Secrets of Sand Hill Road

by Scott Kupor

  But that additional equity that may be granted to the founder doesn’t just get created out of thin air. Rather, doing so requires that the company increase the total amount of equity and issue those new shares to the founder. But that means that everyone else who did not receive that additional equity (including both other employees and investors) will have their ownership interest in the company “diluted,” or reduced by the amount of the new equity issuance. Thus, creating the right incentives comes with a cost.

  Let’s look at a simple example. Imagine that you are the founder and own 70 shares of equity out of a total of 100 shares in the company; you have a 70 percent ownership interest in the company. For sake of simplicity, let’s assume that the other 30 shares are owned by the company’s other employees. As a result of debt converting into equity, assume that we had to issue 20 additional shares of equity to the debt holders. Your ownership in the company has now been reduced—you still own 70 shares in total, but the total number of shares has increased to 120. As a result, your 70 percent ownership has been diluted to 58 percent (70/120).

  If the Series A investors are worried that this dilution may disincent you from working hard to increase the equity value of the company, they may not want to invest in the Series A without increasing your ownership back to, say, 65 percent. How can they do that? Again, by having the company create additional shares and issue them to you. If you do the math, you would need to receive an additional 23 shares (to get you to a total of 93 shares), and the creation of those shares would increase the total shares in the company to 143. Thus, 93/143 = 65 percent. But notice that our poor employees still own 30 shares and have seen their ownership in the company reduced from 30 percent to 21 percent (30/143).

  This dance between these two competing interests—properly incenting an entrepreneur and minimizing the dilution for other shareholders—is a carefully choreographed one that recurs many times throughout the life cycle of a company. So encountering it early on can be a tough way to get a relationship started.

  What often happens to resolve this tension? One option is just to kick the can down the road. That is, the investor invests at the Series A round, the entrepreneur gets what she gets, and everyone agrees that we just might need to solve this dilution problem sometime into the future. While we’ve seen this happen many times, it’s really not the best solution; unlike whiskey, most problems don’t in fact age well.

  The second option is to address it up front. While better to confront these issues head-on, this is a tough one to navigate. Why? Because the new investor coming into the Series A round will want to solve this by having the company issue more stock to the entrepreneur to offset the dilution she has suffered from the convertible debt offerings. But of course those debt investors don’t want to do that because that dilution will come largely out of their ownership stake. And so the dance continues until the parties can come to some compromise that works for all involved.

  The bottom line is that this problem can be avoided easily by just being mindful as an entrepreneur of this constant trade-off between raising the capital you need to grow your business and minimizing the dilution to yourself and other employees and investors who are coming along the journey with you. For every dollar of VC you take, do the calculation to figure out what that means for your existing crew of people involved.

  Price per Share

  Our sample term sheet says two important things about the price that the VCs are willing to pay for the $10 million investment.

  First, the valuation is $50 million “post-money”—what does that mean?

  “Post-money” means exactly what is sounds like: the valuation of the company once the VC has invested her $10 million. You’ll often hear VCs use the term “pre-money” as well; this is the valuation of the company before the VC makes her investment. So, mathematically, pre-money + amount of investment = post-money (in our example, since VCF1 is investing $10 million and has said that the post-money valuation is $50 million, the pre-money must be $40 million).

  You’ll see that VCF1 says in the first section of the term sheet that it wants 20 percent ownership of the company for its $10 million investment. Hopefully, you can see that the math makes sense here—if I put in $10 million and the post-money valuation is $50 million, then I should own 20 percent of the company ($10 million investment divided by $50 million post-money valuation). So far, so good.

  Note also that the term sheet says that the post-money valuation includes two important elements.

  First, any shares that convert as a result of prior convertible debt (called “notes” in the term sheet) have to be included in this valuation. Recall our discussion about the use of convertible debt by many entrepreneurs, particularly in the early stages of company financing. We said at the time that a common mistake we see is the aggregation of quite a bit of convertible debt as a result of the rolling closes that debt permits. Here is where the sins of the past can come back to bite us, as that debt is now being taken into account as part of the valuation the VC is willing to pay. We now for the first time get the full accounting of just how much dilution has been created by the issuing of this debt, and this bill often catches entrepreneurs by surprise.

  Second, and we’ll talk about this more below, the valuation also includes the employee option pool (this is the stock set aside to incent employees of the company). This is important, because it means that when we add up all these shares, they can’t exceed the $50 million post-money valuation for the company.

  The VC could have said—and the founders would have preferred this—that the valuation is $50 million after it puts its money into the company, but that the conversion of the notes and the employee option pool would be additive to the post-money valuation. But, in that case, the VC wouldn’t really own 20 percent of the company when all is said and done. She would own that amount for a fraction of a second and then get diluted by the additional shares issued for the note conversions and the employee option pool.

  This is why the VC wrote the term sheet to hard-code the post-money valuation at $50 million. She wanted to be clear that whatever the existing capital structure of the company and however big an employee option pool the founders wanted to create, the VC would not be diluted by those.

  So how did VCF1 come up with the $50 million post-money valuation in the first place? Let’s take a short diversion to explore valuation in a bit more detail. If you have a background in investment banking, you’ll be familiar with how banks tend to value companies. This is similar.

  Comparable Company Analysis

  We covered this briefly in chapter 5, but the comparable company analysis method of valuation requires that we find other publicly traded companies (or companies whose valuation and financial metrics are publicly known) that look and feel like the startup we are trying to value—so-called comparable companies.

  Oversimplified, it’s like looking at comp prices in your neighborhood when you are trying to buy or sell your house as a way to help set the price of your house or your offer.

  As a better example, if we were trying to value Facebook in early 2012 (while it was still private), we might choose a set of other high-growth internet companies as comparables—e.g., Yahoo, Google. We would then look at how those companies are valued as a function of certain financial metrics: for example, Yahoo might have been valued at five times its revenue, while Google might have been valued at eight times its revenue. We then apply these revenue multiples to Facebook’s revenue to arrive at an estimate of how the public markets would value Facebook.

  Easy math, hard comparison. Maybe Facebook has a higher growth rate than these companies. Maybe Facebook has a higher margin structure. Maybe Facebook has a larger market opportunity to go after. Maybe Yahoo just missed its Wall Street estimates last quarter and thus investors have put it in the penalty box by selling the stock and thereby depressing the valuation. Or maybe the US is on the verge of World War
III (we all hope not!) and thus equity market valuations as a class are at a local minimum. None of these questions is insurmountable, but they do go to the heart of whether “comparables” are in fact comparable.

  This analysis is doubly hard as applied to startups because (we hope) startups are by definition unique, and the ability to forecast revenue is inherently unpredictable. So even if we get the comparables right, who knows if we will get our revenue forecast right—garbage in, garbage out.

  Discounted Cash Flow Analysis

  Financial theory says—and who are we to argue with it—that over the long run, the value of a company equals the present value of its future cash flows. That is, whatever annual cash a company can generate in the future, if we discount that cash to present-day values, an investor should be willing to pay no more than the current value of that stream of future cash.

  How do we do this in practice? Well, it requires that you build out a financial forecast for your company, estimating how much cash flow the company will generate in each future year. Keep in mind that cash flow means “cash”—so we need to estimate not just what the accounting income will be for the company but also how capital expenditures will affect cash and how the timing of collecting cash from customers and paying cash to vendors and employees (otherwise known as “working capital”) works. Once we know that, we then need to discount those cash flows back to present day using what’s called a “discount rate.” The simple way to think about discount rate is that it is the opportunity cost for a company’s investments—so, if the company could earn 10 percent on alternative investments, then we should discount the future cash flows at least at that rate.

  As you are probably noticing, this analysis makes sense for mature companies that have more predictable future financial results based on the history of their existing financial results. It’s really tough to do this for an early-stage startup given that the financial forecasts for the business are probably not worth more than the Excel spreadsheet on which they were created. VCs often joke that “we can make the spreadsheet say whatever we want.”

  More significantly for startups—for those of you familiar with discounted cash flow models—because they tend to consume cash in the early years and (hopefully) generate cash in the mature years, most of the value in a discounted cash flow model will come from the far-out years, where the certainty of forecasts gets even more fuzzy.

  In addition to all these challenges, the comparable company and discounted cash flow analyses also suffer from the fact that they don’t account for dilution in the VCs’ equity holdings resulting from future financings. Huh?

  When a VC invests in a startup company, she hopes that may be the last money the company ever needs to raise, but knows in her heart that that is highly unlikely. Most companies that are successful (and unfortunately many of those that are not) end up raising multiple rounds of financing. In fact, given that companies are staying private for a longer time, they are more likely to raise funding across several different rounds of financing.

  To plan for this, when a VC invests in the first round of a company, she “reserves” additional monies beyond that which she invests in the A round to be able to participate in future financing rounds and preserve her ownership.

  How does this work? Going back to our sample term sheet, if VCF1 invests $10 million to own 20 percent of the company, assuming that the company continues to do well, VCF1 will want to maintain that ownership level. But if the company raises another round of financing, the company will need to issue more shares to that next round investor. As a result, the total share count of the company increases, so by simple math, the shares that VCF1 holds represent a smaller proportion of the total company than the 20 percent it originally held.

  To compensate for this, VCF1 may want to invest more money in this next round, likely in an amount equal to that required to maintain its 20 percent ownership in the company. Thus, at the time it makes the initial $10 million investment, VCF1 will reserve, or put aside for future use, some amount of additional dollars for subsequent financing rounds. To be clear, this is just an accounting fiction in that the money hasn’t been invested, but VCF1 is earmarking this money for the time being so that it doesn’t deploy that capital into another investment.

  Recall that in chapter 4 we talked about getting to know your VC firm and, in particular, getting to know where it is in the investment life cycle of the fund from which the firm is investing into your company. This discussion of reserves helps articulate why that matters—if a firm is early in its life cycle, it probably has the ability to reserve additional dollars to participate in subsequent rounds of financing for your company. If it is later in the fund life and thus the firm needs to start thinking more about distributing cash back to its LPs, it may be less willing to set aside reserves.

  You of course don’t care about whether the firm is able to maintain its full ownership by investing in subsequent rounds, but you do care about whether the fund has cash at all to be able to invest in you. Why? Because often when you raise a new round of financing, the new investor will want to see that earlier investors still have faith in you and that they are willing to demonstrate that by putting new, additional capital at risk. If the fund is later in its life cycle and short on reserves, the fund’s inability to participate in the new round of financing could affect the willingness of new investors to fund the business. Similarly, if the firm has not raised (or doesn’t seem likely to be able to raise) a new fund, there may not be another source of capital it can tap to invest in your new financing round.

  VC Valuation

  So what do VCs actually do to value early-stage startups?

  Wait for it—it’s called the “what do I need to believe analysis.”

  I haven’t trademarked this and, to be fair, some VCs might disagree with me on this, but in my experience, it’s true. If VCF1 invests $10 million in XYZ Company and owns 20 percent of the company, what does the company need to look like in five to ten years to be a meaningful return driver, or winner, for its fund?

  Let’s assume a “winner” means a return of ten times (or $100 million) VCF1’s investment. If VCF1 owns 20 percent (and let’s ignore for now the reserves we talked about), then to earn $100 million on the investment, XYZ Company needs to be sold (or go public) for at least $500 million (0.20 × $500 million = $100 million).

  Borrowing from our comparable company analysis above, let’s assume that mature comparable companies trade at a revenue multiple of five. So to achieve our $500 million valuation goal for XYZ Company, it needs to be generating $100 million in revenue.

  So what would have to go right with the business for that to happen? Is the market size they are going after big enough to support a company with $100 million in revenue? What are all the things that could cause the company to fail? How do I assess the probability of each of those nodes on the decision tree toward success or failure? This is in practice the valuation idea maze that VCs go through.

  To be clear, we are talking here about very-early-stage investments where there are no real financial metrics with which to value a company. As startups get more mature and have financial statements that are more reliable, of course later-stage venture capital deals will adopt more of the traditional valuation metrics we’ve outlined above.

  Now, back to our term sheet.

  Capitalization

  Notice here that VCF1 says that the valuation of the company includes the unallocated employee option pool—in this case, 15 percent. As we talked about before, VCF1 wants to make sure that it gets its 20 percent ownership after all is said and done, so it doesn’t want the creation of the option pool to dilute its ownership.

  How did VCF1 come up with 15 percent as the right pool size? Honestly, this is just a negotiation between the VC and the company CEO, but a good rule of thumb is that the option pool should be sufficient to handle the expected employee hiring until the next round o
f financing. So the VCs often ask the CEO to generate a head-count growth plan for the next twelve to eighteen months (the likely time frame until the company pursues another financing round) and estimate how much stock is required to grant to those planned hires.

  The CEO would like to keep the pool size as low as possible because increasing the pool size before the current financing round dilutes her (and other existing common shareholders). The VC wants to make the pool size as large as possible because if the company needs to increase the pool after she has invested her money, she will also share in the dilution. This is the dance.

  Dividends

  I am not going to waste too many words on this section because it’s generally meaningless, since startups can’t afford to dividend out their cash to shareholders.

  All this section says is that if and when the company’s board decides to dividend out cash to shareholders—which it will likely never do—the dividend will be equal to 6 percent and will go to the preferred shareholders (i.e., the VCs) first before going to the common shareholders (i.e., founders and employees). The whole reason for this section—at least in my humble opinion—is to prevent the founders from dividending out money to themselves at the expense of the preferred shareholders. So if the founders want to pillage the company’s cash, they have to pay the VCs first. Enough said.