06 Feb
We’ve seen a significant increase in founders talking to us about deal terms in the current funding environment, especially as the earliest signs of economic tightening and downrounds are starting to appear. Many ask, “How do I get the highest valuation” and our answer always is “That’s only part of the story, and usually not the most important part”. It is reminiscent of the comments received from a talk we’ve given around the country called: How Much Would You Get if You Sold Your Company for $100M? A surprising number of founders don’t know the answer to this, and it couldn’t be more important as you navigate through the funding landscape on the way to an exit.
What’s important to keep in mind is that venture-backed outcomes tend to be clearest at the extremes. When the company is a homerun with a hockey stick trajectory, everybody wins BIG. When the company is ill-fated early, you pack it up and move on. However, in that messy middle zone, which represents far and away the vast majority of venture deals, adroitly dealing with the issue of valuation vs. deal terms can make the difference between founders walking away with life-changing money or a cup of coffee.
What’s important to keep in mind is that venture-backed outcomes tend to be clearest at the extremes. When the company is a homerun with a hockey stick trajectory, everybody wins BIG. When the company is ill-fated early, you pack it up and move on. However, in that messy middle zone, which represents far and away the vast majority of venture deals, adroitly dealing with the issue of valuation vs. deal terms can make the difference between founders walking away with life-changing money or a cup of coffee.
The Three Things You Need to Know:
1. The terms that make a difference
The core terms that matter are the liquidation preference (with/without cumulative dividends), participation rights (with/without a cap) and anti-dilution rights. The corollary to this is the valuation implied by the round, because these rights (and others) are in place to provide protection to investors if things don’t “go according to plan”—which can include anything from a sale below invested capital to a moderate outcome (in baseball terms, let’s call this latter outcome a “double”). One question that is always worth asking is, “If you are getting a relatively higher valuation, then what are you giving up?” This question is the cousin of the more typically stated “You can pick any valuation you want, but I’ll pick the terms”.
Terms usually matter more than Valuation:
- More than half the deals VCs do trigger protective provisions either during subsequent funding rounds or at exit; founders shouldn’t be caught by surprise. VC’s take a portfolio approach; the math is about finding 20-30 deals with home run potential and getting 2-3 in that group that will not only make up for losses but also generate all the returns
- Cap Tables are not a single source of truth: terms aren’t always apparent from a cap table. Cap tables also won’t reveal things like the fact that convertible debt deals include an effective “full ratchet and multiple liquidations” and that the post-money option pool affects your effective “pre-money” valuation (hint: it’s not the “pre-money” number you read on the term sheet)
- Paper mark-ups on a VC portfolio can be illusory. What matters is what happens at liquidation. If a company takes on an aggressive valuation and has to face a downround, common shareholders take a serious hit; debt or debt-like instruments (like preferred stock) always get paid back first.
2. How multiple rounds of funding change the game
After a few rounds, Preferences and Valuation can separate the interests of the founder and early vs. late investors
- The more differences that exist in terms and valuation for each round the more security holders can have different return profiles/intrinsic interests. In this most recent round of unicorns, there is an unprecedented range of outcomes in which the returns of late stage investors are indifferent – this can give them a significant incentive to roll the dice and hold on for a big exit, while early stage investors may be more motivated to sell earlier
- The Board is likely to control the company, not the founders; even before control shifts, investors have a number of blocking provisions in place
- The higher the valuation, the greater the amount of value that needs to be created before an investor may be willing to hold on to the end rather than get their money back in a early sale if things start looking dicey
- As terms pile up over 3-4 rounds of funding and a 6-9 year life cycle to exit, founders can often be left with very little economic upside except in the event of a massive sale
- Gilt Groupe and Good Technology are just two of the higher profile “unicorns” that have had less than stellar exits after many rounds of capital raised. In our practice, we routinely see the impact of downrounds on companies at all stages and the varying impacts on common stock depending on the deals negotiated.
3. What you can do about it
Knowledge is Power – know your exit hurdle:
Know the payout structure (“waterfall”) for each round of capital you raise, and what the payout looks like for differing possible exit values. You will see the impact of the post-money option pool, the liquidation preferences, dividends, seniority, participation rights & caps, and anti-dilution provisions as well as the impacts of convertible debt/equity conversion and valuation caps. You need to know this for individual security holders, not just each class of stock. Different people in the same class may have very different circumstances that will influence their behavior even for the same exit, and this is especially true where people own several different tiers of the capital structure.
Make sure your advisors have fully walked you through your term sheets and you understand all the terms, including what would happen if things “don’t go according to plan”. Don’t rely on your investors to do this.
How to understand your waterfall. To help address these specific issues that we noticed were continually arising, we have created internal tools that helps founders, investors, employees and their advisors see an easy to understand display of the waterfall and cap table, at the individual stakeholder level. You can also run hypothetical scenarios around funding rounds and exits.
For more information on this article or our software, you can contact us at info@oxfordvp.com.