[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
