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.