06 December 2018

ECGI: May the force be with you - investor power and company valuations

The ECGI working paper shows that this logic changes in the context of staged financing where investors shift from being outsiders in their initial investment to becoming insiders in subsequent investment rounds.

Authors build a theory of staged financing to analyse the effect of investor power on the valuation of a company. They show that whenever there is a powerful investor who is an outsider, he always wants to push down the valuation. However, if a powerful investor already has a stake in the company, there is a trade-off. On the one hand, the powerful investor invests new money and therefore wants a lower valuation, just like an outsider. On the other hand, he already has a stake in the company, and prefers a higher valuation, just like an insider. The net preference depends on the relative sizes of the existing stake versus the new investment. Authors´ theory provides a simple condition that says that a powerful investor prefers a higher (lower) valuation whenever his follow-on investment is below (above) the so-called pro-rata threshold. The important and novel finding is that within a staged financing context, market power may increase, not decrease, company valuations.

This raises the question whether and when a company wants to bring a powerful investor inside? They compare a scenario where the company obtains first-round funding from a powerful investor, with the scenario where the company delays bringing in a powerful investor until a later financing round.

Full working paper

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