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:
| Pre-Money | Post-Money | |||||
| Shares | % | Shares | % | |||
| Founders | 8,000,000 | 80% | 8,000,000 | 60% | ||
| Option Pool | 2,000,000 | 20% | 2,000,000 | 15% | ||
| Series A | - | 0% | 3,333,333 | 25% | ||
| Total | 10,000,000 | 100% | 13,333,333 | 100% | ||
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:
| Pre-Money | Post-Money | |||||
| Shares | % | Shares | % | |||
| Founders | 8,000,000 | 80% | 8,000,000 | 60% | ||
| Option Pool | 2,000,000 | 20% | 2,000,000 | 15% | ||
| Series A | - | 0% | 2,000,000 | 15% | ||
| Warrants | - | 0% | 1,333,333 | 10% | ||
| Total | 10,000,000 | 100% | 13,333,333 | 100% | ||
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.”
My startup partner Ted Hollifield gave me the idea for this post. Click here for his bio.
Related articles
- Valuation and Option Pool (avc.com)
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Hi Matt,
Interesting technique and makes sense. My question is, can you elaborate on the benefits you see for the entrepreneur in trying to sell this to the investors?
Hi Matt,
Interesting technique and makes sense. My question is, can you elaborate on the benefits you see for the entrepreneur in trying to sell this to the investors?
Yes, the benefits are that you potentially don't suffer the dilution if the warrant is never exercised, and typically the exercise will require additional investment (although some warrants have a “cashless” exercise feature).
Yes, the benefits are that you potentially don't suffer the dilution if the warrant is never exercised, and typically the exercise will require additional investment (although some warrants have a “cashless” exercise feature).
Thanks Matt. Seems like a hard sell but worth a try in some cases, good creative ideas.
Thanks Matt. Seems like a hard sell but worth a try in some cases, good creative ideas.
Very interesting idea, going for vc valuation at somepoint soon. Thank you this helped
Very interesting idea, going for vc valuation at somepoint soon. Thank you this helped
Interesting strategy, although I don't know if it justifies the added risk of having a flat (or down) round next time you go to raise. Increased valuation isn't necessarily a good thing in and of itself.
Interesting strategy, although I don't know if it justifies the added risk of having a flat (or down) round next time you go to raise. Increased valuation isn't necessarily a good thing in and of itself.
Brad, while I understand the risk of a flat or down round, I don't
think this justifies not trying to negotiate the best valuation
reasonably available under the circumstances (and taking into account
who you are raising from, etc.). This suggestion is meant to provide
one form of a bridge between the valuation expectations of the company
and the investor. I also don't believe you should negotiate from a
position of “assume the worst” in the future. Thanks for your comment.
Brad, while I understand the risk of a flat or down round, I don't
think this justifies not trying to negotiate the best valuation
reasonably available under the circumstances (and taking into account
who you are raising from, etc.). This suggestion is meant to provide
one form of a bridge between the valuation expectations of the company
and the investor. I also don't believe you should negotiate from a
position of “assume the worst” in the future. Thanks for your comment.
But in the “upside scenario”, the founders are in the exact same position, right? The warrants will be exercised and the investors will have the same share they would have had at a lower valuation.
But in a “sideways” scenario, giving away warrants in exchange for a higher valuation will increase the risk of a down round, which is decidedly negative.
I totally agree that startups should absolutely try to negotiate as best as they possibly can with investors. I've just seen many startups unhealthily focus on the valuation versus things such as the liquidation preference or board control.
But in the “upside scenario”, the founders are in the exact same position, right? The warrants will be exercised and the investors will have the same share they would have had at a lower valuation.
But in a “sideways” scenario, giving away warrants in exchange for a higher valuation will increase the risk of a down round, which is decidedly negative.
I totally agree that startups should absolutely try to negotiate as best as they possibly can with investors. I've just seen many startups unhealthily focus on the valuation versus things such as the liquidation preference or board control.
Not exactly the same position in the upside scenario, because the
investor needs to pay to exercise. So as I mentioned above, this is
the same as raising more money at the higher valuation. However, I
totally get and appreciate your comment about focus on valuation at
the expense of other possibly more important items.
Not exactly the same position in the upside scenario, because the
investor needs to pay to exercise. So as I mentioned above, this is
the same as raising more money at the higher valuation. However, I
totally get and appreciate your comment about focus on valuation at
the expense of other possibly more important items.
Thanks Randy, glad you found it of value.