Negotiating a Better Series A Deal

11/12/09

[Updated 11/18/09, see below] This post is about how to get a better deal from VCs investing in your first round of financing. It is also about how to make the deal into a win-win. The idea for the post came from an exchange with @bakespace about some of the resources for entrepreneurs on FastIgnite.

This is About Series A Deals

Seed investments can be all over the map in terms of size ($50K – $1M+), structure (convertible debt or common/preferred equity), valuation, and investor rights. It’s hard to make generalizations about seed deals.

First-money-in Series A deals, on the other hand, tend to be much more cookie-cutter. Before we talk about why this is the case, let’s put a rough definition around the types of Series A financings I’m referring to:

• Not much has been raised previously—at most a few hundred thousands and ideally nothing.

• The product has not been (fully) built.

• The size of the round is at least $3M but preferably larger.

• You are talking to professional VCs with funds > $100M.

These deals tend be cookie-cutter because they are driven more by the cap table (the list of shareholders in a startup and how many shares they own) than by what the company might be worth independently.

What is Your Startup Worth?

This is a question entrepreneurs think a lot about. They come up with all kinds of arguments for justifying their notion of value pre-funding. The trouble is, most of the arguments are bogus because they miss an important point: a company that needs several million dollars today to build a business is not worth much at all without the dollars.

Say the goal is to stick a flag on top of Everest. You are a great alpinist but you have no money for the expedition. Your friend Bob loves what you do, happens to be excited about you climbing Everest and has tons of dough. Which is more important? Your ability to climb or the financing? You ability to climb is certainly scarcer and hence commands a certain premium, but in the end it’s a partnership. Money without an alpinist can’t get to Everest. An alpinist without funding can’t get to Everest either. It is the combination of the scarce talent (climbing) and the resources to make this talent productive (the dollars) that creates the value.

The Series A Valuation Process

What this means for your Series A deal is that, to a large extent, the value of your company is going to be reverse-engineered from the cap table. Here is how this works:

1. You and your investors agree you need $X ($3M, for example)

2. The investors want to own a certain percentage post-financing (I%) (2 x 20% = 40%, for example if two VCs are syndicating the deal)

3. The post-money valuation is now $X/I% or $3M/40% = $7.5M

4. You negotiate the size of the option pool (P%) (25%, for example)

5. Your true pre-money valuation (what the founders’ stake is worth) is $X*[(1-I%-P%)/I%] or $2,625,000.

There are two things to notice about this process. First, at no point did it require justifying the value of the startup. Second, the margin for negotiation is somewhat limited as (a) the option pool size should be budget-driven and (b) most investors, rightly or wrongly, are pretty set on the percentage ownership they require. (The reasons for this have to do with the business models of venture firms—which are too complicated to cover here.)

Without meaningful deal competition, you’ll be unlikely to affect the investor(s) target ownership percentage. So if you really want to get your VCs to take a lower percentage, you’ll have to work a lot harder to generate interest from multiple firms. Either that, or you’ll have to … Next Page »

Simeon (Sim) Simeonov is a serial entrepreneur and investor. Currently, he is founder and CTO of Shopximity where he works to make shopping better for everyone. You can read his blog at http://blog.simeonov.com and follow him on Twitter at @simeons. Follow @

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  • http://www.startable.com Healy Jones

    I think you nailed it with point #2, that VCs are looking for a particular % ownership in the company. As I’ve blogged about before, I think VCs major valuation tool is how much of the company they’d like to own; thus the more $ you ask for the higher pre-money you are likely to be offered (within reason, of course. And assuming you can raise anything at all.) So to your final point that asking for additional money might be worth it even if you end up with owning less of the company may be less of a trade-off if you ask for it upfront and the request is reasonable.
    My post on how VCs value early stage startups is http://www.startable.com/2009/05/18/early-stage-venture-capital-valuations/

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  • http://www.swifthrsolutions.com Kathi Jones

    This is one of the best articles on Funding I have read in a long time. The focus on win-win is key and since we work with a number of early-stage technology, life science, and Cleantech companies we know how important that is to their success.

    We posted the link to the article on our Blog and also sent it off via email to clients we know are raising money.

    Thank you, Sim, from all of our early-stage clients and prospects winding their way through this confusing labyrinth

  • http://fastignite.com Simeon Simeonov

    Healy, you are absolutely right, which is why it is important to target the right investors in the first place.

    Kathi, thanks, I appreciate it.

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  • Krassen Dimitrov

    OK, this makes absolutely ZERO sense whatsoever.

    Let’s assume a 100% multiplier

    In Case 1 the “Future” value of the company will be $10.5M ($7.5M post-money plus $3M execution “value-add”), of which Founders will own 35%. Thus the value of their holding will be 0.35×10.5M= $3.675M

    In case 2 the Future value of the co. will be $11.277M ($7.777M post-money + execution bump of $3.5M), of which the Founders will own 30%. Thus the value of their holding will be 0.30×11.277M= $3.38M

    $3.675M > $3.38M

    Now let’s look at the VCs. In case 1 their future holding will be valued at 0.4×10.5M= $4.2M, and in case 2 it will be valued at 0.45×11.277M= $5.07M

    Case 1 is better for Founders, Case 2 is better for VCs.

    Summary:

    1.Always, ALWAYS, try to get higher pre-money valuation.
    2. Many VCs lie with numbers.
    3. #2 is especially true if the VC is with Polaris (see GreenFuel Technologies, Inc.)

  • http://blog.simeonov.com Simeon Simeonov

    Krassen, thanks for joining the conversation.

    Let me address your points first:

    1. Your statement that entrepreneurs should always try to get higher pre-money valuation is not great advice for two reasons

    1.1. Pre-money typically includes an option pool. Given the same raise amount, would you prefer a $5M pre with $4M option pool or a $4M pre with a $2M pool. Not sure about you, but I’ll go with the $4M deal in almost all cases. The anti-dilution effect of a large option pool cannot compensate the additional founder dilution of case one.

    1.2. Perhaps you were referring to true pre-money (the founders’ stake) as opposed to just pre-money (which includes the option pool). Even then, entrepreneurs should absolutely not go on valuation alone. Valuation alone is the guide only if everything else is the same (pool, raise, terms). I mention this in the article. However, when other things are not equal, you have to start making the types of comparisons this article is about.

    2. In my experience as both an entrepreneur and and VC I haven’t found VCs “lying” with numbers. Most are happy to share a spreadsheet with their financing model. Not sure how one can “lie” in this case as both numbers and formulas are there for everyone to see. If you are referring to spin, however, I’m 100% with you. Not all but some VCs exploit the informational advantage they have with respect to entrepreneurs. They don’t spend enough time educating entrepreneurs about the process and about the terms, math and consequences of what’s happening. At the same time, entrepreneurs are not interested/focused-enough to learn about this. Time and time again I’ve found entrepreneurs not sufficiently curious about the business models of venture firms and the intricacies of financings.

    3. I’m not sure what you are referring to with respect to Polaris. For the record, I’ve long left the firm and am currently with FastIgnite. If you want to chat with me privately about something that happened, shoot me an email. Contact info is at http://fastignite.com/about.

    As for the numbers, I can certainly have a bug in the calculator. Will look more closely at it today. But I’m afraid you may be misunderstanding the concept of the execution multiplier (or I’m not clear about your math). The execution multiplier applies not to the total amount of capital raised but to the delta ($500K in the example). Perhaps we should chat on the phone?

  • http://krassend@gmail.com Krassen

    Yes, would love to talk, but am stuck at an airport, going to Beijing for a week now. Sorry for the snark; article sounds a bit as lecturing founders to take lower value in exchange for more money, which is a nasty double hit. You may chose more money/higher dil, but not at expense of premoney Val
    are you Bulgarian?

  • http://blog.simeonov.com Simeon Simeonov

    Ok, I will email you my cell. Look forward to discussing.

    The point of the article is true–pre-money (true or not) is absolutely not the sole variable to optimize on.

    Yes, I’m Bulgarian.

  • http://www.commonangels.com James Geshwiler

    Sim: very good points. I would suggest there’s one larger factor in getting the best “deal,” which is having shared expectations with the investor about leadership and exit that works for the founders. It doesn’t matter what deal a founder makes if A) they are gone from the company; or B) the investors push for an exit that’s too high to ever happen. Investors have a portfolio; founders have one shot. If the investors give up because this deal ain’t going to move their needle, the founder is the one left with the big zero. This may be part of your “execution risk,” but it’s a more binary than linear variable.

    In response to the other comments, somewhat counter intuitively, higher valuations can leave founders with nothing. Usually the higher the valuation, the more likely investors are inclined from the start to shoot for the moon. Even if the company is successful, there will be a lot more capital raised a long the way; the resulting dilution may not work out for the founder any better than a lower price on the first round and greater capital efficiency.

  • http://fastignite.com Simeon Simeonov

    James, yes, choosing the right investor partner is, within limits, more important than the financial deal. Only after you’ve reduced the set of potential investors to those with good fit does it make sense to do the type of optimization I write about.

    The second point you raise is interesting. There are counteracting effects there. I wonder whether anyone has done a study of the effects on founders’ returns.

  • http://multipliereffect.net/ calculate multiplier effect

    I love the line about entrepreneurs making mistakes while thinking about percentage owned, as opposed to what it’s worth. Owning 75% something worth 1¢ is worse than owning 1% of a company worth $1000.

    I know the numbers are small, but you get the point!