We are all now aware that the pandemic affects not only our own lives, but also the economy. Naturally, startups also feel the effects of the pandemic. Previously well-established and smoothly functioning processes, such as drawing down investments or bringing in a new investor, have slowed down. But what impact can the pandemic have on company valuation when involving a new investor? Can founders be disadvantaged by the entry of a new investor? In this article, we seek to answer these questions.
First of all, we consider it important to emphasize that even in a prosperous economy, company valuation is nothing more than making assumptions based on the data available at a given point in time, with the aim of determining the future value of a company. But what happens when crisis strikes, in this case a global pandemic? Can a startup’s company valuation change as a result of the pandemic? Does the pandemic affect the world of investments itself?
In the current situation, it appears for the time being that the impact of the pandemic is not yet visible in company valuations, but what is true today may be forgotten by tomorrow. Company valuation plays a major role in deciding whether a given investor will invest in the company at all. In the case of startups, this company value is more about the idea itself, the team and hopeful future results than about past events.
This company value may serve as the starting point for the sale and purchase of a corporate shareholding, whether a quota or shares. There are not many investment agreements that do not include at least a brief provision, even if only in one paragraph, on anti-dilution protection. In fact, common practice shows that investment agreements not only regulate anti-dilution protection, but may also grant veto rights to the earlier investor if a new investor wishes to enter the company.
Why is this important for the investor, and how does company valuation relate to it? What is anti-dilution protection? In short, anti-dilution protection is intended to ensure that if a new investor enters the company and provides capital, that new investor cannot acquire a shareholding on more favourable terms than those on which the existing investor acquired its current shareholding. This is where company valuation plays a particularly important role.
For example, if the earlier investor invested two years ago based on a higher company valuation, and now, during the pandemic, a new investor wishes to enter based on a significantly lower company valuation, a situation may arise where the new investor acquires approximately the same shareholding in the company as the earlier investor, but at a much lower price. This does not seem particularly fair, especially from the perspective of the earlier investor.
In the event of dilution, the earlier investor is naturally entitled to compensation. It is generally accepted that if dilution occurs, meaning that the new investor enters the company at a lower company valuation, the company’s founders are required to provide this compensation to the earlier investor. The compensation is provided from their own shareholding, from which they are required to transfer a proportionately determined part to the earlier investor.
What happens if the anti-dilution provision was omitted from the investment agreement and a new investor nevertheless enters the company? Well, we would not want to be in the shoes of the earlier investor.