A private equity investor or angel investor and an entrepreneur, both may be very interested in working together. However, they may be miles apart on the valuation. Both may be optimistic about the prospects for the company, feel very compatible with their management styles and feel good about the management team and the industry. But there is a gap in the valuation that could keep the relationship from going forward.

So, how can you bridge the gap? Here’s one creative way. First, let’s look at the underlying causes. The entrepreneur may have a very emotional reaction to the valuation. He may sort of be looking at comparable companies and their multiples and extrapolating those to this company. Another cause could be that the entrepreneur may have raised money at too high of valuation during some of the early rounds and as a result that put a psychological floor on the valuation that they feel it just cannot go below with this next round.

Meanwhile, the private equity firm feels its no guarantee that the business plan will be reached and they put a risk premium on the plan with using a higher discount rate. Or, perhaps, they might rework the plan themselves and come up with a set of more conservative numbers that they believe is more realistic.

Put the two together and we have a gap. There could be a way though to bridge the gap. It can work in either one of two directions.

1. The valuation is set at the higher number that the entrepreneur is looking for. However, if certain milestones are not hit along the way, then the private equity firm gets an additional piece of the company. Thereby, effectively bringing the valuation closer to what they had anticipated in the first place. If it doesn’t work out that way and it turns out that the targets are hit, that’s fine too because the private equity firm now has a smaller piece of a much more valuable enterprise than what they were expecting, so that works out nicely for them.

2. The valuation starts out at a lower valuation. The entrepreneur receives option based upon performance to increase their ownership if certain milestones are hit along the way. If the entrepreneur achieves the kind of results that they had mentioned in their plan, they will end up with the valuation and the ownership that they had talked about in their plan. The entrepreneur gets a chance to express their confidence in the plan by, in essence, giving up a stake of the company now with the right to earn it back over time.

Either way can work. It can be a creative way and one that is a very powerful incentive for management to bridge the valuation gap and keep a deal going that might otherwise fall short. When you have an investor and an entrepreneur that otherwise are very interested in working together, it pays to find some creative ways to make the relationship work and cover each other’s interest.

Jon Paul, MBA, CPA, CMC, CM&AA

President, Value Added Finance Resources
Bringing new insights on results and maximizing company value