IPO valuations and the role of bankers – By Aravind G.R

The Business Insider’s Henry Blodget asks ‘how would you feel if your real estate broker sold your house one day for $1 million to someone (a friend of his, presumably) who turned around and sold it the next day for $2 million.’ You’d be pissed, right, and feel betrayed? Of course you would.

To put it simply, LinkedIn execs sold their shares to ‘some people’ at $45 on Wednesday night, while these people sold it $100 on Thursday morning. Obviously, finger(s) was pointed at the Ibankers who simply “screwed their client out of $130 mn” and charged them $25-30mn to do it.

Before we hang the Ibankers in the middle of the street (while a massive protest at wallstreet continues), lets listen to some of their most probable excuses/arguments and try to debunk them:

1. Mr Banker: How in the world can you expect us to know that the stock price would double to 90+? When we priced at 45, we were told by the same pundits that it was unreal and that we had ‘lost it’

My Take: Agreed, it is very difficult to ‘value’ internet & tech companies, especially lightspeeders like LinkedIn. If you remember, a few years ago Google had no idea about their correct value either, but they pioneered a best practice of ‘Dutch Auction’ to clearly put the ball in investors court and ask them-‘tell me how much you want to buy us at’.

So, Mr Banker’s job would have been easier if he’d trusted his institutional investor buddies to come up with the ‘value’ rather than taking a shot at it in the dark.

2. Mr Banker: No two people value a high growth technology company the same way. Our valuation was close to $45. Live with it.

My Take: We Ibankers are hired to solve this exact problem; we are supposed to get the valuation close to what the market is willing to pay. I understand that underpricing has an inherent advantage and has become sort of an ‘expectation’ from IPO investors. The process of Dutch auction addresses this problem as well.  The fact that you are setting a price band is keeping you in control of pricing rather than the buyer who is bidding against thousands of other bidders for the same share. Price discovery is being stifled a bit, isn’t it?

We boutiques face the same problem, we don’t know if our client should be valued at 10X or 30X of something. But, in the name of god, I wish we had 10 VC funds bidding for the current round. We have done so much better to get closer to a ‘fair’ valuation with just 3-4 VC’s jostling for the same opportunity. Lets face it, we all know how much of termsheet shopping gets done and what a couple of termsheets on the table means to a fund which is looking at the opportunity for the first time.

 

3. Mr Banker: These pundits will be on my case if the price comes down after listing. I’m being ‘just’ to everyone!

My Take: There are enough instances where Ibankers have been accused of screwing the ‘unsuspecting investors’ by selling them a crappy stock at a ridiculous valuation. Can Mr Banker really help this? In India, he is ‘paid’ to ‘maintain’ the price for a few weeks/months after listing. But it is not Mr Banker’s job to see that the stock price is always above the IPO price.  Well, buyers beware, right?

4. Mr Banker: Aha, I’m way more intelligent than you think. I’m doing this to ‘bait’ investors (future ones as well) into believing that the stock is ‘hot’. Investors will not support a stock if it did not ‘pop’ on the listing day; I’m attracting a lot more bids in the IPO because of this and investors will continue to be drawn to stock after Meanwhile this also helps

My Take: Please, diligent investors understand that magical ‘pop’ on listing is not a sudden spike in valuation, but rather a bouncing spring that you had suppressed. The only folks who’d be fooled by this ‘act’ are the media and may be some retail investors. This baiting game will eventually make sure someone bites your hand off, Mr Banker

Killing me softly with your Due Diligence – By Deepak Srinath

(This post was originally published on the VC Circle blog on October 14, 2011)

Why does it take so long for a venture deal to close after a term sheet is signed? This is a question entrepreneurs often ask in despair. This interminable state of Due Diligence (DD) kills entrepreneurs and I can’t think of too many reasons an investor would want to drag the process (other than issues with availability of funds).

For those of you who may not be familiar with the Venture Capital investment process, after a termsheet is signed an audit firm and a legal firm are usually appointed to do a financial and legal due diligence on the firm. Sometimes there is a business diligence or a technology diligence added to this, but more often than not the fund does this on their own. Based on the findings of the DD, there may be a renegotiation of the terms (unlikely in early stage firms) and the lawyers then draft the definitive agreements which usually comprise the Share Subscription and Share Holders agreements along with a bunch of other letters, board resolutions, etc.

Every time we sign a termsheet for one our clients, I make it a point to ask the fund how long they expect the Due Diligence (DD) and agreements drafting to take. The standard reply is that if all goes well the deal will close within a couple of months. Every single time, this has proved to be untrue; our experience has been anywhere from 3 to 6 months. Sometimes there are genuine reasons for this, but usually it is a combination of ignorance, incompetence, apathy and ego clashes that cause this wasteful delay.

A few observations on some of these delay factors:

1. Lack of preparedness of the company – It’s easy to pass on the buck to VC’s, auditor or lawyers for dragging the deal; entrepreneurs first need to make sure their own house is in order. Bad or non-existent accounting practices and lack of regulatory compliance are very often the cause to delay.  I’ve heard many entrepreneurs claim they are so busy building the business that they have no time for accounting or compliance issues. All it takes is engaging a good CA firm and keeping your eye on them. If the entrepreneur is using an investment banker, make sure they provide a basic DD checklist in advance and get things in order.

2. Engagement model with audit and legal firms – Audit and legal firms must be engaged on terms that do not give them an incentive for taking forever. The fee for the assignment should preferably be fixed and not hourly billing. Moreover, there must be a show cause and penalty for delays beyond agreed timelines.

3. The fund partner is not driving the process- Sometimes, the senior partner in the VC fund does the deal and leaves it to the junior associates to handle the DD. The juniors are not able to drive the process and exercise control over the firms doing the DD. Partners should stay involved or delegate authority to their juniors and communicate it to the firms doing the DD. This way a fund can influence the DD process and make it move faster.

4. Data checklist relevancy: More often than not DD firms use a standard requisition list of documents irrespective of the target’s sector. Even though it gets clarified during the course of the DD, it always adds a couple of week’s worth of back and forth and mostly redundant work. The fund should make sure that instead of a standard template, a relevant data checklist is sent out.

5. Audit and law firms using inexperienced resources – The DD is not just about gathering data; it requires some judgment calls on what is important and what is not. Inexperienced resources getting stuck on issues that are irrelevant or minor have caused much delay. The fund should make sure that the DD firms they appoint provide adequate supervision of junior resources.

6. Lawyers playing ego games – My lawyer friends won’t like this, but I’ve been in situations where the lawyers representing the fund and the entrepreneur start playing games of one-upmanship and endlessly debating technical terms that have very little impact on the terms of the deal. This is a really tricky situation because even if the fund and the entrepreneurs sense this happening, there is a perceived risk in asking their lawyers to let something pass and move it faster. Nevertheless, funds and entrepreneurs need to be aware of this and discuss it with their lawyers.

7. Simultaneous drafting of definitive agreements – It could be helpful (especially in early stage deals) if the lawyers are instructed to draft the definitive agreements in parallel to the DD. If changes are required based on the DD findings, they can always be incorporated. This can save a few days, instead of waiting for the DD to complete and then start drafting.

8. Lack of trust between the fund and the entrepreneur – In the deals I’ve worked on, when the level of trust has been high between the entrepreneur and the fund, deals have closed much faster. When the entrepreneur goes into a deal wary that he is going to get shafted, every single point is debated endlessly and deals take forever to close. Trust is something that gets built over time and through a lot of intangible actions. I can only urge entrepreneurs not to get into deals where they don’t trust the fund’s intentions completely.

Ideally, all venture deals should close in less than two months. Hopefully, this will become the norm rather than the exception as the VC space becomes more competitive and entrepreneurs more aware.

 

 

Viedea’s pick of must read posts for October

The Viedea team tracks a number of blogs about the startup and investing world. We thought it would be useful to share some of the best blog posts we’ve come across in the past month with our community. We will make this a regular feature henceforth.

1.Building a Company vs Building a Business:  Fred Wilson of Union Square Ventures on the distinction between building a business and building a company; something all entrepreneurs need to understand.

http://bit.ly/rtv2mI

2. The Art of getting back pending dues from customers: Venky from efarm has posted this piece on pluggd.in. Every entrepreneur who’s done business in India has experienced the difficulties of recovering dues. Very relevant and topical post.

http://bit.ly/qtIaWN

3. How to sell your company : Entrepreneurs need to know how to sell. Some are born salesmen, some have to learn along the way. Entrepreneurs are rarely successful if they do not learn how to sell. This Techcrunch post talks about how being a good salesman does not mean you’re a good negotiator. Important distinction and some good tips on sales.

http://tcrn.ch/riAlZH

4. Understanding how dilution affects founders: This is a must read for any entrepreneur aspiring to raise capital. Mark Suster’s blog has a great infographic representation of how founders get diluted over fundraising rounds and the impact of ESOP pools and participating liquidation preferences on their returns. Fred Wilson and Brad Feld have also written some great posts on dilution, but this one has an easy to understand graphic.

http://tcrn.ch/poPNNf

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