Here are a couple of articles (1, 2) detailing some techniques used by investors to tweak a valuation in their favour. The site is a little dubious - basically a collection of articles designed to sell you an eBook about private equity, but the articles are interesting on their own merit.
The tricks being exposed seem devious and misleading, and they are hopefully more representative of private equity than of technology venture capitalists. Personally, I'm not much into the VC money game, but if I was to consider taking on investors and I noticed something like that going on, that'd be the end of the discussion with that particular investor. This is probably a good reason to build a business that doesn't strictly need outside investment: so you can tell any investor who tries to pull a fast one to fuck off.
In any case, if you do intend to raise money from professional investors, make sure you get a good lawyer who can spot these things and warn you that you're about to get shafted.
Here, then, are the devious tricks:
- Vendor financing, aka giving you the money in tranches; for example, $7m now, $7m in 5 years means that the actual value of the deal is only $9.8m based on a 20% discount rate);
- Contingent earn-outs, aka the same, but even worse, because the second tranche is uncertain;
- *Company-paid earn-outs, aka the same, but the wording says that "the company" will pay the extra money, which means the current shareholders (i.e. you) will need to pony up some of the cash yourself;
- Equity clawbacks and ratchets, aka if you don't meet your own targets (because of any reason), we'll take more of your shares;
- Mis-valued employee stock options, aka "Let's shift the options pool into the pre-money valuation (effectively decreasing the value of your shares), and make it even larger by actually calculating it based on post-money valuation";
- Preferred stock with outrageous terms, aka you'll need to grow your business to several times its post-money valuation before you even see a penny of return;
- Huge management fees, aka let me get some of my money back from you for stuff I should be doing anyway, even though I'm supposedly investing in you.
I'd be very surprised if any high-profile, reputable VC (or any VC wanting to preserve their reputation) stooped to those types of obviously misleading tricks. Do that once, have an article written about it, and you're burned in the startup community.
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