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February 15, 2005

Cap Table Math

Many entrepreneurs focus on the amount of capital they raise (which always shows up in the press release) and on pre-money valuations (which never shows up in the press release!), but the truth is that the most important thing that matters (assuming "clean terms", which will be the subject of another post) is what I call "Cap Table Math" -- the composition of the percentage ownership, or capitalization table, at the end of the financing.

Let's take a typical series A example and keep the math simple.  Jane and her technical co-founder have a killer idea, 20 rockin' Power Point slides and a solid prototype.  She lures in two VCs to invest $2.5M each for a total of $5.0M invested to buy 50% of the company - in other words, a pre-money valuation of $5.0M and a post-money valuation of $10.0M.  These VCs inform Jane that although they love her and the idea, there needs to be 25% of the company set aside for all the future hires.  So, VCs get 50%, future managers get 25% and the entrepreneurs get the remaining 25%.  That's pretty typical.  After a series B round of, say $8M on $12M, where another 40% of the company is sold to investors, more options are created and everyone gets diluted, the founders' ownership may drop down to 10-15%.

But let's say Jane decides she can build the company with $1M of angel money from friends and family, giving up only 20% of the company (i.e., $1M raise on $4M pre).  And, she controls the option pool more tightly in the early days rather than hiring high-powered executives, say doling out only 10%.  Thus, she and her founding team have 70% ownership after the angel round and a few key hires.  When it comes time to do the $4M Series A round (to match the $5M of total capital in the earlier scenario), she should be able to command a higher pre-money valuation, perhaps $8M, thus giving up only 33% to the VCs and, even with management ownership of 25% post-money, she and the founding team can keep 42% -- a substantially larger share than in the previous scenario (25%).

So should entrepreneurs, mindful of ownership, always focus on taking money from angels rather than VCs?  It's not so simple.  If a VC is offering you $5M, it's hard to turn that down for $1M in angel money when there's no guarantee more money will show up at a higher price down the road after the angel money runs out.  More money means more runway, which often leads to a better outcome.  And, in theory, a good, hands-on VC will add more value than an angel.

As with every tough decision, it depends, but at the end of the day, VCs and entrepreneurs should pay less attention to "pre-money" and instead focus on the make up of the cap tables and, ultimately, the percentage ownership that results when the dust settles.

Comments

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i'd turn it down. call me stupid but I make it a personal responsibility to grow the company on the minimal of outside capital...not a control thing, just good ol' fashion penny pinching

Keep the pace slow and steady, generate revenues, find your own feet, break even at least, finance the thing by distributing for others, conservative fundraising, keeping costs low etc

But, hey sometimes it's just fun to burn lots of cash, very quickly...hell everyone else is doing it

This blog is excellent. I check it nearly every day. More posts, please!

Ryan Eberhard
CMU MBA '07

I agree with "anonymous".

I add that VC cash is more than just about valuation. There is the dilution when they want the option pool boosted--before their investment is closed!--to allow for compensation of people who will be hired (to replace or marginmalize founders) with the proceeds of the VC financing. There is the loss of control: in effect, even with a minority share, VCs take control. Finally, there is the participating pref structure, and its sinister bookend, the anti-dilution clause. These two allow the VC to have all the perks of a debt instrument while taking equity upside and equity control.

Charles Ferguson wrote a great book on the realities of all this. It is on Amazon. "High Stakes, No Prisoners" is the title. Read it!

* * * *

On a side note, I HATE the phrase "lifestyle business". Most entrepreneurs work ridiculously long hours and personally guarantee credit lines. Yet, if VCs deem a business not worthy of their munificence, they lazily pigeonhole it as a "lifestyle business". Yet I doubt in 99.9% of cases the entrepreneurs are living a lifestyle the spoiled VCs would want. More VC arrogance.

* * * *

By the way, this is a great blog. Keep it up. And keep it honest.

Two points: some vcs are value-added money with their strategic insight and rolodex (20% - mostly i-banker background; although some bankers are good: no real world experience and conservative bskool background makes them better late stage guys than early stage), or negate value (~10%).

2nd point: East coast valuations/terms tend to be more conservative than West Coast. Good west coast term sheets tend to be straight convertible preferred

Given that business is not about the best possible outcome, but about the best outcome possible, I wouldn't worry too much.

I would rather worry about generating choices. If you actually have a choice, sure, then you can actually worry about it. I would rather focus on genrating as many options as possible, so I actually have a choice.

For example, if I had 5m VC money on offer, but no angel funding offers, I have no choice. The same is true vice versa.

The best situation to be in is when you have more than one offer. This will allow you to worry about price amongst other things.

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