How to assess the value of a startup in case of eviction?

Lessons from the Solendro-Breega lawsuit.

In late January, the founders of Solendro revisited the lengthy dispute with the Breega and Internet Attitude funds in a controversial article.

In summary, the two funds (then majority shareholders) have:

  • – Voted for the removal of the founders from their positions as president and CEO in July 2020
  • – Triggered a forced share buyback clause (known as the bad leaver clause) outlined in the shareholder agreement to acquire the founders’ shares at a low price.
  • – Depleted Solendro’s cash reserves and orchestrated its placement under judicial reorganization.

The founders particularly note that in France, the legal system favors a reparative logic. In their case, the court annulled the fraudulent decisions, and each founder received €50,000 in damages for moral prejudice. However, comparing the cost of damages to the perpetrators (€100,000 in total) to the potential gain from their fraud (with the forced buyback of their shares valued at €2.7 million in total), it is evident that there was much more to gain than to lose. The reparative sanction is inherently not dissuasive, especially when considering the means of those involved in this case.

In reality, if the reparative logic had been perfectly respected, the founders should have been compensated for the loss of the opportunity to enjoy a higher valuation of their startup (due to the lost development years until the court decision and the wrongdoing committed against Solendro’s cash flow).

However, judicial bodies allow such behaviors to thrive when they lean too conservatively in granting reparations.

In this specific case, the difficulty lies in the valuation of a startup, bearing intrinsic uncertainty that the judicial system can easily interpret as the outright impossibility of quantifying the damage.

 

Limits of Traditional Valuation Methods

Traditionally, a company is valued using a multicriteria approach, including (i) analysis of future cash flows it can generate based on historical results (DCF method), (ii) analysis of valuations of comparable companies, and (iii) analysis of the company’s assets.

In the case of a startup, (i) the history may be unrepresentative or insufficient to project future cash flows, (ii) the high uncertainty about the company’s evolution significantly limits the use of comparables, and (iii) the company, by definition, has little or no assets.

Moreover, these approaches generally rely on a notion of fair market value that is not easily applicable to a startup. For example, during a capital increase, a startup faces many rejections from investors valuing it close to 0 (or almost) rather than receiving investment proposals.

As a result, the market value of a startup tends to approach 0. Investors looking to increase their stake actually consider an intrinsic subjective value to the company, a potential/development option.

While this intrinsic value can sometimes be approximated by conventional methods, more suitable methods have been developed since the late 80s (with the emergence of startups).

 

Venture Capital Method

The Venture Capital method was developed at Harvard in the mid-80s.

It is an investor-centric method to determine a so-called ‘postmoney’ value.

The valuation logic is as follows:

  1. Determination of a target exit value through a conventional approach (often by DCF or by multiple of revenue/EBITDA) considering the startup’s success.
  2. Determination of a target investment multiple: =(1+r)t / (1-p) with r as the target IRR, t as the investment horizon, and p as the company’s bankruptcy risk.
  3. Determination of postmoney value = (target exit value x capital retention ratio / target investment multiple). The retention ratio accounts for potential dilutions over the investment period.

Option Valuation Methods

The application of real options valuation to startups dates back to the late 90s, but this method was already used to assess numerous projects with limited risk (for example, valuing a gold mine in relation to the exploration cost or the commercial potential of a drug compared to the allocated R&D budget).

This method involves:

  1. Treating the startup as a financial option allowing the possibility to purchase a share (the startup’s cash burn corresponds to the option premium, the duration of this cash burn to the option maturity, etc.).
  2. Applying the relevant financial options valuation model—the most widely used being the Black-Scholes-Merton model (or derivatives).

In a nutshell:

Since the 1990s, valuation methods based on the specificities of startups (such as VC investment and cash burn) have been developed to address the shortcomings of traditional approaches.

However, it is important to note that in a legal context, these methods must be employed within the specific methodology for assessing damages. The loss of an opportunity to enjoy a better valuation should be calculated as the difference between two valuations – one hypothetical, which would have occurred in the absence of faults, and the other actual.

Furthermore, any exchanges between the parties should be taken into account during the evaluation (for instance, contractual liability is limited to the foreseeability of the damage).

For any clarification: arnaud.cluzel@outmatch.fr

 

 

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