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July 15, 2009

In VC deals, Price Doesn't Matter - But The "Promote" Does

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.

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".

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Hi Jeff - great post.

A couple questions:

1) 30% seems like a huge option pool... as a naive entrepreneur, could one take that as a signal that the investors don't believe as much in the current mgmt team as much as the investors who choose 20%?

2) Let's say not all the 20% or 30% option pool is doled out by the day of an exit (which I suspect is fairly common)... who retains that unused pool of shares?

Great questions, Eric. 1) you typically see 15-25% option pools, so yes 30% is large and, in this example, was clearly a ruse to drive down price as well as signal that a new team was needed. 2) unallocated shares are taken out of the demoniator when calculating proceeds per share upon sale. One of my portfolio execs said to me this week regarding an option grant, "it's not dilutive - we have the shares in the pool" and I had to remind him that every grant IS dilutive - if the pool is unused, it's cancelled upon sale and everyone gets a little extra juice.

Great idea. A lot of term sheets come down to optics and promote sounds like a great way to view the deal.

What most entrepreneurs miss (but the VC's don't) is that the option pool is a "tax" on the founders and actually results in a higher per share price to the VC's while protecting their downside (dilution). And of course you (the VC's) get the liquidation preference which protects your downside but does nothing for the entrepreneur.

VC capital is expensive. The only hope is great execution and a high multiple on the exit with as few shares outstanding as possible. Unfortunately with the IPO gone and M&A down to 30/50m you have to be good otherwise the entrepreneur will be working for a paycheck and the VC will only be seeing an IRR of a few percentage points over the lifetime of the investment. In which case the LP's will probably look to save the 2 & 20

Great post, Jeff, invaluable. A couple more questions along similar lines as Erik:

1) Does the option pool cover board members and advisors, or is it reserved for employees only?

2) Do founders ever take part in option grants from the pool? Or are the shares you end up with pretty much it?

3) Do those founders' shares vest?

Again, great post.

Basic question: What about the later rounds? Of course, every financing round is theoretically unique, but won't the investors in the next round see the previous rounds valuation as a guidepost, as well as be pressured by this round's investors? It seems as though this would magnify the differences in the "promote" later?



Great post. Just came out of a negotioation that was came very close to fail due to pre/post and promote misunderstandings. The term promote would have made some difference.

We already decided to work through our term sheet templates to avoid future misunderstandings, your post provides some valueable input to that work.

/@eriktorsner

put up a little Promote Calculator?

Well done Jeff, as usual. I'm curious if you have found entrepreneurs take to this logic during a negotiation? Or does the fact that you are "across the table" make hearing this message difficult? I can't wait for someone to be smart enough to say "oh, you've closed your B, congrats, what was your promote?"

Promote is a common term in the oil and gas business. It is usually less complicated to calculate as it is a straight up number. But it is a good use of the word and makes it easier to understand the dynamics of the negotiation.

see if i learned this right. so what i really want is a $10mm pre, and a much lower post per every dollar invested to own more of the company, yet i still don't understand how post valuations are determined for tech that doesn't exist. say Google before they proved their algorithm.

thanks for the great post!

I always take my clients through these types of numbers when analyzing a deal. Of course, we focus on the upside since the downside is horrible for everyone, especially the entrepreneur.

http://www.chicagolawblogger.com

plus the extra big option pool becomes a discount to the VC if a transaction happens before the pool is used up since they come out of the entrepreneurs % in the financing, yet everyone's % increases proportionally if any of those shares aren't issued

Thanks, Troy! To answer your question: (1) the option pool does typically cover board members (0.3-1.0% each) and board of advisors (0.05-0.10% each). (2) Founders rarely get additional option grants, but sometimes if they are fully vested and remain a central part of the going forward team they get additional grants. (3) Founders’ shares usually do vest. VCs typically give some credit for time served or founding effort, but there is usually some vesting schedule put on their shares.

In later rounds, there is definitely new investor calculus on the terms and the promote. The option pool may get refreshed (which is dilutive to all previous shareholders) and there is definitely sensitivity on the post-money valuation in the optics for follow-on rounds. One of our companies is struggling with that now – they set a high SerA, didn’t nail all their milestones perfectly, saw the general market environment change, and are now struggling to clear their post money on the current round they’re trying to raise.

Appreciate the position. More important is the fit. As an entrepreneur is this someone you want to work with for 5 to 7 years? Most will have weekly or bi weekly calls and monthly board meetings. Yes, the total deal terms are important. Especially, liquidation options. Who decides to accept an exit price or option is very key. Great point of view, if deal terms are close, I would consider the person more important than the valuation.

Great post, Jeff. Insightful and good examples. Just a question about why your competitor will prefer bigger option pool.

Does it mean they expect to have more management from outside? and in other words they evaluate the business risk with the current entrepreneur higher than you do?

Thanks.

In this particular case, the bigger option pool was simply a tool to lower price. Typically, the larger pool is indeed a signal that the VC wants to add a new CEO and other senior managers. We like to sit down with our entrepreneurs and do an option budget with them so we are in agreement on both the positions needed and the "cost" of the positions in terms of stock options.

Thanks, Nabeel! Some entrepreneurs (more analytical types) totally get this. But, yes, many are trained to be emotionally attached to a simple price whenever they buy or sell an asset, whether it's a car, a house, or a piece of their company.

I use an analogy to explain to entrepreneurs how they are at a disadvantage in negotiating: VCs are like car salesmen. We buy cars once every 2-6 years; car salesmen sell 1-5 cars a week (maybe until recently). I tell them I've never negotiated a good deal on a car and gave up years ago to focus on other issues.

I love the idea of the promote (although, like Brad Feld, I think it does make us sound even more like used-car salesmen).

Thanks for the analogy, Stewart. I do think of my role as a VC as a service provider - akin to a lawyer, recruiter, accountant - but a used car salesman?? Ouch!

Great post, thanks Jeff. Though be careful, this clarity and debunking of jargon may not be popular among the fraternity :)

One question, which you may have covered elsewhere - is it common / legal / ethical that a VC will come in at A round and dilute angel investors but leave founders' equity shares intact? If so, the conclusion from that would be that it doesn't matter too much what terms you agree with angels.

It is not common for VCs to purposefully/vindictively screw angels (although now that I've said this, watch readers provide examples!), but, yes, new $ causes new dilution and VCs are sensitive to making sure founders are properly incented going forward with the right ownership. If angels have a good relationship with founders, it helps. If a VC really screws around with angels, they don't get invited to look at many angel deals again.

thanks for this. the walk-through of the basic terms (pre, post, option pool, etc.) was simple and clear, the easiest to understand out of all the VC deal posts I've read.

Jeff, thanks for the article. Are you going to expand it to talk about the effect participating preferred (or other liquidity preferences), cumulative dividends and other potential deal terms have on trying to make apples to apples comparisons between deal options?

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