We like to be as transparent as possible when I’m trying to convince a candidate to join our team. After all, we’re asking for one of their most valuable resources, namely, time and opportunity. When I started this company with my friends, we strived to build a place that, unlike any of the places that we’ve worked at, offered clear transparency and definable upside. Since then, we’ve realized that it’s one of the core tenets of the company. So, in an effort to convince prospective employees to come work with us but also, just be a generally helpful resourceful for people out there, we’ve decided to start a “gotcha” series highlighting all of the things we think you should watch out for when considering a startup opportunity.
The content of this series will mostly be general and applicable to all startups. In specific instances, we’ll be specific about what we do and why we chose a specific policy.
Disclaimer: The people who wrote/edited this (i.e. Allen Li) have extensive financial/startup/legal knowledge but are not lawyers by any means. This is not legal or tax advice. You should consult your lawyer if you have any questions.
PART I: You said the valuation was what?
Let’s face it — valuation is the first thing everyone wants to talk about. What other metric can employees use to evaluate opportunity A with opportunity B? Well, we’re here to tell you that before you take that number at face value you should ask this extensive but non-exhaustive list of questions/topics (they should be able to send your their last term sheet for ease):
Question #1: Where does this valuation come from? When was it from?
Is it the pre/post-money valuation from the last round? Or is it an indicative term sheet you’ve received? Is the valuation equal to the last round’s price per share multiplied by the number of fully diluted shares?
For the people new to startups, post-money valuation generally refers to the valuation assuming all shares were valued at the price per share the last round transacted at. For example, if I had a company with 100 shares and someone bought the one share most recently at $10, this would mean the company is worth $1,000. However, in startup land, because capital is generally injected, the company would issue a new share and that would be sold at $10. So, instead, we have 101 shares making the company’s post-money valuation $1,010. The pre-money is simply the valuation less the amount that was put in ($1,000 in this example).
Question #2: Have you received the entire funding? Are there any stips (requirements) associated with the round?
Sometimes investors will build in milestones prior to the funding coming through. For example, they may say we’ll fund $10M day 1 but only another $10M funded after you’ve hit this much in revenue or have been approved for this license. This isn’t necessarily positive or negative but something to be aware of.
Question #3: Were there any other instruments (warrants) issued along with the round?
In venture, warrants are equity instruments commonly issued to strategic partners to reward them differently versus other equity investors. As a general matter, it makes sense — if I bring business to the company, I should be compensated differently from other equity investors. However, it gets murky if, for instance, the lead investor also is the one who gets the warrants. The price then needs to be adjusted for the warrants they received. For example, if the investor was issued 5% in penny warrants and invested 10% in the company at a $100M valuation, then their investment basis is closer to $66M.
Question #4: What was the liquidation preference in the round? What about the dividend rate? Is it non-cumulative? What is the liquidation preference seniority?
The most well-known example of an unfavorable fundraising term is a >1x liquidation preference — of course an investor is willing to pay MORE for shares that get paid out first up to 2x their invested basis. However that artificially increases the math of valuing the company as price per share x number of shares in the company. Similarly, if they get paid out first (senior liquidation preference), they would, again, be willing to value the shares more as well.
Dividend rates are usually pretty inconsequential but are basically the additional amount above and beyond the liquidation preference that an investor has to earn. Think about this as a minimum return in a liquidation scenario. Cumulative means that it continues to accrue past a single year.
Question #5: Any ROFRs (Rights of first refusal)? Super pro-rata rights?
Right of First Refusals refer to an investor’s right to have the last look at financing at a company. When the company solicits a holistic set of terms from another investor, the Right of First Refusal holder has the right to take those set of terms. In a perfectly liquid market, this doesn’t do anything — every knows the price of an asset and you can go buy at the market price at any time. In an illiquid market like VC, this “chills the bid” or causes investors to shy away from doing work on the company because they know someone else may take advantage of the price setting work they did. Unsurprisingly, this is a favorable term for the investor which they should be willing to pay a higher price for.
Super pro-rata rights mimic the ROFR in terms of allowing an investor to buy more of a company but instead forces a company to take additional dilution at the next round and increase the round size. Mechanically, the company is forced to allow an investor to invest at the terms of the current round up to a certain percentage ownership. This doesn’t “chill the bid” but does result in the company taking more dilution than they wished to take. (Yes, you can argue to solicit a round with lower dilution and achieve the same outcome)
Question #6: What are the non-standard provisions in the round?
All of this points to one simple premise: all valuations are not created equal. If the answer is yes to any of the above, this doesn’t mean that the company is bad, just that they gave something up to get an artificially high valuation. You could argue valid reasons for doing so but it’s something to be careful of. Conversely, a company may also choose to take a lower valuation from an investor for very valid reasons. For example,
On a more technical basis, assuming a company is providing you a valuation based on a “print” (i.e. a transaction that has been or will be completed), what is occurring is that the shares being sold are what is being valued. This includes all the terms and conditions and even the voting rights associated with the shares. You can certainly imagine that the more control an investor has over a company the more comfortable they feel with the outcome and hence the price they paid. This equation also factors in realistic outcomes — a later stage company generally has more tangible value and therefore liquidation preferences are weighted more. Conversely, there’s rarely a reason to think that a 12 person software startup has real tangible value in a liquidation scenario and hence most VCs underwrite it to a zero in case of a loss.
As a final note, while we have probably added a lot more complexity to your calculus when evaluating an opportunity, the good news is that if the following are true, your old framework of thinking about it is PROBABLY fine.
For what it’s worth, we currently:
It’s probably not that unique but important to highlight nonetheless.