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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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One thing I'm not understanding about this promote value, though -- or, more accurately, about your comparing the two offers on that basis.

You say that in your offer, the founders had a promote of 34% of a $13-million valuation, while in the other offer, the founders had a promote of 30% of a $15-million valuation.

Fine and good. But, it's missing the fact that the $13-million company and the $15-million company are the exact same starting company, with the exact same additional $6 million pumped into it. So it can't be that the company is actually worth different amounts here -- it's that the estimates of the worth are different.

(That's not precisely true, as the $15-million company has an additional 10% option pool that it can hand out to new hires, but I can't imagine that making the company $2 million more valuable. Am I wrong there?)

Once the deal is over and done with, does that valuation actually make any difference down the road?

That's a good idea. I will endeavor to provide that in another post. Brad Feld has a nice review of this in his blog post: http://www.feld.com/blog/archives/term_sheet/.

Lesson to entrepreneurs: you are doing yourself a disservice if you raise capital without a good deal lawyer who can clearly explain deal terms like promote. Don't use your dad's buddy who is an attorney ... seek out a lawyer who has advised multiple entrepreneurs on multiple capital raises. As a former PE investor (now entrepreneur), it is scary how many times I saw clueless attorneys (on deal terms) represent even more clueless entrepreneurs. Blogs like this are a great educational tool but in no way can they FULLY prepare an entrepreneur to negotiate his way through a purchase agreement.

While a larger option pool might skew the "Promote" (FPDOV) negatively for the founders, wouldn't the opposite also create misleading founder value? Too small of an option pool would set up the company for more significant founder dilutions down the road.|By the time a share liquidation event occurs, seems likely the founders would have been better off with the [higher pre/bigger pool] combo than the [lower pre/smaller pool] combo discussed in the example?

Very interesting article. Useful for the start-up entrepreneurs. I will be careful about the Option pool when discussing with the VCs

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Great imagination and thinking. A lot of term sheets come down to optics and promote sounds like a great way to view the deal. Keep up the good work.

I just couldn't imagine giving 40%... I have a device right now that has tremendous (realistic) potential in a demand market with no competitors and a potential growth summarizing a few billion a year. I am looking for only $2.5M investment. To even think to offer 30 or 40% of the company on such low investment funds is mind-boggling.

Hi Jeff,
For the two VC term sheets in question, your competitor deal is really better.

You said promote is ~same for founders in both case. But the 2nd deal also leaves larger option pool--meaning founders can hire more people. So, effectively, for the same promote, 2nd deal has room to hire more people than 1st deal, and thus, greater chance of success.

Govind

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6m raise on 7m pre means the money buys 6/13
of the company, or 46%.  The 20% option pool is set aside and doesn’t dilute
the money (i.e., the option pool is typically created pre the money as opposed
to post), so founders own the balance, or 100-(46+20) = 34%.
 

Coming from the real estate world (where the word promote means something entirely different) this is a bit of an adjustment.

Jeff - quick question for you.

Suppose a company earlier established a 15-20% option pool before their Series A. As time progressed, they used most of it on new hires, and now it's time to do a Series B. Will the B investors ask the current shareholders to put another 15-20% in as the new investors come in?

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Hi Steven – typically new investors will
set the option pool based on theirs and management’s assessment of the hiring
needs at that time.  An option budget that both sides develop that links to the
hiring plan helps illuminate this quite clearly.
 

Depending on the value of your products, you may need to discuss payment options with your financial institution as well. While low and moderately priced items can easily be handled through credit cards or online services like PayPal, big-ticket items may require the use of wire transfers with or without escrow, so be certain to consult the necessary professionals first before developing your new marketing strategies.

Simply put - Great post
Promote - I will definitely look for this in my deal i will execute. Should the company become big as planned by entrepreneurs and founding team , a larger promote or as stated in your example 34% of the company would return more in the longer term than the 30% .. 34% of A billion dollar company is sure more than 30 % of A billion dollars. This in turn is another way for entrepreneurs to say - Yes we believe in what we are doing ..

Great article jeff.

I am new to the world of raising money, so please pardon my naivite'
In the second round when the new investor comes in, it is my understanding that the company must then have to be revalued based on current market conditions and hard numbers .. right?

QUESTION: isn't the new value of the company going to be "$XXX" pre?

In other words if a new option pool is negotiated, everyone takes a hair cut in terms of share value prior gets diluted? i.e. not just the founders?

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It varies wildly based on the deal and the
negotiating leverage. If you want more on this, read Chapter 4 of my book
Mastering the VC Game. (www.jeffbussgang.com).
 
 

Each work comes from a long thought process.

Jeff Great article! Thanks foe the share!

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