If you are a company that is fundraising, keep in mind that there are a few different levers you can pull to change the amount of dilution that the founders will experience. VCs know about these levers, and they pull them all the time. Let’s look at an example of a lever that you can pull.
Let’s say you receive a term sheet for a $1 million investment at a $3 million fully diluted pre-money valuation, and you’re kind of disappointed. You have a 20% option pool, so you know this will take your ownership down from 80% to 60%, and the VC will get 25%. Take a look at the numbers:
How can you pump up that valuation without arguing endlessly about the “correct” pre-money, potentially killing the investment or poisoning your relationship with the VC going forward? One possibility is to negotiate a higher valuation and offer warrants (i.e., an option to purchase shares in the future at a pre-determined price) to the investor to purchase preferred stock at the Series A price. Take a look at the numbers when you increase the fully diluted pre-money valuation from $3 million to $5 million and include warrants:
Prior to the VC’s exercise of the warrants, the founders will actually own 67% of the issued shares because the warrant shares are not outstanding until the warrants are exercised. In order to exercise the warrants, the VC will need to pay an extra $666,667 into the company (i.e., 1,333,333 warrants x $0.50 Series A price). This is not all bad for the VC, since they will only exercise if the warrant is “in the money”, meaning the point in the future if and when the Series A value is higher than $0.50. This is usually done when the company is acquired — if the acquisition price per share of Series A is greater than $0.50, the VC will receive the spread between $0.50 and the acquisition price. Of course, this is no different than raising $1,666,667 at a $5 million pre-money valuation, but it’s a little better for the VC because it gives them the option to not put in the extra $666,667 until they see the company is going to be successful.
Why else might this be useful? I just worked on a financing for a company that received a term sheet from a group of VCs at a $7 million pre-money valuation. They had a strategic investor in the wings that wanted to invest, but the company thought they could get a higher valuation from the strategic. So they sold all the shares at a $10 million pre-money, but gave the investors enough warrants to drive down their effective pre-money valuation (as closely as possible) to $7 million.
By the way, here is the answer to the inevitable question about whether VCs will accept this: “It all depends on who has the leverage.”