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VC Insights: Valuations in early-stage investments – what does exit preference mean for the valuation?

This is our fifth post in a series of VC Insights focussed on valuations. We’ve looked at valuing a business, adjusting for debt and options, and in our last post we even tried untangling a bundled debt-and-equity structure.

Next challenge - how do you assess an offer that has complex preferred share rights?

What are we trying to achieve?

In our last post, we developed a mechanism for converting potentially complex investment structures into a single headline price, the vanilla equity equivalent, to which we gave a cute name -  the V ™. The idea was to develop a fairly simple mechanism, useful to investors and founders alike, to allow easy comparison of differently structured funding offers.

Valuing a deal with exit preference 

Exit preference gives the investor a return that stands ahead of other shareholders, the ordinary shareholders especially. The preference can come in all shapes and sizes, from a commonly used but relatively innocuous limited downside protection, to aggressive guaranteed returns of multiples of the amount invested.

So, what’s the issue?

The preferred investor shares are worth more than ordinary shares. The investor will pay more for them, and it therefore is not logical to use their entry price per share to value the entire company’s share capital – preferred shares and ordinary shares alike.

Is it possible to produce an equivalent value for an ordinary share (and hence the value of the whole company, the V ) by reference to the price paid for the preferred shares?

We need a methodology that we can use in practice, recognising the uncertainty of any data we input. So let’s keep it simple. This is only a rule-of-thumb analysis after all, but helpful perhaps, particularly to the founders and existing shareholders in comparing competing offers. The institutional investor will probably be more focussed on their IRR and cash-on-cash analyses, but the V ™ may help as a sanity check: “are we paying more, or less, than the deal we closed last month?”

The preferred share is different to the equity-and-loan combo examined in our last post on valuations. It is a single instrument, but it delivers two different rights: money-back (maybe with a minimum return as well) and/or a pro-rata share in the exit proceeds alongside the ordinary shares.

What we need is a way of calculating the extra value which the preferred shares generate from their additional rights. From that, we can work out the value of a vanilla ordinary share, which does not have those rights.

BrewDog - a real-world example

Background

Let’s analyse a real-world example to illustrate a possible methodology. In April 2017, BrewDog PLC raised a headline £213m from TSG, a US investor, for a headline 22% share in the company, generating headlines of a £1bn valuation. Although a public company that had taken several rounds of angel finance, BrewDog is and was unlisted, and therefore not subject to some of the regulations attached to a quoted company.

The bare bones of the offer, picked out from press releases and a trawl of Companies House filings, were as follows:

  • Prior to the offer, Brewdog had just ordinary shares in issue, owned by the founders and by retail investors;
  • The ordinary shares ranked pari passu, save that retail investors got discounted beer and a book by one of the founders on how to “Break All the Rules”;
  • TSG invested an initial £213m for preferred C shares at £13.18 per share. These got a baked-in 18% compound return or, if higher, they shared exit proceeds shoulder-to-shoulder with the founders and retail investors. (Just to note: 18% per annum sounds less frightening than saying that TSG gets a minimum 3-fold return after seven years, but it’s the same thing);
  • TSG bought £110m of these shares from the founders as ordinary shares, then redesignated them as preferred C shares, increasing their value in doing so; the remaining £103m of their investment was used to subscribe for preferred C shares into the company, providing valuable capital to grow the business;
  • The retail investors were then offered a limited opportunity to sell some of their shares, and TSG has subsequently accumulated shares from them worth about £12m at the £13.18 offer price. This was roughly half of the proceeds that retail investors would have by selling the same proportion as the founders. They were in fact offered the chance to sell a broadly equivalent proportion but, no doubt to the frustration of larger retail investors, the offer was capped at 40 shares per investor.

So far, so complicated, but the core facts are that TSG bought £213m of shares for a 22% stake, but using preferred shares that were more valuable than the ordinary shares.

So how much does this value the remaining ordinary shares at? And just how much was BrewDog worth in April 2017?

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