Negotiating a Better Series A Deal

11/12/09

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find a smaller VC fund that can’t afford to invest a lot of money and will be willing to grant you the same type of pre-money valuation while putting in less capital and hence owning less. Of course, raising less capital may not be a good idea. More on this in a moment.

You absolutely should not low-ball the size of the option pool. Investors have data across many companies and they probably have a better sense than you about how big a pool your type of company will need. More importantly, if you need to grow the pool later, everyone’s ownership stake will go down, yours included.

What’s left to negotiate? The one remaining variable is $X, the capital you raise.

Negotiating a Better Series A Deal

The first part of negotiating a better Series A deal has to do with going to the right investors. Some investors, typically VCs with larger funds, won’t care much about giving you an extra few hundred thousand or even more than a million if you have good reasons for asking for it. Even better, they may give you the additional money without asking for more ownership. That’s a no-lose proposition for entrepreneurs (assuming you don’t squander the money, of course). Why are VCs willing to do this? Because for larger funds, cash is not scarce. Partner time, however, is very scarce. A parter at a larger firm may be more than happy to give you more capital to extend your runway and minimize risk. Follow-on fundraising for portfolio companies takes a lot of partner time. Explain to the partner why putting in more capital now will help make the Series B fundraising much, much easier.

OK, so taking more money while preserving the same founders’ stake is a no-brainer. But what if the VCs do ask for more ownership? Should you take more money for a lesser founders’ stake?

This is the part where I’ve seen entrepreneurs make mistakes time and time again. They focus too much on their percentage ownership as opposed to what that ownership is worth now and, even more importantly, what it will be worth in the future. Therefore, they tend to raise less money in the short run in order to protect their ownership, believing that they can make huge progress in a short period of time.

Statistically speaking, entrepreneurs, who are required to be optimists, tend to overestimate their company’s ability to execute, underestimate their competitors’ ability to execute, and avoid thinking about the various exogenous factors that can disrupt their market. We all know what happens as a result.

Instead, entrepreneurs should at least consider raising more capital, even if it results in lower ownership this round, because putting the extra capital to good use creates value, and that value increase has an anti-dilution effect in the next financing round (by generating a higher pre-money valuation).

Sounds good, but how do you know what’s a good trade-off?

[Editor's Note, 11/18/09: The next section of this essay has been extensively revised and updated.]

The Execution Multiplier

I like to talk to my CEOs about the concept of an execution multiplier. The basic idea is that the pre-money valuation of the Series B round is to a large extent determined by what you can accomplish with your Series A capital. Having more Series A capital should enable a good entrepreneur to accomplish more. The execution multiplier describes the relationship between the next round’s pre-money valuation and the increase/decrease in capital raised in this round.

Pre-money premium =
    Execution Multiplier * % change in investment

Here is an example. Say the execution multiplier is 100% and you are comparing raising $4M vs. $5M. The pre-money premium is 100%*[(5-4)/4] = 25%. What this means is that you expect the extra $1M in capital to help increase the next round’s pre-money valuation by 25%.

This becomes useful when you want to compare financing options as it allows you to model how changes in capital raised affect pre-money valuations in the future. Using the example above, a follow-on round with $16M pre-money valuation in the case where you raised $4M will be equivalent to a follow-on round with $20M pre-money valuation if you had raised $5M as $16M*(1+25%) = $20M. This calculator shows the change in the true pre-money valuation in the next round given the effects of the execution multiplier. It can help you get a better VC deal by letting you trade-off giving up some founder ownership in exchange for raising more capital, if in fact this makes sense given your assumptions about the execution multiplier of your company.

Some businesses really know how to translate additional capital into growth. For them, the execution multiplier can be greater than 100%. Other businesses have multipliers that are less than 100%. You need to decide what’s a good guess for your business in order to know how to compare alternative financing proposals.

The equivalence execution multiplier (EEM) is the execution multiplier which makes the future effect on the founders’ share of the cap table (the true pre-money valuation) of the two different financings identical. We find EEM by multiplying the ratio of founder equity shares by the ratio of invested capital between the two financing scenarios. If in the $4M raise scenario founders own 25% and in the $5M scenario they own 20%, the EEM is (25%/20%)*($4M/$5M) = 100%, which makes the two financings equivalent.

The calculator compares between two scenarios, set up in two columns. The first section sets up a simple cap table. The option pool is assumed to be the same between the two scenarios—if too many variables are changing it becomes difficult to isolate the effect of any one of them. The second section shows the deal from a dollar standpoint and calculates the true pre-money valuation. The last section shows you the pre-money multiplier effect of the additional capital, the equivalence execution multiplier and the net effect of the trade-off between founder ownership and invested capital in the round on the true pre-money valuation in the next round.

Execution Multiplier Calculator

The pre-populated example shows how raising $500K more even if it means 5% less in founder ownership and 11% lower true pre-money valuation this round, assuming a 100% execution multiplier, results in an equivalent true pre-money valuation in the next round. In other words, assuming an execution multiplier of 100%, the two financings are equivalent from the founders’ standpoint.

While the notion of a linear execution multiplier has many limitations, it helps make an emotional argument about founder dilution a little more objective while still keeping things pretty simple. The best way to use the calculator is to have a discussion with your team about what is the right range of assumptions regarding your company’s multiplier. Then play with the numbers and see how different increases in funding affect founder dilution and the adjusted true pre-money valuation. Also, use the equivalence execution multiplier calculation as a gut check in comparing financing offers. This is an educational tool first and foremost.

Summary

• Don’t spend much time figuring out how to justify the value of your pre-product Series A startup.

• Do focus on pitching the right type of investors, specifically, the ones with the right fund size.

• Do consider raising more money up front even if it results in a slightly lower valuation for the founder’s stake.

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!