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!

  • http://bothsidesofthetable.com msuster

    Thank you, Phil. As you'll remember it was a hard decision for me but having been through the wash out of 2000/01 I felt like I had seen the movie before.

    I appreciate the kind words. And it's been great to watch you guys go from being a startup fund to being one of the go-to places for young entrepreneurs. Like First Round Capital, I've never met a True CEO who hasn't raved about their positive experiences working with you guys. Not sure even the best known Silicon Valley VCs could all say that.

    And, yes, fun to finally be working together (even if not yet announced ;-)

    Mark

  • http://bothsidesofthetable.com msuster

    thanks, Ravi. Although I've worked in India before I really don't know how the VC environment works there relative to the US. Sorry.

  • http://berislavlopac.tumblr.com BerislavLopac

    I'm curious Mark: VCs reserve the right to be paid the first, but shareholding has two aspects: participation in returns and the control of the company. How would VCs react to a suggestion that okay, they can have liquidation preference, even preferred, but their shares only bring half as much (or some other factor) votes as the common shares owned by the founders?

  • Ivan Gaviria

    Mark,

    Great post. For those who are still learning about this stuff, I'd also recommend the chapters on “The Term Sheet” and “The Exit” in Jeffrey Bussgang's book which are written in a similarly accessible style and give some additional color and perspective on these issues.

    Two small comments – I'd tweak the cap table in that model spreadsheet to have more like 6-8M shares for founders instead of 1,000,000 so that in a typical Series A deal you are landing on a price per share below a buck. While you can always play with splits and such to move the price per share, you should expect your common stock valuation (for option pricing purposes) to be somewhere in the range of 15-30% of the Preferred Price and so it makes for more attractive option pricing to have a bit lower A price than $3. Also, there is a funny psychology around options. Even super smart people who understand perfectly that 1% = 1% seem to prefer a job offer with 100,000 options over one with 10,000 options.

    Regarding the comment about carve-out plans, I'd also remind people that carve-outs are essentially the company's agreement to pay mgmt bonuses which corporate liability gets paid ahead of liquidation preferences. As such, they are compensation and taxed as ordinary income (as opposed to capital gains on the sale of your founders' stock). Something to keep in mind when you're trying make apples:apples comparisons.

    Lastly, I'll differ a bit with you on the comment that most lawyers don't tell founders how to negotiate these provisions or what is market or how they can get screwed. If that is the case, people are STILL getting the wrong lawyers. The VC world is a specialized place where you need advisors who know their way around and don't just understand the terms but have seen how they play out in real situations in up markets and down. I don't want to start another thread on how to pick lawyers as there are many resources out there. I think it's pretty simple, just get list of the clients and a sampling of the deals; those two things will immediately let you know if you're shopping at the right place. Then it's just an exercise in checking references and seeing who feels like the best fit.

  • sigmaalgebra

    Shuster's blog post describes a sad situation:

    The post makes venture capital look like an effort to get something good out of dirt pit, cock fighting: Dumb because nothing good comes from there — get a lot of blood in the dirt and torn feathers and maybe some money changing hands in a zero-sum game and nothing good.

    Why am I reminded of the Wall Street remark “I could teach my dog to be an investment banker in a weekend”?

    Or if we list everything important in venture capital in large type on one side of a 3 x 5″ card, how much room is left over on the card?

    Or once again, as we can conclude from a recent entry on this blog, that I reference below, this time in venture capital, we see an old 'business model' being pursued blindly, refusing to wake up and see what is going on, and spiraling down.

    Good things have happened and can happen in the economy but not from cock fights.

    Here there are too many people losing and really nearly no one gaining. Let's consider four major cases:

    (1) The limited partners MUST want gains from venture capital because from a table at

    http://www.bothsidesofthetable.com/wp-content/u

    in

    Both Sides of the Table

    What’s Really Going on in the VC Industry? What Does it Mean for Startups?

    by Mark Suster on July 16, 2010 at

    http://www.bothsidesofthetable.com/2010/07/16/w

    commonly university endowments are down 25% from 2008 to 2009; from the financial news fixed income interest rates are low from overnight to 30 years; and we all need to see future inflation is a concern meaning that the real interest rates now are likely negative.

    (2) The general partners MUST want gains because apparently about half of them are about to look for different jobs; as in the blog above:

    “I was at dinner with a large LP and mentioned that I had heard the industry would shrink by 50%. She laughed and said, 'Our predictions are for a much larger drop.' Gulp.”

    Big Gulp, indeed.

    (3) The entrepreneurs, of course, want gains.

    (4) And the US economy needs to get MOVING again.

    So, as in

    What’s Really Going on in the VC Industry?

    these are “The worst of times.”

    It's also “the best of times”; let's see four points:

    (1) Hardware. Now can buy, for about $200 each, a 4 core, 64 bit, x86 family processor with a 3.0 GHz clock, a 2 TB SATA hard disk drive, a motherboard with bells and whistles, about 8 GB of main memory, and a nice tower case and power supply. With three hard disks for reliability, that's a total of $1400.

    Can do a lot of computing with that. A spare bedroom with two 24 x 48 x 72″ wire shelf units full of such tower cases can serve enough Web pages and ads per year to be a significant business.

    One of the last of the 'water heater' mainframes had a clock of about 150 Ghz; so the speed is up by a factor of roughly 80 and the price, electric power, software cost, etc. are so much less they are lost in the old roundoff error.

    AMD and Intel just reported record quarterly earnings — people ARE buying computers.

    (2) Infrastructure Software. Lots of Unix based software is free; the basic Microsoft .NET software is free, and the Microsoft BizSpark program will provide more software for free to new businesses for a while.

    (3) Bandwidth. Internet bandwidth is growing and prices are falling, e.g., can get 15 Mbps upload speed (that used to be 10 T-1 lines) for $55 a month. Can put 100 Gbps on one wavelength on an optical fiber, maybe dozens of wavelengths on one long haul fiber, dozens of fibers in one cable, etc.

    (4) Internet. The Internet is one of the more important steps up in civilization: The 500 million users of Facebook is maybe twice the US population of computer users and means that about one person in 13 on the planet is on Facebook; Technorati has long since been tracking over 100 million blogs; the tree cutting media, TV, and ads are all moving to the Internet.

    The Internet is growing: E.g., as at

    http://www.avc.com/a_vc/2010/06/ad-spend-trends

    in

    Ad Spend Trends

    is a graph by Hal Varian and from Fred Wilson:

    “But what this chart says is that over that past decade Internet has gone from nothing to 5% of all the ad spend in the US.

    “That is the most bullish signal about investing in the Internet that I have seen this year. If you include audio over the Internet (what radio becomes) and video over the Internet (what TV and cable become) in the Internet line, then I bet Internet will someday be over two-thirds of the ad spend.”

    Web 2.0 should be a license to print money for the limited partners, the venture partners, the entrepreneurs, the advertisers, and people looking for good jobs and a rich flow of nitromethane into the engine of the US economy.

    Beyond Web 2.0, higher economic productivity from computer-based automation should be spreading all across the US and then being sold to the rest of the world for whatever they have to trade — I'll take one of Chambertin, one of Montrachet, and two tickets to La Scala, thank you!

    From “the worst of times”, there's a SERIOUS problem, and we need to look at it. Let's consider one entrepreneur typing in software for a Web 2.0 project. In this we should keep in mind the example the Canadian Web site Plenty of Fish as at:

    http://highscalability.com/plentyoffish-archite

    So, there is one guy, two servers, ads just via Google, and $10 million a year in revenue.

    Continuing, apparently what is on the 3 x 5″ card are five 'stages': Angel, Seed, A, B, and C.

    Okay, in more detail, especially for the entrepreneur, there are project 'milestones':

    (1) The early plans that convinced the entrepreneur to do pursue the project.

    (2) Completion of the crucial work in the plans.

    (3) A Web site the VCs can “play with”.

    (4) A live Web site with users — might take $2000 in hardware.

    (5) Ads, say, 10 per second at $0.10 RPM for

    0.10 * 10 * 3600 * 24 * 365 / 1000 = 31,536

    dollars a year in revenue.

    (6) 100 ads a second, and users and revenue per day growing quickly.

    (7) Profitability (doesn't take much revenue considering just one entrepreneur running a Sub-chapter S-corporation).

    (8) $1 million a year in revenue.

    (9) Ads, say, 100 per second with good ad targeting for $4 RPM for

    4.00 * 100 * 3600 * 24 * 365 / 1000 = 12,614,400

    dollars a year in revenue.

    Okay, in this list, let's consider two 'milestones' S1 and S2 where:

    (i) Milestone S1 is the latest the entrepreneur can still use equity funding and, to get venture funding, is willing to get into a cock fight, work for a Board that doesn't understand the work and can fire him, and get a lot of lawyers involved.

    (ii) Milestone S2 is the earliest a good venture firm is willing to offer significant funding.

    It does very much look like in the most important cases S1 < S2 by 1 or several stages. That is, the latest the entrepreneur is willing to take the money is one or more stages short of the earliest a VC is willing to invest the money.

    Here's the rub: About the smallest S2 can be for significant venture interest is when the Web site has gone live and the number of users is significant and growing. Everything the entrepreneur did before that point has value $0.00 on the 3 x 5″ card. However, by then, assuming the project is as planned, the entrepreneur is also likely within just a few months of being profitable enough to fund growth just from revenue until revenue is above the Plenty of Fish $10 million a year at which time the entrepreneur already has in his bank account more money than from a Series A. Then he has no Board and little need for lawyers; he spends no time entertaining a Board that doesn't understand the work; he keeps his bookkeeping and tax returns simple; he needs no 'option pool'; he need spend no time on 'negotiating', 'term sheets', or dirt pit, cock fighting; he owns 100% of the company with no 'vesting' schedule; and there is no Board that can fire him.

    Here's another point: As we know from Facebook, there are more than 500 million Internet users out there.

    Well, for a Web 2.0 site, there is some number, say, n, of Internet users that, once they hear about the site and try it, will become users. Okay, what fraction of Internet users is n? Well, if the site has grown fairly quickly to, say, 100,000 unique users a month or 25 million ads a month or some such, then we are beginning to estimate that the fraction is significant. Or, if you will, imagine a survey that asks Internet users if they have heard of the site. Maybe when extrapolate from the survey sample the number that have heard is 1 million. So, the 100,000 is 10%. Then we guess that we are close enough to a simple random sample and estimate that the site could get 10% of all Internet users. Now we're talking millions of unique users a month and a significant business. Net, an early 100,000 is an important 'sample' that extrapolates to something significant.

    Well, both the venture partner and the entrepreneur can see this sampling and extrapolation.

    The next question is how fast the growth will be? For that can set up a little differential equation: time t, users per day y(t), users now y(0), total eventual users b, so that for some k, we have k y'(t) = b y(t) (b – y(t). The solution is left as an exercise (hint: it is in terms of some exponentials).

    So, the k is essentially a 'viral coefficient' that says how fast people who have heard of the site tell people who have not heard of the site. The solution is an S-curve, really the 'logistic curve' that once saved a now famous company. Should be able to estimate the viral coefficient.

    Doing this calculation, the entrepreneur can begin to guess when the 'big bucks' will start.

    So, with the extrapolation and the S-curve, the entrepreneur might conclude that waiting a few months, less time than he'd need to get a VC check anyway, he should just ignore venture capital and pay attention to his business.

    So, venture capital is not looking for deals like Plenty of Fish (which stands to have its revenue continue to grow). So, instead, venture partners are reduced to looking for much less good deals where both sides are reduced to some dirt pit, cock fighting. Bummer for everyone (except maybe the lawyers).

    If the venture partners were doing well, then they might not be concerned. But on average, they are going out of business. They need to do better. Cock fighting over bad deals looks like bad business, and it is.

    The situation is too close to private equity investing: For the value of a company, just use obvious criteria, say, from accounting. Then, look for owners just desperate for some cash due to, maybe, a nasty divorce, loss of a key employee, too much in fast women and slow horses, some family member who wants a few million dollars in cash to build some monument to ignorance. Such investing is dirty business, bottom fishing and not innovation or a way to move the economy forward. The economy needs buyers of last resort, but it's still not nice business.

    Above I outlined the problem, serious for nearly all concerned except possibly for a site like Plenty of Fish, and we should not expect that to be the only future for Wen 2.0 or computing.

    Now I move on to the solution:

    Get venture capital needs to get out of the dirt pit of cock fighting, off the 3 x 5″ card, past the Mother Goose story 'The Little Red Hen', and somewhere into the 20th century, hopefully the 21st century.

    In particular, essentially everything important in innovation should be clear enough at stage (1) above. For this, two changes are needed:

    (A) The entrepreneurs need much more definite, solid planning. E.g., as in the blog post with a talk by Eric Ries

    Founders 2010 #9: Conditions of Extreme Uncertainty

    July 21st, 2010

    at

    http://www.feld.com/wp/archives/2010/07/founder

    entrepreneurs need to dumpster the planning with such “uncertainty”. It did appear that Ries had fun running down the entrepreneurs telling them that 90% of them would fail. Ries embarrassed himself: What is important is the conditional probability of success given a solid plan; that should be much higher than the Ries 10%; and the Ries statement indicates that he doesn't see that it is possible to tell in advance what solid plans are. Ries thinks the work is just throwing wet stuff against the wall to see some random 10% that sticks — ignorant, destructive, disgusting.

    Instead, right there in stage (1), entrepreneurs need to know quite definitely what the heck they are doing and build a solid, rational case. Right: Can't do that in a 'foil stack' of 12 foils in large type or six foils, etc. And if all the venture partner wants to do is 'play with the Web site', then they are ignoring nearly everything that is important and, in a biomedical analogy, looking at the color of the pills and the label on the bottle and ignoring the important aspects of the contents — just SUCKS for everyone concerned.

    Referencing this blog, Fred Wilson just posted

    Terms, Term Sheets, and Terminal Value

    and emphasized that what really matters is “terminal value”. Right. But starting with an early milestone, for people without some golden intuition, seeing that far into the future takes serious, solid work, MUCH more than just a short 'foil deck'.

    Is such planning possible? Yes, and else we in the US would all be speaking German, Russian, or Chinese by now. E.g., essentially everything important in US national security for at least 70 years has been from solid planning, just on paper, at essentially just stage (1): The proximity fuse, radar, radar jamming, passive sonar, spread spectrum radar with shift register sequence encryption, …. And except maybe for DARPA projects where high risk was accepted, the failure rate has been lower than admitted for venture capital. Beyond technology projects, for operational projects the US WWII effort in Europe — North Africa, Sicily, Normandy — emphasized planning in fine detail with essentially 100% success. E.g., in the first 55,000 allied troops who landed at Normandy, about 10% were injured and about 3% died.

    (B) VCs need to be able to read and evaluate such plans and, then, DO that effectively. Reviewers at DoD, NSF, and NIH can; likely some biomedical VCs can; Web 2.0 VCs should also.

    Else entrepreneurs with poor plans and VCs with just 3 x 5″ cards will be forced into dirt pit, cock fighting where everyone loses.

    Many entrepreneurs with good plans will take the path of Plenty of Fish.

    However, this path is still not good for many of the most promising founding CEOs: The model assumes that the founder takes the project from the first plans all the way essentially to first revenue and, for a good project, within a few months of significant revenue, just with his own checkbook. So, this approach tends to rule out as venture funded founders the most experienced mid-career people with families. Instead, if the project is good with, say, $500 million estimated market capitalization within a few years, then for venture capital to play hard to get and to refuse to evaluate the project early on when the entrepreneur had to is bad for nearly everyone.

    I am reminded again that not everyone can get rich. Instead, it is too common for people to snap, like the alligators in the pit in the movie 'Romancing the Stone', at any short term food.

    It looks like information technology venture capital will morph more into private equity where they invest mostly in 'special situations' and not in the mainstream of the future of computing or the Internet.

    Guys, this is SERIOUS. We need to start actually thinking and do better.

    For me, I want nothing to do with dirt pit, cock fighting and entertaining a Board that doesn't understand my work and can fire me, and with my vesting schedule has a big fiduciary reason to do so, and am learning more about what to do with my project from the Plenty of Fish example, $1400 computers, and ad arithmetic than from VC blogs.

  • http://www.jasonwolfe.co.uk/ Jason Wolfe

    Thanks John for the input, yes I agree those are all excellent factors for potentially deciding the valuation of a business. I still struggle with the natural difference (usually in perception) between what the entrepreneur (the current owner of the business) and the investor thinks those are worth. You're absolutely right about how a better-informed investor should come up with a better price.

    But given that there's no easy way to get to this number still vexes me. The entrepreneur usually knows their proposition really well, but often doesn't have the experience to be able to come up with a sensible valuation. The investor often has a view of what they want to pay, but not necessarily what it is worth.

    Throw in “greed” where both sides are looking to get the best of any deal and it gets cloudy quite quickly.

  • http://profiles.yahoo.com/u/NAQ2FQDBCTAOR3W5HIUJI6IHWE ankit

    After reading this post I got great understanding of the VC company evaluation. Thanks.

  • http://twitter.com/yegg Gabriel Weinberg

    What would you think if the next financing was carved out? That is, if there is no financing it is 2x, but if there is, it falls back to a “clean term sheet?”

    On your first point, just to press a bit harder, if they raised 10K and it was 2x that would be harmless, right? So there is a sliding scale so-to-speak, where the amount does matter. Maybe it causes everyone to ask for it, but the retort of it being a small amount does carry some weight. You make it seem that every VC would unreasonably dig in on that point regardless of the amount of preference.

    I realize it is tough to think in my shoes given that you're seeing and funding stuff that by definition requires more financing.

  • http://www.klatergoud.com Rik Wuts

    How would this conversation change when the founders have put in cash and/or already have a meaningful revenue stream? What would that mean for the preferred-ratios in particular?

  • http://www.vcexperts.com Michael

    Great post. VC Experts has some excellent data on the terms and valuations venture funded companies are getting at http://www.vcexperts.com . They also have a new web application that can show entrepreneurs the effect certain terms will have on their ROI at liquidity.

  • jrh

    You're absolutely right about bargaining, but as your own comment says so eloquently — the most important term is trust.

  • jrh

    I agree with Al. Having a participation rate greater than 1x shouldn't be a deal breaker.

    All serious investors get preferred stock, and all are expecting to get more than their investment back in return. It makes sense to set out this expectation in the term sheet.

    I've definitely seen VCs fighting destructively for nickels, and I would never deal with those people again. But I don't see the correlation between that behavior and participating preferred.

  • http://blogs.fluidinfo.com/terry terrycojones

    Hi Mark

    Funny to see you disagreeing :-) But I think we're talking about different things. I agree with your comment – if you're putting in X in exchange for Y, you shouldn't be then hit with the surprise creation of an option pool. The fact that the option pool is going to be created should be known and factored into the price you pay.

    My issue is with other things that seem clearly wrong / awkward with the standard process. I gave a couple of simple examples in the comments that follow on that thread in AVC in case you want to read more. E.g., the company gets sold an hour after a financing, before any pool stock is issued: who owns that pool stock? It should very clearly be the property of the original team, not shared with the incoming investors who didn't pay for it, but the argument from the VC world is that they own a percentage of that pool stock too. Sorry if this seems unclear, the example I give is clear & simple. The whole arrangement is just far clearer and simple when the pool is created after the financing is closed. Then everything is aligned.

    Terry

  • Michael_RightSite

    Mark — this is the most helpful post on understanding the basics of VC deals that I have seen yet. I would like to find out more, but I think you may have put me off of VC funding forever.

  • http://bothsidesofthetable.com msuster

    Agree to disagree on this one ;-)

  • http://bothsidesofthetable.com msuster

    Options are always common.

  • http://bothsidesofthetable.com msuster

    There are great lawyers out there and the best ones walk entrepreneurs through the details. Still, I have never seen a lawyer calculate voting percentages of preferred stock and walk entrepreneurs how these could possibly be used as veto power in certain scenarios and/or describe how different investors might see financing events differently going forward depending on fund size, etc. Lawyers do much – but there is much more to do.

  • http://blog.yourentwesplit.com Mike

    I just hope I can find it 1 year from now!

  • http://bothsidesofthetable.com msuster

    When founders put in money it gives them more leverage in the negotiations but never more than having competitive investors wanting to put money to work. If you have a meaningful revenue stream you have huge leverage and deal structures will be totally different.

  • http://bothsidesofthetable.com msuster

    Cool. Thanks for the link for people.

  • http://bothsidesofthetable.com msuster

    No reason to be put off. There are great VCs out there. I'm just pointing out that you need to be educated about how valuation and term sheets work. And triangulate enough with other entrepreneurs to find out who the good VCs are.

  • http://www.klatergoud.com Rik Wuts

    Thanks! That's what I figured.
    Can you elaborate a bit on what exactly will change in the deals in that situation?

  • http://www.mattbartus.com/ Matt Bartus

    If a founder wins the voting battle, it's typically the opposite — they have shares of a separate class of super voting common stock (e.g., 10 votes for each share of common). But in my experience they need to have huge leverage to win that battle, and at the early stage most do not. I think Google has this.

  • http://www.businessmoneytoday.com/ Phanio

    Please dive deeper on term sheets. I really like your perspective being from both sides and still feeling some of the pain from not understanding your eariler terms.

  • ariel

    Can you quantify meaningful revenue stream. If you are 1-3 months post a beta launch and you have revenues from 5-10 trial customers (assume its a B2B sale) — is that leverage?

  • http://twitter.com/rlhez Romain Lhez

    Thanks for your post. I know how hard it can be to describe as accuratlely and simply something that is, I guess, really obvious for you now.

    I wanted to know if things work in the same fashion with Business Angels or are there some major differences (option pull included in pre-money valuation (?) & liquidation preference (?))

    Thanks a lot,

  • http://technbiz.blogspot.com paramendra

    Dig deeper, dig often.

  • http://www.gordonbowman.com Gordon Bowman

    Great post and video. I wish I had seen it when I was learning all this years ago. I posted it on my blog too.

    Here's another great resource for learning about term sheets. Justin Fishner-Wolfson's Term Sheets 101 presentation:

    http://www.slideshare.net/dmc500hats/term-sheet

  • Susan Morgan

    Great post. I am both an attorney and entrepreneur, having started two companies, and worked for 10+ years as a corporate attorney focused on entrepreneurs, startups and private companies (currently: Of Cousel to Scott Walker – at Walker Corporate Law Group). I am also an adjunct professor at Golden Gate University, where I teach a course on “High Tech Startups – Business and Legal Issues” (course is cross-listed with Law and Business/Management Schools). A significant portion of my course focuses on this topic – teaching law and business students how to understand VC financing terms and term sheets, and their implications.

    I have looked at a lot of books on this subject, and the one I use in my class is by Alex Wilmerding: “Term Sheets & Valuations”. It's paperback, affordable, and understandable by the uninitiated. And it does a pretty good job of going through the “gotchas”. (No, I do not receive any renumeration for recommending the book – I have no economic interest here). This stuff is hard enough to learn (and a real challenge to teach), so I thought I would throw out this resource, in case anyone was interested, or found it helpful (particularly, for the entrepreneurs).

    Cheers!

  • philsugar

    I can give you one at DLAPiper that definitely does…..he has a large practice.

  • http://influads.com/ damiansen

    As an entrepreneur, I can't say good enough about this post. Great learning.Definitely make the 3-hour TWIVC with lawyers and all :)

    I just wonder one thing: KISS, could these things just be simpler, plain flat terms?

    If these terms were “flattened” to a simpler, non abusive form, VC's money would consequently be worthed differently due to the risk they had to take but it would remove complexity from the process and have “money on the table” as the variable to discuss.

    I'm newbie on this subject so I am not sure if it make sense… Could it be?

  • http://berislavlopac.tumblr.com BerislavLopac

    Matt, thanks for the answer. But are those super-voting stocks instead of the common, or in addition to them?

  • http://www.emergingenterprisecenterblog.com/ Dave Broadwin

    Great post. Entrepreneurs who have delivered good exits can and should negotiate fair (even advantageous) deals. Everyone else ends up taking what they can get (if they can get any investment at all). As a result, “normal” terms reflect a strong bias towards the investor. Appreciate your stand against participation (at 3x entreprenuers should run screaming from the room).

  • Susan

    Years ago the Council for Entrepreneural Development in RTP,NC had a course taught by local entrepreneurs called FastTrac. Kauffman Foundation sponsored it and they taught all sorts of things like this and some patent law. They modified it over the years and I believe put it out for other groups to use.

  • http://twitter.com/mikikian Michael Mikikian

    Hi Mark, great post and video. Kelly great job!

    If Venture Hacks coined the phrase the “Option Pool Shuffle”, can I coin the phrase the “Preference Giveaway”?

    The “true” or “effective” valuation of the common stock is actually less than your spreadsheet calculates because it assigns an equal value for preferred stock as it does for common stock. As we know, preferred > common (as the name implies ;) and should be reflected as such in the cap table. The formulation in your cap table (and every other cap table I've seen on this topic) “gives away” these preferences for free, which I would argue is not accurate.

  • kris

    Request for the next show: options.
    How do VCs make sure the option pool won't be increased after they've done the deal?
    Who decides what the fair value is in between 2 rounds?
    A few examples of what employees get would be nice.

    When I started watching the show I was like oh no, spreadsheets and a business guy who never started a business … am I supposed to listen to this?
    However, I'm glad I ignored my allergy and I listened to the entire show.
    You should definitely do more shows like this, it's a good resource! Thank you.

  • http://javierrincon.posterous.com/ Javier Rincón

    Great framework for valuations. I would love to know about your experience in other countries. It seems that everything I learn, when applied to Spain, I have to divide by factor of 2 or 3.

    Do you have any experience in Europe, for example, the UK? How do these frameworks fit in with VC market in Europe?

  • http://twitter.com/oscarjofre Oscar A Jofre Jr.

    hi Mark,
    I am from Canada, I must tell you that I found your post extremely useful. How VC work has been such a hush topic nobody talks about it and everyone is doing the guessing game.

    I will make sure you post gets to all the entrepreneurs sites in Canada.

    EDUCATION is critical and the more we have the better Entrepreneurs and future leaders we become.

    Look forward to reading more post from you
    Oscar A Jofre
    Founder, President/CEO
    BoardSuite Corp.

  • http://twitter.com/earbits Joey Flores

    Hey Mark, great post and very helpful. Is it safe to say much of this applies to Angel investments as well?

  • http://www.kraasecurity.com Baha

    Hi Mark
    A friend of mine from SVB turned me on to your blog this morning. This post was exactly what we were talking about this morning, great coincidence. I will definitely have to read all your posts.

    I am glad to hear you had a positive comment about True Ventures.
    Regards,
    Baha
    KRAASecurity.com

  • http://bothsidesofthetable.com msuster

    Thank you for the book recommendation. Much appreciated.

  • http://bothsidesofthetable.com msuster

    I've come to realize that all terms exist for a reason. Somehow at some point in the past some company had a situation that required each term. So they stay. But the key is to KISS especially in the early stages of companies.

  • http://bothsidesofthetable.com msuster

    In April 2001 that was all I could get!

  • http://bothsidesofthetable.com msuster

    For 409a valuations the IRS agrees with you. Generally, I don't. It's true that preference stock has more “rights” associated with it and therefore more “value” – sure. But in terms of how the pie gets sliced the preference itself doesn't impact returns other than specific rights (like participation, PIKs, etc.). And each of these can be quantified individually.

  • http://bothsidesofthetable.com msuster

    Thank you, Kris. Yeah, I'm going to cover options on TWiVC.

  • http://bothsidesofthetable.com msuster

    Thanks, Oscar. And tell them to watch This Week in Venture Capital where every week we try to demystify things just a little bit more.

  • http://bothsidesofthetable.com msuster

    Most angel deals have less terms attached to them. But if angels are asking for a huge number of rights normally associated with VCs – run.

  • http://twitter.com/mbartus matt bartus

    From a legal perspective, there are typically 2 ways that a VC can ensure that it has a block on whether the options pool is increased, and usually one or both are included. The most straightforward is to require a specific vote of the preferred stock to increase the pool. The other, which is more complicated to explain, essentially says that any increase to the pool with the consent of the preferred stock would trigger “anti-dilution” protection — a topic too complex for a blog post comment, but suffice to say it is something that dilutes the common stockholders and is not desirable. From a practical perspective, you want the Board to be in agreement on actions taken such as increasing the option pool, so if you ever get to the point where you are looking at the legal ramifications then you probably have bigger problems.

  • http://twitter.com/LarsHinrichs Lars Hinrichs

    You should check the dilution calculator at HackFwd: http://hackfwd.com/dilution

  • http://twitter.com/rahul2084 Rahul

    Awesome post Mark. Question about the option pool: What happens if you don't end up using all the shares allocated to the option pool? Say you use only half of them. Does the other half default to the founders?

    And would it be correct to say the term sheets offered by angel/seed investors tend to be light weight like YC's and cover only some of the main terms you discuss?