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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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Early Stage Angel Round Valuations

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I’m getting a lot of questions these days about early round valuations – specifically for angel rounds.  While these vary over time, and by segment, most of them tend to settle into a pretty tight range for early stage angel investments.  I’ve talked about the different approaches – either a “convertible debt” or a “light preferred”in the past.  I’ve also stated that I prefer the light preferred approach.

So – assuming you are doing a light preferred – what is a fair price?  I’ve been doing these types of investments for the past 12 years and I’ve investment in companies where the pre-money valuation has ranged from $250k to $5m and the amount raised has ranged from $50k to $2m.  While there are obviously some outliers, the normal range seems to be $1m to $2.5m pre for up to a $1m investment.  I’ve seen this reinforced recently with a number of deals done in this range.

How Many Stock Options Should I Give An Advisor?

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I received the following question recently:

Just want to ask you a question. I’m looking to bring in a couple of advisors for my startup, how much stock and the approximate % of equity should I give that’s fair to the advisors for their invaluable advice? I was thinking of 100,000 shares each that equates to 1% company equity. Can you advice me on what’s the norm?

1% is rich.  In the past, I’ve given some ground rules for equity grants for directors – 1% vesting over four years is at the top end of the range.  Advisors typically (although not always) contribute much less value to a company than directors and their equity grant should correspondingly be less.  Of course, the amount you give depends on a number of factors, including things like your expectation of what the advisor will provide, how much you value this involvement, and the existing capital structure of the company (e.g. larger grants if you are younger, smaller grants if you are a more mature company.)

Usually, you’ll be granting stock options (non-qualified stock options – “non-quals” or NQSO’s) to the advisor.  As a result you should think through vesting carefully.  Many advisors contribute much of their value early in the life of the relationship so rather than giving a grant that vests over four years, you might consider making an annual grant and then revisiting things in a year to see if the relationship is living up to expectations.  A savvy advisor will prefer to get a bigger grant that vests over four years since it will allow them to lock in a strike price at today’s fair market value (FMV) of the stock (which – in the success case – will likely be lower than the FMV in the future).  At the minimum, this will facilitate a conversation about revisiting things annually to make sure everyone’s expectation is being met with the relationship.

How to Set The Strike Price on Stock Options

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I received the following question on pricing stock options recently.

In a post you wrote last year, you said “Let’s also assume that company did a financing and is worth $10.5m post-money (e.g. $3 / share), that the financing was done with preferred stock, and the board determined that the fair market value (FMV) for the common stock is $0.30 / share (common stock in a venture-backed company is often valued at 10% – 25% of the preferred – I’ll leave that for a separate post.)” Could you help explain the justification for the 10% – 25%?

A year ago when I wrote that post, I hadn’t thought much about the implication of the new IRS regulation 409A.  While a draft had been published, it didn’t really catch the attention of the venture community until a critical memo was released in the fall.  As a result, when I wrote the post in mid 2005, I was referring to a typical rule of thumb that VCs have been using since fire was invented to set the strike price for stock options.

The old rule of thumb was to price them at roughly 10% of the price of the preferred shares if the company was a very early stage company.  As the company matured, the percentage would increase, usually slowly, and reach 25% of the current preferred price well before the company was profitable.  In the days when software companies went public, the SEC looked back 18 months to determine “cheap stock issues” and – as long as the board was making an appropriate fair market value (FMV) assessment of the common stock and increasing it over time, with more significant increases occurring as the target date for the IPO drew nearer - all was probably ok (plus – the cheap stock charges were P&L accounting charges but were non cash charges so no one really struggled with them much anyway.)  When the company went public, the stock would now have a market price that fluctuated regularly and stock options would be priced at whatever the stock traded with on the date of the grant.

This approach worked fine for a while. Serious lawyers would even encourage companies to price their options lower than a conservative board might suggest, as they were trained to use the 10% rule. 

With the emergence of 409A, all of that went out the window.  While the board still needs to determine the FMV of the common stock for purposes of pricing the stock option grant, the 10% rule no longer applies.  Instead, a more rigorous analysis needs to take place.  I’ve explained this extensively – with the help of my trusty sidekick Jason - in the 409A series on this blog.

Ironically, now that we’ve been living with 409A for a while, a bizarre unintended consequence has emerged.  In order to comply with the 409A statute while being extra conservative, we have our companies hire an outside valuation expert to do a 409A valuation.  In a number of cases, the FMV has come in at less than 10% of the preferred price (in one case it came in at under 5% of the preferred price.)  Presumably, one of the goals of 409A was to increase the strike price on common stock as the premise was that many boards were setting FMV too low.  Hah – be careful what you wish for.

Right of First Refusal

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Following is a question I got the other day.

We have some people who are currently interested in doing a Series A round with us.  They aren’t VC’s – they’re a company in our market who offer a pile of services complimentary to ours (they aren’t competitors, or substitutes.)  In our conversations with them, they’re asking for a Right of First Refusal – I know this is standard stuff, however, they’re asking for a ROFR for acquisition offers, as well.  Their reasoning (which is valid), is that they don’t want one of their competitors coming and buying us outright – they’d want to do it themselves. My question is, in an acquisition scenario, will this type of ROFR cause problems that make us a less appealing acquisition?  What type of issues might we run into in the future?  Any advice?

In our Term Sheet series, Jason and I talked about the Right of First Refusal (ROFR) in the context of a financing.  When a ROFR is requested for future financings, this is a standard term and one that isn’t usually worth negotiating much.  However, it’s an entirely different case if a ROFR is requested in a financing that will apply to acquisition.

While a rational request, it’s very dangerous to provide a ROFR on an acquisition to investors in a financing.  A VC will rarely request this (and – if he does – tilt your head sideways at him as say “huh – why?”)  However, corporate investors (also known as “strategic investors”) will often ask for this.  The theory is almost always the one posited in the question above – namely – we want to invest in you now but want first crack at acquiring you if one of our competitors starts sniffing around.

Good theory; bad implementation.  Giving an early investor a ROFR on an acquisition materially handicaps the company and disadvantages all shareholders, except the corporate investor that is getting the ROFR.  The corporate investor will already have visibility into your company and will likely have a variety of rights (including potentially a board seat) by virtue of their investment.  In some cases, they’ll be aware (by virtue of their board seat) of any potential acquisition activity.  If they aren’t, it’s likely that if you get into discussions with a potential acquirer, you’ll bring it up (carefully – of course) with your corporate investor and suggest that – if they are interested – that now would be the time to consider making an offer for the company.  So – the notion that they’d be left out in the cold completely – while possible – is unlikely.

If you have a ROFR in place, you are in a bad position with regard to a potential acquirer that is not the corporate investor.  Depending on how the ROFR is written, you’ll likely have a difficult time signing an LOI with a potential acquirer without first notifying the corporate investor and giving them a ROFR.  In the extreme case, you’ll need to disclose the terms to them so that they have an opportunity to match or exceed the offer.  In the mean time, you will lose major deal momentum with your new potential acquirer.  In addition, since your discussion with your potential acquirer is likely governed by a confidentiality agreement, you’ll have to tread carefully as to what you discuss or disclose.  This gets even more difficult when you are balancing multiple potential offers and buyers – the logistics of managing the ROFR can get very challenging.

In all scenarios, unless you have developed a negative relationship with your corporate investor, it’s all probably unnecessary anyway.  Since the corporate investor already owns a percentage of your company (typically less than 20%), they have a built in discount on the acquisition based on the ownership position they already have.  While they’d of course love to buy the company at the lowest price possible, the ROFR probably won’t help them accomplish this as any savvy seller will be able to manage the buying process to get the best offer on the table before exposing the ROFR.  All the ROFR does is jeopardize the deal, which doesn’t do anyone any good (e.g. your corporate investor decides not to proceed with acquiring the company but the intervening time has caused the buyer to get cold feet and back off.)

While it’s conceivable the ROFR will reduce the number of companies potentially interested in acquiring your company, this can be managed.  It’s often said that buyers won’t pursue a company that has a ROFR – in practice I’ve found it relatively easy to “trip” the ROFR early in the process and get that out of the way.  I have run into aggressively written ROFR’s that cause me to shake my head as it is possible for the ROFR to completely tie up the seller – but I attribute this to poor negotiation on the part of the attorney’s for the seller that negotiated the ROFR in the first place.

The bottom line is that a ROFR on an acquisition is never helpful to the investee and rarely accomplishes what the investor that insisted on it wants.  My simple recommendation is to negotiate hard on this term – it’s not worth having it hanging around.

The Personal MBA

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As a follow up to my MBA post from yesterday, I noticed an article in BusinessWeek titled “Can a Personal MBA Match the Real McCoy?”  Interesting and provocative content, along with a few interesting links for those of you thinking about an MBA.

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