Securing capital based on its prospective or future value to the company is one of the most important decisions for a young, growing firm and a challenge for its CFO. How do you assess not just the price of the capital being offered, but also it’s true worth (including intangibles) over the long term?
If only securing equity or debt capital were more like buying insurance. As the simplest example of financial prospective value, insurance is a well-defined contract whereby a policy holder is willing to pay premiums in exchange for future remuneration when a warehouse burns or some other calamity occurs. The mature insurance market and actuarial science drive a tight correlation between premiums paid today and potential payout later. This ability to quantify and correlate value is very different from debt and equity capital decisions, where measuring future value is a daunting task for both buyer and seller.
The Sage of Omaha, Warren Buffett, is credited with the quote, “price is what you pay, value is what you get,” a notion critically important when making decisions about capital sources. In product or service purchases, there is an inherent financial collar around the potential upside or downside surprise of the decision. But in decisions around business capital, the future value — yet-to-be determined or delivered — can vary widely, for both parties. With an abundance of capital currently seeking the best investment opportunities, CFOs have plenty of choices. However, they often overlook the most important terms without realizing it. Whether debt or equity, it’s important to look at price, but resist the urge to consider it above all else when weighing offers.
In equity transactions, price is about company valuation, and the CFO’s “ask” is invariably greater than the investor’s or acquirer’s “bid.” A tug-of-war ensues, as parties try to narrow the spread and get a deal done at a negotiated price that is acceptable to both. This myopia can be very dangerous.
Witness the entrepreneur defending at all costs his bottom-line pre-money valuation of $10 million, while giving little notice to the super-voting rights or liquidation preference (which investors get paid first in a liquidation event?) on page three of the term sheet. These structural elements of the deal — much more than valuation — can determine distribution of capital upon the investor’s exit, and also provide a window into the alignment between the investor and entrepreneur at the point-of-purchase. Wouldn’t it be helpful, when evaluating an offer, for management to have an appreciation of the level of shared confidence in management or optimism in the market opportunity? Price alone doesn’t tell the CFO that. (Harvard Business Review offers a valuable view on the risks of minimizing prospective value and the costs associated with equity investment decisions in “How to Negotiate with VCs.”)