Buying a startup: deep dive into a concrete case study

The value of a startup is hard to define. As a private company, nothing can determine an exact valuation other than how much another a company would be willing to pay for it… The startup will pitch intangible assets such as their IP (their “secret sauce”), the customer loyalty and the quality of the team. They will also use market comparables (similar M&A or data from public companies in the same space). 

The problem with market comparables is that they can create a fake inflation on company valuations. Only good deals are advertised in the press and for private companies, it is not rare to disclose inflated revenue and valuation numbers to make all the buyer and the seller look good.

You will need other data points to determine their price point. For instance, if they have raised capital, they do have an official valuation. It’s not public data and it might be recent information but that’s what is going to truly drive the amount they would sell the company to you.

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In order to not waste too much time in negotiations, you should ask the company for its latest capitalization table (aka. cap table). A cap table is the document that details the ownership of the company. It lists the percentage of ownership for each shareholder, the different categories of shares (ordinary or preferred), the stock options, warrants as well as any other types of securities.

Startups don’t always share their cap table upfront but it’s worth a try. It will help understand the equity story of the company. Who has invested and at what valuation, the type of shares they own, the strike price for employee stocks and their vesting. The equity story tells you how much everybody will make with the transaction and determine a valuation floor under which a deal will be harder to get.

Cap tables can be very messy, demonstrating complex equity stories. It usually happens when they have done multiple financing rounds with various categories of stocks at different prices and conditions.

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Let’s dive into the example of a tech startup founded 8 years ago by Emma and Alex who both owned 50% of the business when the company was launched. They almost bootstrapped with just a bit of love money from friends and family who got in exchange 5% of equity. They built their first product that got good traction and quickly reached $1m in recurring revenue. Thanks to that they managed to raise a $3m round at a $12m pre-money valuation with a well-known venture fund. They created a new category of shares with a 1x liquidation preference. It means that when the company sells, investors will be looking to get their initial investment back first before ordinary shares owners start getting their piece of the pie. It’s a typical model in the venture world used to minimize risks. The Venture Capital investments category is very volatile and  some returns can be disappointing. VCs need some level of protection. Emma and Alex raised at a decent time. They did not get beat-up like some of their friends who raised later at a less favorable time. Tech investments were drying up for them and they had more aggressive conditions with terms like 2x preferences and ratchet clauses. They did not get a home run either like other startups who raised at the peak of the bubble and got a deal with no preferences and even managed to do some cash-out. Emma and Alex had a fair deal for both investors and entrepreneurs.

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The founders now own 71% of the company. The press release for the raise mentioned a $5m round which was not technically entirely true since Emma and Alex leveraged the new capital with an additional $2m of debt from a bank. Altogether they received $5m of cash to invest to grow their business. They built a stock option plan to attract talents with a strike price of $12m as well as an advisory board of experts in their field distributing another 5% of the equity of the company. 

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The company continues to expand, opens offices internationally and 3 years after the series A, Emma and Alex raise another round of capital, this time $25m at a $100m valuation diluting all the current shareholders by 25%. As for the first round, the startup adds some debt leverage for another $10m and creates a new pool of stocks for the staff. After this second round the cap table looks like that:

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The founders own 51%

Investors own 43%

Employees and advisors 3.75%

Company has $13m of debt

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Unfortunately, two years after the Series B, the business has slowed down and now grows at a 40% annual rate but still shows 20% losses. The company does not meet the rule of 40 anymore that every investor looks at. 

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The rule of 40 states that a healthy company should have its 

ANNUAL GROWTH RATE + % EBITDA > 40%. 

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Nothing too worrying at this stage for Alex, Emma and their board. The market is still hot and they have plans to improve their numbers. Still, it does introduce some first doubts among board members. It might be time to watch for cost reductions.

A mid-cap, they already partner with, approaches them to discuss acquisition. After initial conversations, they shoot an LOI at a $75m valuation in cash with a 15% earn-out paid in 2 years if the business meets its business plan. It’s a very decent amount of cash but the offer is lower than the $100m of their previous round. 

The board is divided. The early investors fear an upcoming market change and a drop in valuations and think they would get a very acceptable return with a $75m cash exit. More recent investors are more aggressive, they are expecting stronger multiples from the company and do not want to sell now. 

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Let’s look at how the money would be distributed among shareholders

The offer is cash free / debt free.

The company has $5m left in the bank and still $10m of debt. It brings down the net purchase price to $70m.

Offer includes a $3m escrow for working capital adjustment that will be quickly released and a $10m escrow to cover reps and warranties.

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At closing, the initial cash payment from the buyer is $70- $13m escrow =$57m

$1m goes directly to the advisors who contributed to the deal process

Liquidation preference, owners get their 1x return first and get their $28m

The rest of the cash is spread across the ordinary shareholders

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The equity story gives us an idea of a theoretical valuation floor under which we know that it will be hard to get consensus among shareholders. We can understand at what price point nobody loses money. 

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This floor is not a hard one. It can be discounted by various factors including the level of cash in the bank, the capacity of the company to raise capital and other market threats.

When this valuation floor is still too high, you will need a bit of digging and negotiation skills. 

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