Problem:

Early-stage client company is conducting a private placement offering of its securities.  A legitimate investor is willing to subscribe, but questions our client’s valuation.  Because client does not yet have revenue, and because the operations of the company are extremely preliminary in nature, client experiences difficulty defending its valuation against the valuation demanded by the prospective investor.  The founders of the company were hesitant to subscribe the prospective investor at his proposed valuation, because to do so would dilute the founders’ interests.  The investor was hesitant to subscribe at the company’s valuation, because it did not adequately reflect the speculative nature of the endeavor.

Solution:

We recommended that client subscribe the prospective investor at the investor’s proposed valuation and draft a “claw-back” contract with terms allowing the founders to recover equity in the event that client’s valuation prevailed.

Result:

By subscribing the investor at his proposed valuation, the company was able to bring-in much needed capital.  By providing the founders with options/warrants to purchase additional securities at a nominal value in the event the company achieved certain objective goals (which, in effect, would justify the company’s original valuation), the company’s founders were able to avoid indefinite dilution.

Lessons Learned:

Early-stage valuation need not be a win-lose proposition.  At some point in time, either the prospective investor or the founders will be proven correct.  The methods employed in this case study effectively deferred the valuation argument to a point in time when objective criteria would exist to better value the company.  By drafting a mechanism to effectuate a change in ownership percentages, we were able to alleviate the dilution concerns of the founders while also addressing the valid concerns of the investor.

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Author:

Scott Levine, JD
slevine@aegisps.com