Young entrepreneurs (at age or at heart – It doesn’t matter) are very sensitive about valuation or in their eyes: “how much I’m going to get diluted”. After doing several deals both as co-founder and as investor, it became clear to me that it’s the wrong thing to focus on. Moreover, in such an early stage of a startup, no one can do a valuation. It’s all guesses. So the numbers and the arguments over them are ridiculous. What I do find important, are the terms. The ‘little’ details in the term sheet that will drive the future outcomes.
You need to understand what is the meaning of each basic concept like: liquidation, participation, ratchets and preferred shares.
Let’s have a quick look.
- Preferred Shares – A type of stock that has preferences over the “common stock” with respect to such things as distributions, dividends, redemption rights, certain types of voting rights, anti-dilution, and other items. Usually, preferred votes just like the common stock and the number of votes are calculated by reference to how many shares of common stock the preferred could convert into at that time.
- Liquidation – When your startup is terminated or bankrupt, its assets are sold and the proceeds pay creditors. Any leftovers are distributed to shareholders, according to the order that is defined in investment agreement. Creditors liquidate assets to try and get as much of the money owed to them as possible. They have first priority to whatever is sold off. After creditors are paid, the shareholders get whatever is left with preferred shareholders having preference over common shareholders.
This is the key!
If you (as a shareholder) coming to the party, after all the beers are gone (to the creditors) it’s not as fun as you image it to be, right?
Imagine a VC that buys 50% of a company for $5 million, for a $10 million post-money valuation. If that company then sells for $7.5 million, the VC gets more than 50% of the $7.5 million. Why? because due to the magic of ‘preferred shares’ the VC gets her $5 million out first, and then half of the remaining $2.5 million for a total return of $6.25 million. The “common stock” holders split the remaining $1.25 million. But wait, there is more! What we saw here is only a classic (and common) 1X liquidation preference. Think about cases when preferred stock owners have 2x or 3x liquidation preferences. In this case, if the VC gets 2x the “common stock” holders will get zero.
- Participation – We talking about participation in future rounds and what will be the terms for the current investors in these future scenarios. In most cases, I saw the pro-rata right. This right allows the investor to maintain their ownership level by participating in future rounds.
- Ratchets – Ratchets determine how existing investors will be diluted by future financings. Liquidity preferences (the bullet before) determine payouts at the point of a liquidity event. Suppose that you buy 2 shares in a company for $2, with a full ratchet. The company later sells additional shares in a dilutive financing for $0.50 per share. Your shares are repriced at $0.50 per share, which means that you now own one share rather than two. Rather than converting the existing shares at the new share price, a weighted ratchet converts at the average of the original price per share and the new price pers share, resulting in less dilution to the original investor. This is more common than a full ratchet. I’ve seen cases, when even if you give your investor a full ratchet (= anti-dilution) it won’t hold in the next round because the new investors won’t agree to it.
- Convertible Notes – It’s common today to see startups using convertible notes in the early rounds. Instead of buying shares in your startup, the investor just gives you the money on a loan with some nominal interest rate (7%-10%). The startup promises that when you raise your next round of funding, the loan converts into shares as if they had put that money in during that second round. Since the investor took additional risk by backing you early, they get a discounted share price (they get more shares than someone who puts in the same amount of money in the second round), and that discount is fixed and agreed upon beforehand (~20% but it could get higher). The best part of this method is that we don’t require to set a valuation because the share price will be determined in the next round.
Most of these methods were invented by venture capitalists over time. Why? because they learned that terms are valuable to recover capital in downside outcomes and improve their share of the returns in cases the startups goes well. You as the founder needs to remember that cap tables don’t tell the full story. Especially, when we have a startup with different classes of stock and terms that control the outcomes. Before you close on any round, you should create a spreadsheet that shows what you and each other stakeholder would get in a range of exits. Try to lower the numbers for each bucket: low, medium and high. This will give you more sense what is going to be the outcomes and who is going to be smiling.
- Focus on terms – Understand what are the terms and what will be the outcome. More importantly, leverage a lawyer that does tech venture financings for a living, someone who did tens of deals in the past. They will be able to give you business advice that based on real experience. However, don’t delegate everything in the contact – make sure you are on top of it and you fully understand. Keep asking WHY.
- Create a spreadsheet for 3-5 scenarios – Once you understand the terms being offered, build a spreadsheet so you can see what is the portion of each stakeholder will be in a range of potential values.