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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Term Sheet: Price

Comments (17)

A the end of the year, I completed a financing that was much more difficult than it needed to be. As Jason Mendelson (our general counsel) and I were whining to each other we decided to do something about it. At the risk of giving away more super-top-secret VC magic tricks, we’ve decided to co-author a series of posts on Term Sheets.

We have chosen to address the most frequently discussed terms in a venture financing term sheet. The early posts in the series will be about terms that matter – as we go on, we’ll get into the more arcane and/or irrelevant stuff (which – ironically – some VCs dig in and hold on to as though the health of their children depended on them getting the terms “just right.”) The specific contract language that we refer to (usually in italics) will be from actual term sheets that are common in the industry. Ultimately, we might put this into a Wiki, but for now we’ll just write individual posts. Obviously, feel free to comment freely (and critically.)

In general, there are only two things that venture funds really care about when doing investments: economics and control. The term “economics” refers to the end of the day return the investor will get and the terms that have direct impact on such return. The term “control” refers to mechanisms which allow the investors to either affirmatively exercise control over the business or allow the investor to veto certain decisions the company can make. If you are negotiating a deal and an investor is digging his or her feet in on a provision that doesn’t affect the economics or control, they are probably blowing smoke, rather than elucidating substance.

Obviously the first term any entrepreneur is going to look at is the price. The pre-money and post-money terms are pretty easy to understand. The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. There are two items to note within the valuation context: stock option pools and warrants.

Both the company and the investor will want to make sure the company has sufficiently reserved shares of equity to compensate and motivate its workforce. The bigger the pool the better, right? Not so fast. While a large option pool will make it less likely that the company runs out of available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the company should be increased, they will insist that such increase happen prior to the financing. Don’t bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a higher pre-money valuation if the actual value gives you heartburn. Standard language looks like this:

Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.

Alternatively:

Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully-diluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by [ ] shares prior to this financing.

Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. Warrants as part of a venture financing – especially in an early stage investment – tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who – for some reason – want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round – it’s not worth fighting these warrants.

The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company – (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.

  • http://furrier.typepad.com/john_furrier/2005/01/vc_financing_te.html John Furrier

    VC Financing Term Sheet Postings Series

    Another good post by Brad Feld, VC Blogger from Mobius.

  • http://sshu-s4.tripod.com/blog Steve Shu

    Although I don’t have enough info to say, I wonder if the financing (say if a Series A round) was made difficult if the seller did not have adequate counsel and/or was unable to discern what current market conditions were (e.g., for ratchets, liquidation preferences, dividends). Sometimes sellers need to use informal networks to solicit for market condition information on valuation, allocation of stock option pool across senior management, etc.

  • http://www.theconglomerate.org/weblogs/archives/000968.html Conglomerate

    VC Term Sheets

    Brad Feld, the Managing Director of Mobius Venture Capital and proprietor of the Feld Thoughts blog, has launched a series of posts on term sheets. If the first post is any indication, these will be very valuable….

  • http://www.feld.com/blog Brad Feld

    Unfortunately, in the case I was whining about, the folks involved were very sophisticated and had adequate counsel. They just chose to focus on things that were not very important. That said – your comments are on the money.

  • http://www.sjl.us/main/2005/01/term_sheet_term.html Scott Loftesness

    Term Sheet Terms

    Brad Feld of Mobius Venture Capital has posted a couple of great reads for entrepreneurs on his blog this week: Term Sheet: Price and Term Sheet: Liquidation Preference. Between Brad and David Hornik, there soon won’t be any trade secrets

  • http://www.sjl.us/main/2005/01/term_sheet_term.html Scott Loftesness

    Term Sheet Terms

    Brad Feld of Mobius Venture Capital has posted a couple of great reads for entrepreneurs on his blog this week: Term Sheet: Price and Term Sheet: Liquidation Preference. Between Brad and David Hornik’s VentureBlog posts, there soon won’t be any

  • http://peterhoskins.typepad.com/tailwhip/2005/01/feld_thoughts_t_1.html Peter Hoskins'

    Feld Thoughts: Term Sheet: Price

    Link: Feld Thoughts: Term Sheet: Price.

  • http://peterhoskins.typepad.com/tailwhip/2005/01/feld_thoughts_t_1.html Peter Hoskins’ Blog

    Feld Thoughts: Term Sheet: Price

    Link: Feld Thoughts: Term Sheet: Price.

  • http://loxos.blogspot.com/2005/01/business-financing-for-startups.html DAtum

    [Business] Financing for startups

    I suppose that complexity is the real hurdle here. But at the risk of sounding juvenile, is accepting a lower valuation in exchange for no warrants a good thing?

  • http://www.adamscapital.com Michael Blake

    For what it’s worth from a guy working in valuation, I typically advise early stage clients not to get too worked up over valuation, unless they have multiple sources of capital. I routinely turn away such clients because although I’d be delighted to take their money, they’d really be no better off after having obtained an appraisal report (and investors would likely dismiss it anyway). As the blog mentions, the only real leverage you have in valuation is to establish an auction, and that will more or less set the price anyhow.

    I’d offer an alternative view on issuing warrants, however. Warrants are tricky, (particularly if you value the warrants directly) but as someone mentioned in a comment, valuation of preferred stock is at least equally tricky. At least with warrants, you can pretty much assume full dilution to the common and fairly simply estimate the appropriate share price. The place where we see people get tripped up is they give away WAY too many warrants because they treat their value as de minimis.

    Preferred stock valuation requires fairly complex option pricing models (it’s incorrect to treat it as debt, as many even in the valuation field do) to figure out what the actual value/price is.

    – mike

    http://www.adamscapital.com
    http://www.startuplounge.com

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  • http://intensedebate.com/people/fiwedding fiwedding

    I’m not sure if you need to be “more experienced” to use stealth effectively. I think ultimately it comes down to playing your own game at your own tempo.

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