Want to Know How VC’s Calculate Valuation Differently from Founders?

Posted on Jul 22, 2010 | 113 comments


Back in 1999 when I first raised venture capital I had zero knowledge of what a fair term sheet looked like or how to value my company.  Due to competitive markets we ended up with a pretty good term sheet until we needed to raise money in April 2001 and then we got completely screwed.  It was accept the terms or go into bankruptcy so we took the money.  Those were the dog days of entrepreneurship.

But the truth is that I didn’t really understand just how screwed I was until years later when I finally understood every term in a term sheet and more importantly I understood how each term could actually be used to screw me.  Things like “participating preferred stock” in legalese unsurprisingly never actually call out, “hey, this is the participating preferred language.”  We got a 3x participating liquidation preference with interest (not participating with a 3x cap, but 3x participating.  Ugh. I explain the difference later in the post or you can click through on this link above for an explanation).

Back then VentureHacks didn’t exist.  Brad Feld hadn’t written his seminal “term sheet series” and The Funded hadn’t yet been created.  And for some strange reason entrepreneurs didn’t share this information.  Other founders, “as a privately held company we don’t disclose our valuation.”  Me, “dude, I’m not a journalist.  I just want to figure out what a fair valuation is.”  I figured all the VC’s talked so we should. Duh.

I don’t feel that as a VC sneaking in nefarious terms into a term sheet that the entrepreneur doesn’t understand is a good way to build a long-term relationship nor to build a long-term reputation but this does happen and more frequently than we all would like.  I’ve started from day one trying to build total transparency into my process with entrepreneurs.

This starts with understanding how VCs and entrepreneurs often see valuation differently.  And no prizes for guessing which side of the table really understands the right answer.  I’m not sure I really even need to write this at length because Nivi absolutely nailed the topic in his article “The Option Pool Shuffle.”

When I went to raise money in 2006 I thought I knew every term in a term sheet but somehow I still got a bit duped by the option pool shuffle.  I had several term sheets and one of the leading term sheets had an option pool of 40% in it.  I couldn’t understand why they wanted so many options until a friend pointed out that this just lowered their “true” pre-money valuation (they also asked for some sharp elbowed terms in the deal).

I turned them down.  They were nonplussed.  They couldn’t understand how I could turn them down when they considered themselves the leader in my field and they had worked so hard to get the deal.  I told them that True Ventures had stuck to their brand name and submitted a totally clean term sheet.  No gotchas.  No option pool shuffle.  No hidden terms.  So they agreed to match True’s term sheet.  I thought to myself, “OK, they were willing to F me when they thought I had no idea what I was talking about . Now that I do they’re willing to accommodate?  Gee, if they treat me like this in good times I wonder how they’d treat me in bad times!”

So to make sure it never happens to you, as a loyal reader of this blog and hopefully an occasional watcher of This Week in Venture Capital, I recorded a video session with my colleague Kelly Hwang on how VCs calculate valuations and he’s created a cap table spreadsheet you can download from DocStoc to plug in all of the terms and you can watch the video here and/or read the text summary below.

How VC’s Calculate Valuation: We walked through a standard deal where you raise $1 million at a $3 million pre-money valuation leading to a $4 million post money valuation.  The math works out that the investor owns 25% of the company post deal ($1 million invested / $4 million valuation) and assuming 1 million shares, each share would be valued at $3 / share ($3,000,000 pre-money / 1 million shares = $3 / share).  Investors own 25%, the founders own 75%.  NOTE: In the video I talked about how VC’s and entrepreneurs decide the total number of shares at the first major funding round and why it’s often a high number.

But this example above is all entrepreneur math, not the VC’s.  The VC assumes you’ll have an option pool.  That’s normal.  You’ll need to hire and retain talen to grow your company.  Those options need to come from somewhere.  The more senior members you have (say you already have a CEO, CTO, VP marketing, VP Biz Dev, VP Products) then the less options you’ll need and vice versa.  Industry standard post your first round of funding will be 15-20%.  I say “post” funding because you’ll need more than this amount pre-funding to get to this number after funding.  We walk through this in the video.

So taking the same fund raising round and assuming that the VC wants the options including before he or she funds (and before is totally standard) then the math works like this: Assuming a 15% option pool post funding then you need a 20% option pool pre funding (because the pool gets diluted by 25% also when the VC invests their money).  So your 100% of the company is down to 80% even before VC funding. Normal.

The VC’s $1 million still buys them 25% of your company – it’s you who has diluted to 60% ownership rather than 75%.  The price / share is actually $2.40 (not $3.00), which is $3,000,000 pre-money / 1,250,000 shares (because you had to create the 250,000 share options).   Thus the “true” pre-money is only $2.4 million (and not $3 million) because $2.40 per share * 1 million pre-money outstanding shards = $2.4 million.

Note that the term sheet you get will still say, “Pre-Money = $3 million” and there won’t be anywhere in the term sheet that says “true Pre-Money” or “effective Pre-Money” – that’s for you to calculate.  So let’s start calling the term sheet listed pre-money valuation as the “nominal” pre-money valuation.  Luckily you all now have the spreadsheet to download that will calculate both for you.

Term Sheet Overview:

The second most important economic term in the term sheet other than price is “liquidation preference.” This states how the proceeds from a sale or dissolution of the company will be distributed.  Investors will always want to get their money out of the company before founders, which in the case where the company is sold for a low price is fair.  You almost certainly will have liquidation preferences if you raise VC so don’t worry about having them.

But not all liquidation preferences are equal – we discuss all this in the video – some can have a “multiple” on top of them such as a 2x liquidation preference, which means that investors get 2x their money before founders get anything.  In an early round of investment where there is not an extremely high price relative to normal valuations this is anything but benign.

More likely what you’ll see if you have an aggressive term sheet is “participating preferred” stock.  This means that investors get their money back AND they get to share in the proceeds.  If you’ve raised $6 million in total and still own 40% of the company and sell for $10 million (not a great outcome but it happens) then with participating preferred investors would take $6 million off the top and then 60% of the remaining $4 million so the founder’s take would be $1.6 million (.4 * $4 million) and not $4 million. Note that it might be even less than $1.6m because liquidation preferences often have interest calculated on top of them.

VC’s in early rounds will argue that “participation” is simply downside protection and if you sell for a lower price they should get more of the proceeds.  While true, the problem I have is that any terms you have in your early stages will certainly be asked for by future investors in your later funding rounds so all of these terms pile up when you’ve been through 3-4 rounds of funding over a 5 year time frame.  And by the time most companies get to an exit (which despite what you read on TechCrunch about all the high-profile early exits the most realistic case is still 8-10 years) often the founders own very little of the economic upside.  This is a shame.

Privately some early-stage VC’s talk about participation helping them to “juice their returns” on smaller exits.  This is silly talk.  I don’t imagine any VC seriously makes money by having tons of small to mid-sized outcomes and therefore “juicing” to me is delusional. I think VCs make money by investing in 20-25 deals and finding 2-3 outliers that drive extra-ordinary returns.  And those are often done by the best and smartest founders who have enough knowledge to know which VCs are juicers and which aren’t.  You reap what you sow.

I also won’t say there is never a time for “participating preferred” but it tends to be in later-stage rounds and particularly in the case where the founders are getting an exceedingly high valuation relative to the norm.  In those cases there are all sorts of mathematical reasons why participation might make sense.  These are edge cases.

But for founders stuck in this negotiation about participation or not with VCs the most standard compromise is “participation with a cap” which is usually set at 2-3x their investment.  This means that participation truly only applies in downside scenarios and once your exit outcome is above a certain price investors would still be better off converting to common stock and not taking their preference.  I prefer to see no participation but this is a good compromise if you can’t get a straight 1x liquidation preference.

After valuation in the video we went through Liquidation Preferences, Board Seats, Protective Provision, Voting Rights, Drag Along Rights, Redemption, Anti-Dilution and a few other key terms.  We spend a lot of time on them in the video but frankly we could have done a 3-hour session.  If I get demand from people after this video to do a deeper dive on term sheets we will.  Heck, maybe we’ll even invite a lawyer on to do it with us!

  • Howard

    Great Stuff Mark! I raised NO money for my first start-up. My 2nd Start-up, now 6 years old, was primarily funded by Venture money and OH! (ouch!) what a difference in my daily mindset and fundamental approach to business. I am an operator and like many entrepreneurs, neglected some critical subtleties in deal terms, hoping it all will take care of itself (or my attorney would) in my zeal to get on with building business. This is a must read primer for all thinking about VC raise. thx

  • paul s germo

    Outsatnding post – makes those of us who are seeking capital – a little nervous and much more aware. Thanks for your integrity.

  • kris

    require a specific vote to increase the pool … is that done very often?

    When you don't get permission, it could sort of make it difficult to find good employees.

  • kris

    Thanks.

  • http://www.betadvisor.com Jerome Camblain

    Mark, I have a question that might be trivial about the second sheet of your spreadsheet (incl options).
    If options are added in order for the VC to calculate the option dilution before investing, shouldn't the cash paid at the exercise time by the option holders (the strike price) be included (on top of the negotiated entreprise value) in the valuation to a) reflect the true value of the exercise and b) reduce the dilution for the founders by including both sides (dilution compensated by extra cash) of the option equation?

  • justfunded

    Thanks, just going throught the same process and your account matches our experience.

  • Piyushp

    Great post, Mark. You are a real hero who is providing valuable information to people. It's not that this information is not available anywhere but providing in way which people can read in 5 minutes and understand easily is rare to find.
    If an investment firm is asking for more than 1x liquidation preference, I will prefer to put a clause where they cannot make more than 20x returns. Higher the liquidation preference, lower the maximum return. I guess this is very reasonable. If you are looking for limited risk you deserve limited returns as well.

  • http://www.graduatetutor.com/finance-tutor.php Finance tutor

    Thank you for joining Brad and Fred. Reading your blogs is a true education. I tutor business school students and tell them to start reading here know whats going on in the real start up world!

  • LV

    Here is a link to an article that they posted that follows your post. http://vcexperts.com/vce/news/buzz/archive_view
    We currently use the company analysis tool that modeled this, and it is amazing.

  • Susan Morgan

    There is a great tool for computing the complete waterfall analysis of distributions (including options, warrants, management/bonus plan carve-outs …), for ANY and ALL values of merger or acquisition sales. Go to http://www.equilytics.com, and download the “Sample Spreadsheet” there for an example of the MergeComp Analysis.

  • Bhagya4

    Good one Mark. What a treasure of good advice for entrepreneurs!

  • http://profiles.yahoo.com/u/TBCK2YLRQHFAUN5K5RFF7I3CEE Trent

    You should write a (book or 2) and go into teaching, at least as an 'adjunct'…

  • Curious investor

    Quick Question:
    For the option pool, are there stipulations on who those options go to? i.e. can the board issue those future options to the current management team?