In a pay-to-play provision, an investor must keep “paying” (participating in future financings) in order to keep “playing”(not have his preferred stock converted to common stock) in the company.
“Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above under “Right of First Refusal” below will be converted into Common Stock.
[(Version 2, which is not quite as aggressive): If any holder of Series A Preferred Stock fails to participate in the next Qualified Financing, (as defined below), on a pro rata basis (according to its total equity ownership immediately before such financing) of their Series A Preferred investment, then such holder will have the Series A Preferred Stock it owns converted into Common Stock of the Company. If such holder participates in the next Qualified Financing but not to the full extent of its pro rata share, then only a percentage of its Series A Preferred Stock will be converted into Common Stock (under the same terms as in the preceding sentence), with such percentage being equal to the percent of its pro rata contribution that it failed to contribute.]
A Qualified Financing is the next round of financing after the Series A financing by the Company that is approved by the Board of Directors who determine in good faith that such portion must be purchased pro rata among the stockholders of the Company subject to this provision. Such determination will be made regardless of whether the price is higher or lower than any series of Preferred Stock.
What are some key issues for founders? There are several issues founders should focus on. First, they must understand that pay-to-play provisions will not typically be included in a Series A term sheet – and that’s something they’ll need to raise and appropriately discuss with the investors.
A reasonable position might begin like this: “We are looking for investors who are in for the long haul and will agree to support the company throughout its lifecycle.” From there, pay careful attention to how the investors respond.
Liquidation preferences for many series
Liquidation preferences are easy to understand when dealing with a Series A term sheet. It gets complicated to understand what is going on as a company matures and sells additional series of equity.
There are 2 primary approaches:
1. The follow-on investors will stack their preferences on top of each other (known as stacked preferences) where Series B gets its preference first, then Series A.
2. The series are equivalent in status (known as blended preferences) so that Series A and B share proratably until the preferences are returned.
Series A ($5m invested at a $10m premoney valuation)
Series B ($20m invested at a $30m premoney valuation)
Sale of $15m
Approach 1 (Stacked preference) Series B investors get all $15m
Approach 2(Blended preference) Series A get 20% and Series B get 80% ($5m/($5m+$20m) = 20%)
In both cases, founders receive nothing.
In early stage financing, it is better to have no participation as it sets the precedent for future funding.
Participating Preference, Straight Preference, Participation Caps
A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).
To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.
Obviously, this can get much more complicated as you start to have multiple rounds of investments with a PP feature. A simple way to think about how the economics of a PP works is that the total dollar amount of the preference will come off the top of the exit value (and go to the investors); everyone will then convert into common stock and share the balance based on their ownership percentages. For example, assume a company raises $40m over 3 rounds where each round has a PP feature and the investors own 70% of the company. If this company is sold for $200m, the first $40m would go to the investors and the remaining $160m would be split 70% to investors / 30% to everyone else. In this case, the investors would get a total of $152m, ($40m + $112m, or 76% of the proceeds – 6% more then they would have gotten if there was no PP.)
If you sit and ponder the math, you’ll realize that a PP usually has material impact on the economics in low to medium return deals, but quickly becomes immaterial as the return increases (or – more specifically – as the ratio of the exit value to invested capital increases). For example, if a company is sold for $500m, a $10m PP re-allocates a small portion of the deal ($10m of the $500m) to the investors vs. the $40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP usually only matters in a low to medium return situation. If a company is sold for less than paid in capital, the liquidation preference will apply and the participation feature will not come into play. If a company is sold for a huge amount of money, the PP won’t have much economic impact, as the preference feature of the PP becomes a small percentage of the deal total. In addition, in essentially every case, PP’s don’t apply in an IPO where preferred stock (of any flavor) is typically converted into common stock at the time of the offering.
However, we do still use the participating preferred in two circumstances. First, it is a great way to bridge a valuation gap with an entrepreneur. Let's say we feel the business is worth $10mm but the entrepreneur feels it is worth $20mm. We could bridge that valuation gap by agreeing to pay $20mm with a participating preferred. If the Company is a big winner, then it won't matter if we paid $10mm or $20mm. But if the Company is sold for a smaller number, say $50mm, then having the participating feature gives us a return that is closer to what it would have been at our target valuation of $10mm. The other place a participating feature is useful is when the entrepreneur might want to sell the company relatively soon after your investment. In that case, there is a risk that not much value will be created between your investment and an exit. A participating preferred works well in that situation as well.
As PP started showing up in more deals, some creative lawyer came out with a perversion on the preferred feature called a “cap on the participate” (also known as a “kick-out feature.”) In this case, the participation feature of the PP goes away once the investor holding the PP reaches a certain multiple return of capital. For example, assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor would benefit from their PP until their proceeds from the deal reached $15m. Once they reached this level, their shares are no longer counted in the cap structure and the other shareholders share the remaining proceeds. Of course, the investor always has the option to convert their shares to common stock and give up their preferred return (but participate fully in the proceeds). Put another way, at a high enough valuation the investor is better off simply converting to common (in the current example at an exit value above $30m).
Participation caps, however, have a fundamental problem – they create a flat spot in most deal economics where the investor gets the same amount across a range of exit values. If we stay with the example above and assume a 50% ownership for the Series A, the PP would apply until the exit value reached $25m, at which point the investor receives $15m in proceeds. Between $25m and $30m, the investor would continue to receive this same $15m (this is the flat spot – it doesn’t matter whether the exit value is $26m or $29m, the investor would get $15m). At exit values above $30m, the investor would convert to common stock and take 50% of the proceeds (i.e., their as-converted share of the proceeds would exceed the $15m cap so they would be better off converting to common and taking this share of the exit value). This is an odd dynamic, since the common shareholders are clearly not indifferent to exit values in this flat spot, but the investor is (and consider a case where this flat spot was much larger than the one in the example above). Any way you cut it there is misalignment, at least for a range of outcomes, between the investor and the rest of the shareholders.
Another perversion is the “multiple participate”. In this case, the investor gets some multiple of his participate off the top of the transaction. For example, a 3x multiple participate on a $40m investment would mean the first $120m would go to the investor (and then the remaining proceeds would be distributed to the investor and the rest of the shareholders). This type of PP only appeared for a short while when investors were doing recapitalizations without actually going through the mechanics of recapitalizing the company (more about this in a future blog post).
Interestingly, there is a case to be made that PP in early financing rounds can actually end up disadvantaging early investors. The math on this gets complicated very quickly, but if you assume that every subsequent investment round has at least as favorable terms as the initial round (i.e., include a PP if the first round does) and that subsequent rounds include new investors there are many cases where the initial investor is actually disadvantaged by the existence of the PP (they would have been better off to have not put it in the initial round and because of that pushed for its exclusion from subsequent rounds). It’s counterintuitive, but it actually works out this way in a number of very common financing scenarios.
So – if PP simply relates to economics, why is it a term that brings out such emotion in entrepreneurs and investors alike? A close friend of mine who is an extremely successful entrepreneur recently told me “I’ve walked on every investment deal for any company that I’ve run that even smelled of multiple dips of participation – and spit back in the direction the term sheet came from!” We debated back and forth a while. For example, I asked him “would you take $5m for 33% of a company with no participate or 25% of a company with full participate?” He responded “I would go find a deal where I gave up 26.5% without a participate” which, while an emotional reaction, ironically reinforced my point that it was just economics. After pondering this term over the years, I’ve concluded that participating preferred is one of those terms that creates real tension between the entrepreneur and the investor – it forces the acknowledgement by the entrepreneur that a moderate return is not a success case for the investor and at the same time forces the investor to acknowledge that in those moderate cases they believe it is fair to receive a greater percentage of the proceeds at the expense of the entrepreneur.
The vast majority of VC investments are structured as preferred stock. It’s called preferred because it “sits in front of” the common stock. Typically in VC investments, founders receive common stock, employees receive either common stock or options to purchase common stock, and the VCs receive preferred stock. This preferred stock has a series of special rights which almost always include a liquidation preference. The liquidation preference means that the VC will have the option – in a liquidity event – of either receiving their liquidation preference as their return or converting into common stock and receiving their percentage ownership as their return.
ExampleConsider the following example. Acme Venture Capital (AVC) makes an investment in an established company called Homer Software that has been bootstrapped by the founders. Homer Software has shipped a product in an exciting market and generated $3m of revenue in the past 12 months. AVC invests $5m at a $10m pre-money valuation. As part of this investment, AVC and the founders of AVC agree to a 20% option pool for new employees that are going to be hired to be built into the pre-money valuation (see Venture Capital Deal Algebra if this doesn’t make sense). The result is that AVC owns 33.3% of the company, the founders own 46.7% of the company, and 20% is reserved for options for employees. In this example, AVC purchases Series A Preferred Stock that has a liquidation preference.
Now – consider two outcomes.
- Homer Software continues its rapid growth and is acquired for $100m. AVC has a choice – either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($33.3m). Easy choice.
- Homer Software struggles and is acquired by a competitor for $9m. AVC again has a choice – either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($3m). Again, easy choice.
When cash or public company stock is used in an acquisition, the valuation can be mathematically determined with certainty. However, when the acquirer is a private company, the valuation is much harder to determine and is often ambiguous as it depends on the value of the private company and the type of stock (common, preferred, junior preferred, or some other special class) being used. In these cases, the use of the liquidation preference is less clear cut and it’s critical that the company have objective, outside (independent) directors and experienced outside legal counsel to help with determining valuation.
One exception to the liquidity event is an IPO. Typically, an IPO will force the conversion of preferred stock to common stock, eliminating the liquidation preference. In most cases, the IPO event is an “upside liquidity event” so the need for the liquidation preference (and corresponding downside protection) is eliminated (although this is not always the case).
Capitalization table and liquidation model
Capitalization table - A spreadsheet or table that shows ownership stakes in a company, typically a startup or early stage venture. A capitalization table is a record of all the major shareholders of a company, along with their pro-rata ownership of all the securities issued by the company (equity shares, preferred shares and options), and the various prices paid by these stakeholders for these securities. The table uses these details to show ownership stakes on a fully diluted basis, thereby enabling the company's overall capital structure to be ascertained at a glance. (Investopedia)
- All three classes of preferred (Srs A, Srs B, and Srs C) are straight preferred
- No multiple or dividends.
- Srs C is senior to the Series B which is senior to the Series A
Seed round financing - Valuation caps on convertible debt
Convertible debt: A convertible note is a loan that converts into equity in the Series A round.Valuation cap: The valuation cap sets the maximum price that your loan will convert into equity.
Convertible notes are often used for seed rounds (the first investment money taken by a startup) because they delay the difficult task of deciding how much the company is worth to a later point in time when it is easier to do so.
How does a convertible note work?
When you invest through a convertible note the startup receives the money right away, but the number of shares you are entitled to is determined during its next round of financing, or Series A. At that point the company will have some operating history that more experienced angel investors or venture capitalists can review in order to determine a fair price. Once the series A investors have determined a price, your loan converts into shares at a discount to the series A price to reward you for the additional risk you took on by investing early. The amount of equity that a note converts into depends on the price of the A round plus 2 key components of the your note.
Discount Rate: The discount rate establishes how much you will be compensated for the additional risk you take on by investing in a company before the series A investors. For examples, if you invest using a note with a 20% discount rate, and the A round investors wind up investing at a price of $1/share, your note will convert into equity at $0.80/share and you will receive 25% more shares for the same price.
Valuation cap: The valuation cap is another way to reward seed stage investors for taking on additional risk. The valuation cap sets the maximum price that your loan will convert into equity. To translate that into a share price, you divide the valuation cap by the series A valuation.
Seed financing of $1m convertible note
- Convert at 15% discount price
- $4m pre-money valuation cap
- $10m pre-money
- $10m investment
- $20m post-money
- Outstanding 1m shares prior to financing
- Therefore price per share of series A preferred stock = $10m pre-money / 1m shares = $10 per share
- $10m / $10 per share = 1m shares issued to Series A investor
Case one - 15% discount
- Share price for Angels = 85% * $10 = $8.50 per share
- Receive 117,647 stocks ($1m note / $8.50 per share = 117,647 shares)
- Ownership = 5.9% ( 117,647 / Total 2m shares after Series A)
Case two - $4m valuation cap (Only happens if pre-money valuation > valuation cap)
- Share price for Angels = $4m/$10m pre money valuation = 0.4x
- 0.4 * $10 = $4 per share
- Receive 250,000 stocks ($1m note/$4 per share = 250,000 shares)
- Ownership = 12.5% (250,000/ Total 2m shares after Series A)
It is important to note that the discount rate and valuation cap do not both apply, only the method which results in the best price for the investor.
Two more important components of convertible notes
Interest Rate: Convertible notes are technically loans so they also carry an interest rate. Unlike traditional loans however this interest is paid in additional shares upon conversion of the note instead of cash. Let’s say you invest $1,000 in a startup through a convertible note with a 5% interest rate. If they receive a series A investment one year later, you would have accrued $50 worth of interest and would be entitled to $1,050 worth of shares at the appropriate conversion rate.
The note’s maturity date determines when the note is due, and the entrepreneur needs to repay it. If a startup is unable to raise a series A, or is profitable enough to make it unnecessary, the convertible note will convert into a set number of shares. This will generally be the same as if the startup had secured a Series A investment at the maturity date. For example, lets say you invest $2000 in a startup with a 24 month maturity date, a 20% discount, a $4 million valuation cap, and a 5% interest rate. Assuming shares are worth $1, after 24 months your note would convert into: $2000*1.2 = or $2,400 after the discount, plus 5% interest for 2 years = $100 so a total of $2500 worth of stock.
How Funding Works – Ownership and splitting The Equity Pie With Investors
First, let’s figure out why we are talking about funding as something you need to do. This is not a given. The opposite of funding is “bootstrapping,” the process of funding a startup through your own savings. There are a few companies that bootstrapped for a while until taking investment, like MailChimp and AirBnB.
If you know the basics of how funding works, skim to the end. In this article I am giving the easiest to understand explanation of the process. Let’s start with the basics.
Every time you get funding, you give up a piece of your company. The more funding you get, the more company you give up. That ‘piece of company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your company.
Splitting the Pie
The basic idea behind equity is the splitting of a pie. When you start something, your pie is really small. You have a 100% of a really small, bite-size pie. When you take outside investment and your company grows, your pie becomes bigger. Your slice of the bigger pie will be bigger than your initial bite-size pie.
When Google went public, Larry and Sergey had about 15% of the pie, each. But that 15% was a small slice of a really big pie.
Funding Stages:Let’s look at how a hypothetical startup would get funding.
Idea stage: At first it is just you. You are pretty brilliant, and out of the many ideas you have had, you finally decide that this is the one. You start working on it. The moment you started working, you started creating value. That value will translate into equity later, but since you own 100% of it now, and you are the only person in your still unregistered company, you are not even thinking about equity yet.
Co-Founder Stage: As you start to transform your idea into a physical prototype you realize that it is taking you longer (it almost always does.) You know you could really use another person’s skills. So you look for a co-founder. You find someone who is both enthusiastic and smart. You work together for a couple of days on your idea, and you see that she is adding a lot of value. So you offer them to become a co-founder. But you can’t pay her any money (and if you could, she would become an employee, not a co-founder), so you offer equity in exchange for work (sweat equity.) But how much should you give? 20% – too little? 40%? After all it is YOUR idea that even made this startup happen. But then you realize that your startup is worth practically nothing at this point, and your co-founder is taking a huge risk on it. You also realize that since she will do half of the work, she should get the same as you – 50%. Otherwise, she might be less motivated than you. A true partnership is based on respect. Respect is based on fairness. Anything less than fairness will fall apart eventually. And you want this thing to last. So you give your co-founder 50%.
Soon you realize that the two of you have been eating Ramen noodles three times a day. You need funding. You would prefer to go straight to a VC, but so far you don’t think you have enough of a working product to show, so you start looking at other options.
The Family and Friends Round: You think of putting an ad in the newspaper saying, “Startup investment opportunity.” But your lawyer friend tells you that would violate securities laws. Now you are a “private company,” and asking for money from “the public,” that is people you don’t know would be a “public solicitation,” which is illegal for private companies. So who can you take money from?
- Accredited investors – People who either have $1 Million in the bank or make $200,000 annually. They are the “sophisticated investors” – that is people who the government thinks are smart enough to decide whether to invest in an ultra-risky company, like yours. What if you don’t know anyone with $1 Million? You are in luck, because there is an exception – friends and family.
- Family and Friends – Even if your family and friends are not as rich as an investor, you can still accept their cash. That is what you decide to do, since your co-founder has a rich uncle. You give him 5% of the company in exchange for $15,000 cash. Now you can afford room and ramen for another 6 months while building your prototype.
Registering the Company: To give uncle the 5%, you registered the company, either though an online service like LegalZoom ($400), or through a lawyer friend (0$-$2,000). You issued some common stock, gave 5% to uncle and set aside 20% for your future employees – that is the ‘option pool.’ (You did this because 1. Future investors will want an option pool;, 2. That stock is safe from you and your co-founders doing anything with it.)
The Angel Round: With uncle’s cash in pocket and 6 months before it runs out, you realize that you need to start looking for your next funding source right now. If you run out of money, your startup dies. So you look at the options:
- Incubators, accelerators, and “excubators” – these places often provide cash, working space, and advisors. The cash is tight – about $25,000 (for 5 to 10% of the company.) Some advisors are better than cash, like Paul Graham at Y Combinator.
- Angels – in 2013 (Q1) the average angel round was $600,000 (from the HALO report). That’s the good news. The bad news is that angels were giving that money to companies that they valued at $2.5 million. So, now you have to ask if you are worth $2.5 million. How do you know? Make your best case. Let’s say it is still early days for you, and your working prototype is not that far along. You find an angel who looks at what you have and thinks that it is worth $1 million. He agrees to invest $200,000.
Now let’s count what percentage of the company you will give to the angel. Not 20%. We have to add the ‘pre-money valuation’ (how much the company is worth before new money comes in) and the investment
$1,000,000 + $200,000= $1,200,000 post-money valuation
(Think of it like this, first you take the money, then you give the shares. If you gave the shares before you added the angel’s investment, you would be dividing what was there before the angel joined. )
Now divide the investment by the post-money valuation $200,000/$1,200,000=1/6= 16.7%
The angel gets 16.7% of the company, or 1/6.
How Funding Works - Cutting the PieWhat about you, your co-founder and uncle? How much do you have left? All of your stakes will be diluted by 1/6. (See the infographic.)
Is dilution bad? No, because your pie is getting bigger with each investment. But, yes, dilution is bad, because you are losing control of your company. So what should you do? Take investment only when it is necessary. Only take money from people you respect. (There are other ways, like buying shares back from employees or the public, but that is further down the road.)
Venture Capital Round: Finally, you have built your first version and you have traction with users. You approach VCs. How much can VCs give you? They invest north of $500,000. Let’s say the VC values what you have now at $4 million. Again, that is your pre-money valuation. He says he wants to invest $2 Million. The math is the same as in the angel round. The VC gets 33.3% of your company. Now it’s his company, too, though.
Your first VC round is your series A. Now you can go on to have series B,C – at some point either of the three things will happen to you. Either you will run out of funding and no one will want to invest, so you die. Or, you get enough funding to build something a bigger company wants to buy, and they acquire you. Or, you do so well that, after many rounds of funding, you decide to go public.
Why Companies Go Public? There are two basic reasons. Technically an IPO is just another way to raise money, but this time from millions of regular people. Through an IPO a company can sell stocks on the stock market and anyone can buy them. Since anyone can buy you can likely sell a lot of stock right away rather than go to individual investors and ask them to invest. So it sounds like an easier way to get money.
There is another reason to IPO. All those people who have invested in your company so far, including you, are holding the so-called ‘restricted stock’ – basically this is stock that you can’t simply go and sell for cash. Why? Because this is stock of a company that has not been so-to-say “verified by the government,” which is what the IPO process does. Unless the government sees your IPO paperwork, you might as well be selling snake oil, for all people know. So, the government thinks it is not safe to let regular people to invest in such companies. (Of course, that automatically precludes the poor from making high-return investments. But that is another story.) The people who have invested so far want to finally convert or sell their restricted stock and get cash or unrestricted stock, which is almost as good as cash. This is a liquidity event – when what you have becomes easily convertible into cash.
There is another group of people that really want you to IPO. The investment bankers, like Goldman Sachs and Morgan Stanley, to name the most famous ones. They will give you a call and ask to be your lead underwriter – the bank that prepares your IPO paperwork and calls up wealthy clients to sell them your stock. Why are the bankers so eager? Because they get 7% of all the money you raise in the IPO. In this infographic your startup raised $235,000,000 in the IPO – 7% of that is about $16.5 million (for two or three weeks of work for a team of 12 bankers). As you see, it is a win-win for all.
How Start-up valuation works?
Let’s lay down the basics. Valuation is simply the value of a company. There are folks who make a career out of projecting valuations. Since most of the time you are valuing something that may or may not happen in the future, there is a lot of room for assumptions and educated guesses.
Why does startup valuation matter?Valuation matters to entrepreneurs because it determines the share of the company they have to give away to an investor in exchange for money. At the early stage the value of the company is close to zero, but the valuation has to be a lot higher than that. Why? Let’s say you are looking for a seed investment of around $100, 000 in exchange for about 10% of your company. Typical deal. Your pre-money valuation will be $ 1 million. This however, does not mean that your company is worth $1 million now. You probably could not sell it for that amount. Valuation at the early stages is a lot about the growth potential, as opposed to the present value.
How do you calculate your valuation at the early stages?
- Figure out how much money you need to grow to a point where you will show significant growth and raise the next round of investment. Let’s say that number is $100,000, to last you 18 months. Your investor does not have a lot of incentive to negotiate you down from this number. Why? Because you showed that this is the minimum amount you need to grow to the next stage. If you don’t get the money, you won’t grow – that is not in the investor’s interest. So let’s say the amount of the investment is set.
- Now we need to figure out how much of the company to give to the investor. It could not be anything more than 50% because that will leave you, the founder, with little incentive to work hard. Also, it could not be 40% because that will leave very little equity for investors in your next round. 30% would be reasonable if you are getting a large chunk of seed money. In this case you are looking for only $100, 000, a relatively small amount. So you will probably give away 5-20% of the company, depending on your valuation.
- As you see, $100,000 is set in stone. 5%-20% equity is also set. That puts the (pre-money) valuation somewhere between $500,000 (if you give away 20% of the company for $100,000) and $2 Million (if you give away 5% of the company for $100,000).
- Where in that range will it be? 1.That will depend on how other investors value similar companies. 2. How well you can convince the investor that you really will grow fast.
How to Determine Valuation?Seed StageEarly-stage valuation is commonly described as “an art rather than a science,” which is not helpful. Let’s make it more like a science. Let’s see what factors influence valuation.
Traction. Out of all things that you could possibly show an investor, traction is the number one thing that will convince them. The point of a company’s existence is to get users, and if the investor sees users – the proof is in the pudding.
So, how many users?
If all other things are not going in your favor, but you have 100,000 users, you have a good shot at raising $1M (that is assuming you got them within about 6-8 months). The faster you get them, the more they are worth.
Reputation. There is the kind of reputation that someone like Jeff Bezos has that would warrant a high valuation no matter what his next idea is. Entrepreneurs with prior exits in general also tend to get higher valuations. But some people received funding without traction and without significant prior success. Two examples come to mind. Kevin Systrom, founder of Instagram, raised his first $500k in a seed round based on a prototype, at the time called Brnb. Kevin worked at Google for two years, but other than that he had no major entrepreneurial success. Same story with Pinterest founder Ben Silbermann. In their cases, their respective VCs said they followed their intuition. As unhelpful a methodology as it is, if you can learn how to project the image of the person who gets it done, lack of traction and reputation will not prevent you from raising money at a high valuation.
Revenues. Revenues are more important for the B-to-B startups than consumer startups. Revenues make the company easier to value.
For consumer startups having a revenue might lower the valuation, even if temporarily. There is a good reason for it. If you are charging users, you are going to grow slower. Slow growth means less money over a longer period of time. Lower valuation. This might seem counter-intuitive because the existence of revenue means the startup is closer to actually making money. But startup are not only about making money, it is about growing fast while making money. If the growth is not fast, then we are looking at a traditional money-making business.
The last two will not give you an automatically high valuation, but they will help.
Distribution Channel: Even though your product might be in very early stages, you might already have a distribution channel for it. For example, you might have sold carpets door-to-door in a neighborhood where almost every resident works at a VC firm. Now you have a distribution channel targeting VCs. Or you might have run a Facebook page of cat photos with 12 million likes, now that page might become a distribution channel for your cat food product.
Hotness of industry. Investors travel in packs. If something is hot, they may pay a premium.
DO YOU NEED A HIGH VALUATION?
Not necessarily. When you get a high valuation for your seed round, for the next round you need a higher valuation. That means you need to grow a lot between the two rounds.
A rule a thumb would be that within 18 months you need to show that you grew ten times. If you don’t you either raise a “down round,” if someone wants to put more cash into a slow-growing business, usually at very unfavorable terms, or you run out of cash.
It comes down to two strategies.
- One is, go big or go home. Raise as much as possible at the highest valuation possible, spend all the money fast to grow as fast a possible. If it works you get a much higher valuation in the next round, so high in fact that your seed round can pay for itself. If a slower-growing startup will experience 55% dilution, the faster growing startup will only be diluted 30%. So you saved yourself the 25% that you spent in the seed round. Basically, you got free money and free investor advice.
- Raise as you go. Raise only that which you absolutely need. Spend as little as possible. Aim for a steady growth rate. There is nothing wrong with steadily growing your startup, and thus your valuation raising steadily. It might not get you in the news, but you will raise your next round.
SERIES AThe main metric here is growth. How much have you grown in the last 18 months? Growth means traction. It could also mean revenue. Usually, revenue does not grow if the user base does not grow ( since there is only so much you can charge your existing customers before you hit the limit).
Investors at this stage determine valuation using the multiple method, also called the comparable method, well-described by Fred Wilson. The idea is that there are companies out there similar enough to yours. Since at this stage you already have a revenue, to get your valuation all we need to do is find out how many times valuation is bigger than revenue – or in other words, what the multiple is. That multiple we can get from these comparable companies. Once we get the multiple, we multiply your revenue by it, which produces your valuation.
INVESTOR’S PERSPECTIVEIt is important to understand what the investor is thinking as you lay down on the table everything you have got.
- The first point they will think is the exit – how much can this company sell for, several years from now. I say sell because IPOs are very rare and it is nearly impossible to predict which companies will. Let’s be very optimistic and say that the investor thinks that, like Instagram, your company will sell for $1 Billion. (This is just an example. So do not get caught up in how unrealisict that is. This is still possible.)
- Next they will think how much total money it will take you to grow the company to the point that someone will buy it for $1 Billion. In Instagram’s case they received a total of 56 Million in funding. This helps us figure out how much the investor will make in the end. $1 Billion – $56= $ 940 million That is how much value the company created. Let’s assume that if there were any debts, they were already deducted, and the operational costs are taken out as well. So everyone involved in Instagram collectively made $940 Million on the day Facebook bought them.
- Next, the investor will figure out what percentage of that she owns. If she funded Instagram at the seed stage, let’s say 20%. (The complicated piece here is that she probably got preferred shares, which just means she gets the money before everyone else. Also, there might have been a convertible note as part of the funding, which gave her the option to buy shares later on at a set price, called “cap”.) Basically, all of these are just anti-dilution measures. The investor that funded you early on does not want to get diluted too much by the VCs who will come in later and buy 33% of your company. That’s all that is. Let’s assume in the end, like in How Startup Funding Works, the angel gets diluted to 4%. 4% of $940 million is $37.6 Million. Let’s say this was our best case scenario.
$37.6 Million is the most this investor thinks she can make on your startup. If you raised $3 Million in exchange for 4% – that would give the investor a 10X returns, ten times their money. Now we are talking. Only about a 3rd of companies in top-tier VC firms make that kind of a return.
DOES THE VALUATION REALLY MATTER?
Consider two scenarios – Dropbox vs. Instagram.
Both Dropbox and Instagram started as a one-man show. Both of them were or are valued over $1 Billion. But they started with very different valuations:
- Drew Houston went to Y-Combinator, where he received about $20K in exchange for 5% of Dropbox. Valuation 400K (pre-money).
- Kevin Systrom went to Baseline Ventures and received $500k in exchange for about 20% of Brbn (predecessor of Instagram). Valuation $2.5M.
Why were the valuations so different? And, more importantly, did it matter in the end?
OTHER THINGS THAT INFLUENCE VALUATIONOption Pool. Option pool is nothing more than just stock set aside for future employees. Why do this? Because the investor and you want to make sure that there is enough incentive to attract talent to your startup. But how much do you set aside? Normally, the option pool is somewhere between 10-20%.
The bigger the option pool the lower the valuation of your startup. Why? Because option pool is value of your future employees, something you do not have yet. The options are set up so that they are granted to no one yet. And since they are carved out of the company, the value of the option pool is basically deducted from the valuation.
Here is how it works. Let’s say your pre-money valuation is $4M. One million is coming in new funding. Post money valuation is now $5M. The VC gives you a “term sheet” – which is just a contract that contains the conditions upon which the money is given to you, and which you can negotiate. The term sheet says that the VC wants a fully diluted 15% option pool in the pre-money valuation. This means that we need to take 15% of the $5 million (post-money valuation), which is $750, 000 and deduct it from the pre-money valuation ($4 million minus $750,000). Now the true valuation of our company is only $3.25 Million.
Pre-money, Post-money and Option pool
Pre-money: Valuation of a company prior to an investment from VC or Angel calculated on a fully diluted basis.
Post-money: Valuation of a company after an investment from VC or Angel.
Option pool: Shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a start-up company
Fully diluted: Include issued and outstanding options, warrants and other convertible securities. May include unissued options.In-the-money: Strike price < market price
Pre-money = Founders' share + option pool
Post-money = Pre-money +investment amount
Example 1 (wikipedia)
Initial shares in company = 100 (100% owned by founders)
Investors buy 20 newly issued stock at $10 million.
Post-money = $10million/20shares * 120shares = $60 million
Pre-money= $60m - $10m = $50m
Founders ownership = 100shares/120shares = 83.33%
Initial shares in company = 120 (100 owned by founders and 20 owned by Round A investors)
Investors buy 30 newly issued stock at $20 million.
Post-money = $20m/30shares*150shares= $100m
Pre-money= $100m - $20m = $80m
Founders ownership = 100shares/150shares = 66.67%
Pre-money valuation of round B > Post-money valuation of round A = Upround
Pre-money valuation of round B < Post-money valuation of round B = Downround
Successful companies receive series of uprounds until they are acquired or go public.
Example 2 (wiki)
Initial shares = 1,000,000
Convertible loan note = $1,000,000 at 75% of the next round price
Warrants for 200,000 shares at $10 price
ESOP of 200,000 shares at $4 price
Investment of $8,000,000 at $8 price
Post money = $8 * Total number of shares after transaction
Total number of shares = Initial 1,000,000 + 1,000,000 from new investment ($8,000,000 / $8) + 166,667 from loan conversion ($1,000,000 / (75% * $8) ) + 200,000 from ESOP in-the-money options = 2,366,667 shares
Warrants cannot be exercised because they are not in-the-money (the price of $10 per share is higher than investment price of $8 a share)
Post money = $18,933,336
Pre money = $18,933,336 (Post money) - $8,000,000 (Investment) - $1,000,000 (Loan conversion) - $800,000 (ESOP) = $9,133,333
Example 3 (socaltech)
Pre-money valuation = $4.5m
Capitalization: 3 founders own 3m talks (1m each)
Option plan: Employees granted options to purchase 1,500,000 shares of Common stock. None exercised yet and option pool is 3,000,000 shares
Pre-money = $4.5m
Post-money = $7.5m ($3m + $4.5m)
Price per share of Series A = Pre-money valuation / total number of shares outstanding fully diluted = $4.5m/(3m+1.5m from option plan) = $1.00 per share
By basing the share price on a fully diluted basis, the investors are making existing common stockholders assume the diluting effect of the un-exercised options. Sometimes, investors will also negotiate for the fully-diluted number to include unissued options and any increase in the size of the option pool in connection with the financing. Occasionally, venture capital investors will request that an option pool be increased to make sure there are enough shares to provide adequate incentives to the startup’s employees and management. This will dilute the existing common stockholder even more.
Impact of fully diluted basis: Nothing changes except for the definition of the fully-diluted basis on the dilution of post-money percentage ownership of the existing common stockholders. From Scenario 1 to Scenario 3, I want to highlight the fact that the nothing changes except for the definition of the fully-diluted basis – the valuation never changes – and the investors still go from owning 25% of TechStartup, Inc. to owning 40%.
Example 4 (fast ignite)
Deal: 2 on 3 with 20% option pool ($2m investment with $3m pre money and 20% on post)
Means company is worth $2m (true pre money), investors put in $2m and $1m is reserved for option pool for a post money valuation of $5m. Investors and founders both own 40% of the company. If no option pool, they both own 50% and the post money will be $4m.
Why increase option pool?
- Deal engineering. It’s true, some investors pad the pre-money with a large option pool and try to sell this to entrepreneurs as their company having a higher value. That’s bull and won’t fly in the end. Even if an entrepreneur doesn’t understand what’s going on, the company’s lawyers will be able to point it out. If they didn’t, fire them.
- Pushing more capital. Sometimes, a large option pool allows an investor to deploy more capital. This works in the case when the investor wants to (a) invest relatively more money into the company and (b) positions that they absolutely must own at least X% of the company. Say, the investor wants 20%. If the company is valued at $10M then the investor would put in $2.5M for a post money of $12.5M ($2.5M / $12.5M = 20%). However, if a 30% option pool is added then the post money will be $20M (the pool will be $6M) and the investor will put in $4M ($1.5M or 60% more than before!). The pre-money would have jumped to $16M. As an entrepreneur, I’d love this. I get more money ($4M as opposed to $2.5M) and I don’t get diluted any further. Well, technically, the true pre-money valuation is a smaller percentage of the total but as long as I don’t waste the option pool, the unused portion will come back.
- Convenience. It is easier for investors to start owning X% and, with a well-padded option pool, know that their ownership percentage is more likely to go up on exit, when unissued options are canceled, as opposed to down, as the option pool is increased. Also, from a board perspective, it is simply easier to not have to grow the pool every few months.
- Board dynamics. Increasing the option pool requires board approval and in some cases, depending on the rights of the preferred investors, various shareholder votes. When there are multiple investors and/or classes of preferred shareholders, it may be difficult to grow the option pool even for very legitimate reasons. Investors who want companies to be able to appropriately reward employees and others through equity may want to ensure that the option pool is sufficiently large at the point when they have maximum leverage–during a financing. I experienced this situation with a European investment I made. The partner representing the largest existing European VC had a rather limited notion of how much equity it took to motivate management and employees. I negotiated hard to get the maximum increase in the option pool possible (on top of a valuation we had already agreed upon) because I doubted the company’s ability to increase its pool post financing.
- Protect from dilution. They protect everyone from dilution. If you take a term sheet with an artificially small option pool, it will have to be increased in the future and your ownership will be diluted. To take Jeff’s specific example, the second deal 6 on 9 with 30% pool is noticeably better than the 6 on 7 deal with the 20% pool even though the promotes are nearly identical because the extra 10% in the pool are insurance against another 10% dilution. In short, don’t get into deals because you feel you’ll own more of the company only to find out that you get further diluted in the future through option pool increases.
Example 5 (simenov)
Pre-money is not what the founders should look at because it includes the option pool. Instead, founders should look at "the promote" which is founder ownership * post money
A: 6 on 7 offer with 20% pool ($6m investment on $7m pre money with 20% options on post)
B: 6 on 9 offer with 30% pool ($6m investment on $9m pre money with 30% options on post)
A = $4.4m promote
B = $4.5m promote