Negotiating a Better Series A Deal
[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 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.
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.
• 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.