Valuation: Return of the ratchet

The bottom line is that the job of the entrepreneur is to deliver a financial gain for the VC – it is not the job of the VC to give the entrepreneur a ‘fair go’. DORON BEN-MEIR

By Doron Ben-Meir

In my last blog entry on valuations, I used a simple case study to show how entrepreneurial expectations may not necessarily align with investor interests.

Needless to say, these issues are not always easily resolved. The artificiality of the debate is always interesting as valuation often becomes more a function of the investment sought versus available equity rather than a first principles derivation. Nevertheless, setting a pre-money valuation is an important part of the venture capital courtship as it can be an emotive issue.

Consequently there are a variety of techniques that can be used to mitigate disagreements with respect to pre-money valuations. One of the most common is an anti-dilution provision (or ratchet). The principal is very simple.

In the event that a future capital raising (series B) is conducted at a lower valuation than the current round (series A), additional shares will be issued to series A investors such that the average price paid per share is equal to the series B share price.

The effect of this is to further dilute non-series A investors – typically founders and ordinary shareholders. Through this mechanism the reasonable argument can be made that if future rounds are raised at higher valuations then the founders are vindicated.

Conversely, if the business struggles and is forced to raise capital at a lower valuation, then series A investors are not disadvantaged by having paid too much up front. Importantly, ratchets typically do not survive subsequent rounds so series A investors often find their interests realigned with ordinary shareholders unless they stump up again in the future round.

For a founding team to reject an anti-dilution ratchet can be construed as a demonstration of lack of confidence – something no-one wants to see before the race is run.

But wait, I hear you cry, isn’t this just the type of “having it both ways” behaviour that has given VCs a bad name? If the business hits a speed hump the VCs screw ordinary shareholders out of their equity?

As with all situations in life there are fair ways to handle situations and unfair ways. Often this is a judgement clouded by self interest. No doubt some VCs behave in a predatory fashion and no doubt some entrepreneurs will say and do anything to get what they want.

However, the bottom line is that the job of the entrepreneur is to deliver a financial gain for the VC – it is not the job of the VC to give the entrepreneur a “fair go” (whatever that might mean). Investors in VC funds likewise apply pressure to VC managers, and so on up the food chain.

Good investors will do all they can to help, but the responsibility for execution inevitably lies with the management team. The ratchet increases the probability that the investor will achieve a return which is consistent with the fundamental investment contract.

We’re all accountable to someone…!

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Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.

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