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Understanding the Valuation Math on the VC Term Sheet

by kirkcoburn
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Let’s pretend for a minute that the economy we’ve known and understood for the past ten years is back: we’re allowed out of the house, business is booming, and you’re ready to take your show on the road to rustle up some cash from energy-oriented venture capitalists. If you’re a newbie founder and this is your first rodeo, you’re in for a ride.  Not everything you’ve heard and read about VC funding will apply here. After all, this is energy and while we try to stick to the vanilla NVCA term sheet, it does not always happen. Start by reading about how to avoid the valuation death spiral and keep learning about how VC term sheets work.

What’s the Price?

At the end of the day, the price seems to be what most first-time entrepreneurs care about. What is the valuation. In reality, this is important but just one part of the term sheet that can either make a deal good, bad, or ugly.

So to continue my series on VC term sheets, let’s dig into what the price on the term sheet really means, and how the VCs want to allocate their returns — the liquidation preferences. Keep in mind that as you go through successive rounds of fundraising,  you’re inviting more VCs to the party and the structure of the company, and the liquidation preferences and participation get more complicated with every round.

In VC, All Math Is Not the Same

Forget what you learned about math. In the VC world, there are two kinds of arithmetic — founder and VC versions.  And both maths have two different outcomes.

Founder Math

Founder math is pretty straightforward. Your company has a value of, let’s say, $3M as a pre-money valuation. Your first round of fundraising brings in another $1M, so your post-money valuation is $4M. With founder math, you own 75% of the company shares, and the VC owns 25% of the one million shares outstanding. Each share is worth $3.

VC Math

VC math is a little more complicated. In the VC world, an option pool is baked into the numbers. This option pool is set aside for senior members of your team (and or soon to be team): the assorted experts in software engineering, marketing & sale, and product management that you’ll need to really get up, running, and viable. If you’ve already got these people in place when you start your fundraising, the option pool will be smaller than if you need to go on a recruiting binge. The VC standard for these options is 15-20% post-funding, which means you’ll need more on the front end to hit this number.

Funding the pool before the round is the standard, too. Here’s how the VC does the math.  Sharpen your pencil for this, unless you’re a math geek on top of being a tech whiz.

If the term sheet states that there needs to be a15% “fully diluted post-money” option pool, this means that the option pool must be added prior to the investment by the VC. If the investor wants to invest $1M and get 25% of your company, this means that the post-money valuation will be $4M ($1M / 25%). This also technically means that the existing shareholders (typically the founders) must dilute themselves by adding the option pool prior to the VC investing.

In other words, a 15% options pool post-funding costs $600,000. Since the VC is not paying for the options pool, you are, this comes out of the pre-money valuation.  Here’s how that just happened:

  • Pre-Funding Valuation (before Options Pool) — $3M
  • “True: Pre-funding Valuation (15% Options Pool) – $2.4M ($3M – $0.6M)
  • Post-Funding Valuation — $4M
  • Option Pool Cost — $600,000 (15% x $4M)
  • Founders original equity prior to new investment – 100%
  • Founders equity prior to adding option pool – 75% (VC wants 25% post-money)
  • Founders equity after adding option pool – 60% (VC has 25% + Option Pool of 15% = 60% left)

The VC puts in their million bucks, and they have a 25% stake in a $2.4M company.  Since you’re the one who had to take the hit with the option pool (and this is all on paper, by the way), your stake has dwindled to that 60% rather than 75%.

The term sheet states that the pre-money valuation is still $3M. VC math might calculate “true” or “effective” pre-money valuations, but that data will not be iterated on your term sheet.  Your accountant, however, can do the math for you so that you have a clear understanding of the real value they’re talking about.

Liquidation Preferences and Participation

This far into the game, it may not have escaped your notice that venture capitalists are playing a different game than you; see the math above.  While I do not believe most VC’s are vultures, it sure makes it important that you pay attention. This brings me to another critical nuance that can make or break whether you ever see cash coming back to you from an exit or most commonly referred in a term sheet as a “liquidation.”

In most of the world, liquidation is a bad thing. It represents bankruptcies, poor judgment, professional and financial ruin, and roadside furniture sales out of the back of a van. In the VC world, it’s generally a good thing. It’s how the investors will be paid when your company is bought or goes public.

The term sheet addresses “liquidation preference,” and, like the valuation equation, what’s left unsaid is what matters. For example, what about investor participation?

Are Investor Shares Participating?

According to VC guru par excellence Brad Feld, the liquidation preference of the term sheet is the second most important component of the document, the price being the first. Just to make things even more complicated, liquidation preferences have two components to them: (1) the preference itself (do you get a preference (to be front of the line) upon a liquidation event) and this is stated in usually a multiple of your investment (i.e. 1x = get your money back) and (2) the type of participation (described below) upon a liquidation event.

To be accurate, the term liquidation preference should only pertain to money returned to a particular series of the company’s stock ahead of other series of stock. Consider for instance the following language:

Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).

In short,  investors are guaranteed a certain multiple of their original investment before any common shares receive any returns. The standard in the industry is 1x,  or just getting your money back, maybe (hopefully) with some dividends.

Then it gets a little tricky. There are three participating options for investors: full participation, capped participation, and non-participating. Here’s how those break down, with an example of returns for each:

Fully participating stock shares in liquidation proceeds on a pro-rata basis with common stock, after the liquidation preference is paid, until a stated multiple return is reached. Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

In plain English?

Your company has issued $1M in participating preferred stock, a 10% stake in the company. You sell the company for $10M, so the owners of the participating preferred shares would get $1M in liquidation preference, plus an additional 10% of the remaining $9M, for a total of $1.9M.

Capped participation means the investor shares in liquidation proceeds on a pro-rata basis until they receive their stated multiple returns. Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

Let’s suppose the second round of your investors were all capped participants. Their $1M investment is capped at a 2X multiple, so when the liquidations triggered, these shareholders double their money with a $2M return. This is the end of the road for them; they’re not entitled to any dividends.

WARNING: participation is more important for liquidation events that are lower than for higher outcomes. This is why many VC’s want to reduce their risk by negotiating when the company does not exit at levels “hoped” (as presented) in the pitch deck. In energy, liquidation preferences can even trump price as being the most important economic term in the term sheet.

No participation (a.k.a. simple preferred) means the investor can either receive its liquidation preference (in the case of 1x, the investor gets their money back) or convert its preferred shares into common shares and received its % ownership returns.  Down round investors are more likely to be issued non-participating stock. Here’s how these shareholders are paid:

  • The preferential liquidation price, with no other dividends
  • The returns they would receive for an equal amount of common stock

Now, let’s say your company isn’t going as well as you had hoped. You do have a buyer for the company, for $10M. The non-preferred shareholders get their $1M back (in the term sheet, this would be known as 1x liquidation preference with no participation).

Suppose your technology gets some traction with another energy tech company, and you merge with a liquidation price of $15M. In this case, the non-participating investors would get 10% of the $15M, since they would be entitled to the common share price — they get whichever is larger.

Create an Exit Strategy on Your Terms

man waiting on a surfboard for large waves

Don’t wait so long that you’re left with next to nothing at the end of the day.

One mistake newbie entrepreneurs make is to buy into the VC’s economic scenario. Houses in the Hamptons, helicopters, and rubbing shoulders with JayZ takes serious bank.  Every VC fund out there has several investments going at any given time, and most of them will fail. So the pressure to go big or go home, that you should settle for nothing less than a billion-dollar IPO, is a construct created by the industry. It’s not what you and your company really need to be a success.

The billion-dollar start-ups are called unicorns for a reason, and the reality is that most start-ups go out with a whimper, not a billion-dollar bang. And you have read my data on VC performance in energy. For founders, there’s no shame in a merger or acquisition for your company; the average M&A deal in 2017 was $150 million.  For founders, that’s likely a better economic outcome than holding out to go public.

Sure, you can hold out for the unicorn horn, but at what cost? By the time you’ve gone through four rounds of fundraising and have a table full of investors, what’s your ownership in your company? Hard reality check: not much. So after the big payout is distributed to investors,  you’re left with less than you would have netted had you sold earlier. Sure, it’s a smaller pie, but you’d have a lot more of it.

If you want to talk more about setting up solid term sheets and getting investors for your big energy idea, talk to me here.

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