Step-by-step price discovery for private companies
By RApport
May 27, 2022
There is a simple process by which any board of a private company can ensure that it finds a price at which its existing investors and new ones will give it the funding it wants. Aspects of this process are relevant whether a company is heading into a private financing or preparing for an IPO.
Basically, just ask each investor how much they want to invest in a financing of size X if the valuation were to be anywhere from $0 to some sky-high number. Once you have those data, you’ll be able to identify a clearing price at which the company can raise funds, akin to a Dutch Auction.
Specifically,
1. Send each investor a spreadsheet with two columns. In Column A, write out a range of pre-money valuations going up as high as you like (let’s say 10x higher than your last round) in any reasonable increments (e.g., $10M increments, $25m increments, or 10% of your last valuation, etc.).
In Column B, ask the investor to write in how much they would want to invest towards a round of Size X if the round were done at that particular pre-money valuation. Something like this:
If you are considering raising various amounts, then you can have a column for a round of size X and columns for rounds of Size Y and Z.
And if someone doesn’t want to participate in this process, be clear that this is equivalent to saying that they don’t want to invest at any valuation and therefore will be cut out of the round. Since no one has a contractual right to an allocation in the IPO, they must participate in the process or else they risk that the IPO will be done at a very attractive (low) valuation but management won’t allocate anything to them.
(This process doesn’t work so well if a company is doing another private financing when investors have a contractual right to invest their pro rata; in those cases, an investor is not obliged to participate in price discovery and can just wait to see how much demand the company drums up before declaring if they want to take their pro rata. In that case, you may just have to respect their right to not give information, assume that they won’t invest at all as well as that they will invest their pro rata, and proceed with price discovery with everyone else.)
2. Have all the investors send back the spreadsheet at the same time or even let them password protect it and send it to the board without the password; then they can all transmit their passwords at the same time. In this way, all investors will know that no other investor could piggyback on the conviction (i.e., the eagerness to invest conveyed in the spreadsheet) of any other investor. This is how the public markets work, with investors competing to buy shares without any investor knowing how any other investor truly feels about a stock or how much they would buy at what price, and therefore it’s important that the IPO be priced this way if the IPO price is to reflect how investors will act as public shareholders.
Your finished spreadsheet might look something like this:
3. Once the board has all the data, it can integrate all the demand of all investors at each valuation level and find a level where there is enough insider support to cover enough of the IPO to approximate what the IPO price might be. If that’s a down-round, so be it. If it’s an up-round, that’s fine too. What matters is that the price emerges from a competitive price discovery process. This price won’t necessarily be where the IPO is priced because the company still has to attract new investors into the IPO. Ultimately, because of the imperfections in the price discovery process, it’s important to actually price the IPO at a level where there is more stated demand than what the company actually raises so that it leaves some demand on the table.
A company could start the valuation exploration range at $0. By doing so, the board is not tipping its hand to investors as to how low it would actually be willing to go to get the round done. $0 is clearly absurd, but by having investors give an answer as to what they would invest at $0, the board can learn how much actual capital the investor could possibly invest.
When investors don’t like the valuation that a company wants them to invest at, they might make excuses for why they can’t or won’t participate. While it’s possible that those reasons are true, it’s also possible that the investor just doesn’t want to offend the company by suggesting that, given the market conditions, they might be overvalued in the investor’s opinion. And yet, that’s not helpful to the company. Unless there is already plenty of demand from others at higher prices, it would be better for the company to know how much the investor could invest even if at lower prices.
So there is no better way to find out if that’s true than to ask them how much they would invest if the valuation were much lower. If the answer is still $0 no matter how low the valuation, then the investor really is unable to invest (or really doesn’t value the company at all). Call it disloyalty or something else, but that’s the kind of information a board needs.
Investors who claim to not have enough funds to invest at one price may find the cash to invest when a company they value is raising at a very low price. It’s just a matter of one company making itself a more attractive investment opportunity than other companies. Just as investors compete to invest in the best companies, companies compete for finite investment dollars, and they do so with both the quality of their science/business propositions and their valuations. It can be stressful but it’s the stress that the market puts on all of us to ensure that we are making the best decisions we can about how to deploy capital to create products that society will value.
It’s a market
Just because investors are valuation-sensitive doesn’t mean they aren’t supportive of the science. What price-sensitive investors risk is not getting an allocation in the round if others value the company more highly. Again, that’s just how the public markets work (and sometimes the private market, too). But they aren’t risking that their valuation sensitivity will leave the science unfunded as long as other investors outbid them to win allocations in the round. And if no one is competing to invest at a given valuation, then that’s not the right valuation… go lower.
We are all working together to advance worthy life science R&D programs over the long run. What we can take heart in is that the market’s price discovery mechanism allows us all to find a way to do just that. Engaging with that mechanism is how we can advance science and medicine through all market conditions.
For a much more detailed explanation of price discovery, deal allocation, and other aspects of conducting a data-driven IPO, click here.
Please click here for important RA Capital disclosures.
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