perspective.

Private company investing is a risky business. The US National Venture Capital Association reports that on average 40% of VC investments fail, 40% just return the investor’s capital, and a scant 20% produce substantial returns. The Wall Street Journal suggest the situation is even more dire in an article aptly titled:  “The Venture Capital Secret – 75% of start-ups fail.”

While you know your company will be a success, an investor must take a broader view which means playing a numbers game: minimize the write-offs, maximize companies that return capital, and bank on relatively few wins to make its portfolio profitable. Aggressive valuation makes this difficult.

When faced with a higher than desirable valuation for an otherwise attractive company an investor may look to contractual tools to push the risk profile back into the acceptable zone. They include:

  • The right to approve key business decisions. In virtually all venture investments the investor reserves the right to approve company changes that can negatively impact its position, such as creating or issuing a superior class of preferred shares. But as valuation increases the tolerance for missteps decreases and an investor may insist upon the right to approve matters more typically delegated to the board, such as borrowing, issuing common shares, hiring and firing senior management, or perhaps even hiring the investor’s candidate for a key position.
  • The right to an enhanced payout in the event of a lower value exit. The securities the investor purchases can increase the investor’s share of profits on an exit, particularly at lower valuations. An investor may insist upon secured convertible debt (particularly useful where the company has assets that can be readily sold), cumulative dividends (effectively interest on the equity investment), or participation rights that return the investor more than 1x its invested capital.
  • Reverse vesting shares. An investment in an early stage company is usually an investment in the founders. To mitigate some of the risk, particularly where the valuation is high, an investor may require ‘reverse vesting shares’ – contractual terms under which some or all of a founder’s shares are forfeited if he/she leaves the company within a specified period (typically 2- 4 years) following the investment. When the founder leaves the shares are cancelled thereby increasing the ownership % of other shareholders (including the investor) and creating a pool of equity that can be offered to replacements without diluting the investor’s original position.
  • The first right to buy additional shares. In addition to guarding against the downside, an investor can deal with risk by increasing its leverage (i.e. amount of capital at play) when the company is doing well.  This may take the form of a multi-tiered investment – where the investor has the right to put more money into the company for a period of time following first closing; investor friendly pre-emptive rights – where the investor has the first right to buy any future shares being offered by the company; investor friendly first refusal rights – where the investor has the first right to buy any shares being sold by other shareholders (it can be a long haul to liquidity and founders and early stage investors often look to sell some or all of their shares along the way); and even a first financing right – where the investor has first right to provide all future capital required by the company.

Successful negotiation requires understanding the issues and objectives of the other side. Companies that understand the investor’s perspective negotiate better term sheets. And one of the keys to negotiating a better term sheet is understanding how investors view risk, and the impact a battle over valuation can have on the other terms.  You may actually end up with more money and have an easier life if you back off valuation . . . just a little bit.