Jeff Bussgang did a guest post on PEHub on the topic of how entrepreneurs should look at and compare competing term sheets.
Jeff correctly points out that the pre-money valuation of the company is not what entrepreneurs should focus on exclusively because the pre-money includes an option pool, which is under board control. Instead, he suggests that entrepreneurs should look at “the promote” which is the ownership of the founders * the post money as an indication of how good a deal they got. In his example he compares a 6 on 7 offer with a 20% pool with a 6 on 9 offer with a 30% pool. The promote in the first case is $4.4M (34% of 13M post) and in the second it is $4.5M (30% of $15M post).
This all makes sense–focusing on ownership as opposed to pre-money valuation is important but I disagree that “the promote” is the key financial metric to focus on when comparing term sheets. The main reason for this is the obvoious but often forgotten point that nobody makes money on a financing (in early stage financings it is extremely rare for founders to be able to take some cash out). Therefore, what really matters is the value of the stake that founders are going to have at exit.
Typically, if things go OK, that’s ownership-at-exit * exit-value. Exit value depends on too many things to be predictable. However, the ownership at exit can be predicted to an extent. In a typical technology startup, on average, founders will experience 45-65% dilution before exit. That’s quite a range. Here are some rules of thumb related to financings for how to end up on the lower end of the dilution scale:
- Have large option pools–they protect everyone from dilution. If you take a term sheet with an artificially small option pool, it will have to be increased in the future and your ownership will be diluted. To take Jeff’s specific example, the second deal 6 on 9 with 30% pool is noticeably better than the 6 on 7 deal with the 20% pool even though the promotes are nearly identical because the extra 10% in the pool are insurance against another 10% dilution. In short, don’t get into deals because you feel you’ll own more of the company only to find out that you get further diluted in the future through option pool increases.
- Raise more capital and don’t spend it faster. In well-managed companies, there is a correlation between the amount of capital that is raised and the amount of progress that’s made, which, hopefully, results in an increase in pre-money valuation for the next financing round and hence less founder dilution. Even if they put just a little bit of money into your company, VCs will own rights that essentially give them substantial control over future financings. Don’t accept a deal just because you’ll own a lot after this round. You have to think about follow-on financings also.
- Pick the VCs carefully. Some firms and partners have much better brands and, other things being equal, are more likely to help you get great terms on a follow-on financing. However, there are circumstances where the VCs on your board don’t really have a great incentive to help you get a great price. The reasons are too complex to summarize here.
I advise every founder and startup CEO to have a good spreadsheet showing how every major shareholder is impacted in various financing and exit scenarios. When you put things down to numbers, it becomes much easier to understand why it is rational for certain parties to behave in certain ways.
As for comparing across competing term sheets, there is no single financial metric to focus on. You have to think about the overall financing model for getting to exit.