Useful clauses for negotiating an increase in the company's valuation within a venture capital or private equity transaction

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As we've discussed many times on this blog, M&A, private equity, and venture capital transactions are negotiated within the framework of three types of agreements: (a) those related to valuation or price, (b) those related to the company’s governance, and (c) those related to risk allocation.

When an M&A transaction involves the acquisition of 100% of the capital, discussions about the company's governance rules disappear, as the acquirer gains full control of the company, eliminating the need to negotiate and sign a shareholders' agreement. However, in partial M&A transactions, as well as in venture capital and private equity deals, the three main areas for negotiation remain. In any case, valuation or price is always a point of negotiation.

In this case, we will highlight some clauses that the founders or existing shareholders of a company can use during the negotiation of a financing round for a start-up/scale-up or a private equity transaction to achieve a higher valuation of the company.

The first thing to keep in mind is that to have a real impact on the valuation, timing must be managed carefully, so that the clause intended to increase the valuation hasn't been considered previously. Otherwise, the investor will have already factored it into the valuation (or will claim to have done so).

The first clause that usually appears as a tool for adjusting valuation is the possibility of linking the valuation to the achievement of certain milestones. The equivalent in M&A transactions would be the use of an earn-out (as we discussed in this post), but in this case, it would be a valuation subject to milestones, functioning differently from a traditional earn-out. Through this type of agreement, the founder and the investor can agree on a subsequent increase in valuation if those agreed objectives are met, or a decrease, depending on whether the agreement has been formalized with or without the higher valuation subject to such objectives. This type of clause is useful when the founder is confident in achieving certain milestones that the investor does not consider feasible and is not factoring into their valuation. It is important to handle this approach carefully, or it could end up reducing the valuation instead of increasing it.

The second clause of interest to achieve a higher valuation, especially in financing rounds (venture capital), is the founder's offer of a reverse vesting. We covered this type of agreement in this post. As mentioned in the post, reverse vesting can be linked to (a) the founder's permanency in the company, (b) the achievement of specific objectives, or (c) the fulfillment of one or more obligations. These types of agreements work in a very similar way to the first type of agreements discussed and allow for a higher valuation by providing comfort to the investor. The most common use of reverse vesting is linking it to the founder's permanency, as it is an objective and easily applicable variable.

The third clause that can be used is related to liquidation preferences, which we have already discussed in this other blog post. These clauses are very common in both venture capital and private equity transactions. Their legal configuration can be achieved either by creating classes of shares or without creating different classes, although the creation of distinct classes is the most common option. This mechanism allows for an increase in the company's valuation by granting the investor a minimum preferential and priority return over the founder or other shareholders. Due to the significant impact this can have on the founder(s) and other shareholders not benefiting from the liquidation preference, granting this enhanced economic right to the investor must be weighed against the company's actual economic forecasts, as incorrect use of this clause could result in the complete loss of economic return for the founder(s) and shareholders that are not receiving this right.

A fourth clause useful for increasing the valuation is related to anti-dilution rights, commonly used in venture capital but less used in private equity. The use of anti-dilution clauses has been discussed in several previous posts, such as this one. This clause is perhaps one of the easiest to negotiate due to its conceptual simplicity, although there are many formulas that can be used for its implementation. In this case, as long as the company continues to raise investment rounds without decreasing its valuation (i.e., without a downround), it will not be affected by this clause.

A fifth clause (or rather a parallel agreement) that the parties can agree upon to achieve a higher valuation is offering the investor a future investment or acquisition right at a certain valuation, such as at the same valuation as the current investment round or private equity investment. In other words, the granting of a warrant at an attractive price for the investor, which they will execute depending on how the company evolves. The problem with this instrument is that while it may allow an increase in the current valuation, it could have a significant dilutive impact in the future if the company performs well. Its success for the founder and existing shareholders will depend especially on whether its use is accompanied by a greater increase in the next valuation and whether its dilutive effect is also borne by future investors entering the company.

A sixth and final clause worth highlighting is the granting of put options in favor of the investor at a specific, significant price (not at one euro). However, these types of clauses carry a legal risk of nullity in Spain, as they could be classified as prohibited financial assistance. In this post, you can see how these types of put options should be analyzed in relation to the prohibition on financial assistance in Spain.