In an earlier post on fundraising do’s and don’ts, I wrote that startups should optimize for success rather than valuation. Specifically, I wrote that sometimes it’s worth “taking a few additional points of dilution [by accepting a lower valuation] to get the right partner in your company”.
Marc Lore, the founder of Jet.com which was acquired by Wal-Mart for about $3 billion in cash and $300 million in Wal-Mart shares, gives several other reasons why taking a slight discount on your company’s valuation is likely to increase your company’s likelihood of success.
In addition to letting you work with the right partner for your company, the benefits of taking a slight discount on your company’s valuation are that it:
1. Increases investor demand for the round, thereby creating scarcity which sometimes even results in a higher final valuation for the round.
2. Makes it more likely that the round’s investors have a nice paper return by the time of the next round, thereby making them more likely to be happy investors who refer the company to other investors.
3. Lowers the likelihood of a potentially morale hindering future down round.
4. Increases the pool of potential buyers of the company by not boxing out smaller buyers who would otherwise not put in the time to evaluate the company due to believing that they wouldn’t be able to meet its valuation expectations.
As startups mature, existing shareholders can look to sell some of their shares in order to convert some of the increase in the paper value of their ownership into actual cash. Such transactions, which can be initiated by both employees and investors, are known as secondary share sales.
When a secondary share sale takes place, it’s important to note that it will take place at a lower valuation than the valuation that would be placed on the company if the transaction were a primary investment. A primary investment is one where the investment goes towards buying new shares which are being issued by the company. As such, the proceeds from a primary investment are used by the company for its growth.
There are two reasons why secondary share sales of startups take place at a lower valuation than if the same company at the same moment in time were accepting a primary investment.
The first reason is that startup shares are a relatively illiquid asset class. Unlike public market shares for which there is a steady stream of demand, private company shares have less buyers. So when a potential buyer evaluates the purchase of secondary shares in a startup, they keep in mind that their purchase would let the owner of an illiquid asset class achieve liquidity. And once they become the owner of these shares, they’ll be subject to the same illiquidity constraint as faced by the original owner. It will likely take years before the company goes public or is acquired and they’re able to get a cash return on their investment. So they apply a discount to account for the illiquidity of the shares they’re buying.
The second reason why a discount is applied to secondary valuations is because primary valuations take into account the growth that the company will be able to achieve once it receives the capital injection. Money that is used to cash out an existing shareholder is money that isn’t used for the company’s growth. As a result, the company will be less valuable than the same company which has the funds available for its growth.
I’ve seen discounts on secondary share sales range anywhere between 30% and 50%. So, a company that could raise a primary round at a price per share of $10 may see its shares trade for between $5 and $7 in a secondary transaction.
That said, the discount percentage could be lower than 30% or higher than 50%. The same illiquidity that is partially responsible for the discount applied to secondary shares is also responsible for the large variance in the ultimate price of secondary transactions.