Valuation in Germany · Unternehmensbewertung: In VC deals, Price Doesn't Matter

Jeff Bussgang, a General Partner at Flybridge Capital Partners (fka IDG Ventures Boston), wrote a quite interesting column about how we should think about valuation:

VCs have an unfair advantage when it comes to financings. They simply have more experience doing deals.

A typical start-up company will do 2-4 venture capital financings before a successful exit (or, conversely, an ignomious ending). A typical serial entreprenur may lead 2-3 companies in their career before calling it quits (or checking themselves in to an insane asylum). Thus, the universe of financings that even the most experienced entrepreneurs get directly exposed to is typically 5-10 financings over a 15-20 year career. In contrast, the typical venture capitalist, either individually or across their partnership, will do 5-10 financings in any given year. Year in, year out,

Thus, VCs and entrepreneurs are not operating on an equal playing field when it comes to negotiating financings and interpreting the impact of the terms involved.

One area that has always struck me where this assymetrical relationship comes into sharp focus is when there's a discussion around the price of the deal. Entrepreneurs often mistakenly focus solely on the pre-money valuation while VCs look at multiple knobs in the negotiation to drive to a set of terms that, in total, they find acceptable. And if they don't focus on the pre-money, they focus on their ownership position after the financing, irrespecive of the amount of capital that was raised.

In my partnership, we've come up with a new term (I think it's new - I don't see it written or talked about much) called the "promote" to help communicate with entrepreneurs the real value behind a particular deal so get them to step back from concentrating only on the pre-money valuation or post-money ownership.

What is the promote? First, let me take a step back and define a few terms. In the world of VC-backed financings, there are multiple terms that impact the ultimate price of the deal. The first, and most focused on, is something called the pre-money valuation. That is, what is the company worth prior to the money being invested? This pre-money valuation is own known in shorthand as “the pre” and you will hear entrepreneurs and VCs discussing other company finances using this term (“You were able to raise money at a $9 pre? I had to struggle to get to $6 pre and I have a prototype and real customers! Life isn’t fair.”)

But the pre-money isn’t the only term that defines price, the amount of capital raised and the post-money plays a part as well. The post-money is the pre-money plus the invested capital. That is, if a company raises $4 million at a pre-money valuation of $6 million, then the post-money is $10 million. The investors who provided the $4 million own 40% of the company and the management team owns 60%.

Another term that impacts the price is the size of the option pool. Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business. These new hires typically receive stock options, and the issuance of those stock options dilute the other investors. In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment. In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team. In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires.
Jeff Bussgang, a General Partner at Flybridge Capital Partners (fka IDG Ventures Boston), wrote a very interesting column about how we should think about valuation:

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs. I learned it the hard way in the first term sheet that I put forward to an entrepreneur. I was competing with another firm. We put forward a “6 on 7” deal with a 20% option pool. In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company. The founders would own 34% and we would set aside a stock option pool of 20% for future hires. One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company. But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%. The entrepreneur chose the competing deal. When I asked why he looked me in the eye and said, “Jeff – their price was better. My company is worth more than $7 million”.

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic. That's why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”. The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation. It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

In my example of the “6 on 7” deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation. In other words, they have a $4.4 million “promote” in exchange for their founding contributions. Note that in the “6 on 9” deal, the founding team had a nearly identical promote: 30% of a $15 million post-money valuation, or $4.5 million. In other words, my offer wasn’t different than the competing offer, it just had a smaller pre and a smaller option pool.

Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price - the pre-money, the post-money, the option pool - and do the simple math to calculate the "promote". There are many other elements of the deal that affect price (participation, dividends) and control (board composition, protective provisions), but make sure you think hard about the value you're carrying forward, not just the price tag you think the VC is giving your company in the "pre".