MANYVentures

Pre-money and post-money valuation

Pre-money valuation is what investors say the company is worth before their money arrives. Post-money valuation is that figure plus the new investment, and the investor’s ownership equals the investment divided by the post-money value.

The difference is real equity. If an investor puts $2 million into a company at an $8 million pre-money valuation, the post-money value is $10 million and the investor owns 20 percent. If the same $2 million buys in at an $8 million post-money valuation, the investor owns 25 percent.

Ask for a pro forma capitalization table showing every holder’s shares and percentage after closing. The National Venture Capital Association publishes model financing documents that many investors start from, which makes unusual terms easier to spot.

The option pool

Investors usually want shares reserved for future employee grants, and they often ask that the pool be created or enlarged before they invest, inside the pre-money valuation. Its dilution then falls on existing holders, mostly founders, rather than on the new investor.

The effect is a lower price than the headline suggests. In the example above, a pool equal to 10 percent of the post-money company, created before the round, is worth $1 million, so founders are effectively selling at a $7 million pre-money valuation.

Size the pool from a hiring plan that lists the roles you expect to fill before the next round, not from a round number.

Liquidation preferences

A liquidation preference sets who is paid first when the company is sold or wound down. Under the common 1x non-participating preference, preferred investors receive either their original investment or what they would get by converting to common stock, whichever is greater.

Participating preferred lets investors take their money back and then share in what remains as well. Suppose investors put in $5 million for 25 percent and the company sells for $12 million. Non-participating, they take $5 million and common holders keep $7 million. Fully participating, they take $5 million plus 25 percent of the remaining $7 million, leaving common holders $5.25 million.

Also check for multiples above 1x, caps on participation and seniority, meaning whether later investors are paid before earlier ones or alongside them.

Anti-dilution protection

Anti-dilution clauses protect investors if the company later sells shares at a lower price, a down round. They lower the price at which the investor’s preferred stock converts into common, so the investor ends up with more shares.

Broad-based weighted average protection, the most common form, adjusts that price in proportion to how many new shares are sold and how deep the discount is. Narrow-based versions count fewer existing shares in the formula, which makes the adjustment larger. Full ratchet drops the conversion price all the way to the new price, however few shares are sold, and can sharply dilute founders.

Check the carve-outs as well. Standard ones keep employee option grants and certain other issuances from triggering any adjustment.

Board seats and protective provisions

The board hires and fires the CEO, approves budgets and decides whether to sell, so its makeup can matter more than any economic term. One common arrangement after a first priced round gives founders two seats and the lead investor one, and later rounds often add an independent director.

Protective provisions are separate vetoes that preferred stockholders hold as a class. Typical ones cover selling the company, changing the preferred stock’s rights, issuing new senior or equal stock and changing the board’s size. Resist lists that reach into routine operations such as budgets or hiring.

• How many seats will founders, investors and independents hold after this round?
• Who chooses the independent director, and can either side veto the choice?
• Does consent require a majority of all preferred, or can one investor block a decision?
• Which of your current plans would need investor approval?

Pro rata rights, founder vesting and the no-shop

Pro rata rights let an investor buy enough of a future round to keep its ownership percentage. They are standard for major investors, but granting them to many small holders can leave too little room for a new lead.

Investors often ask founders to put their own shares on a vesting schedule, frequently four years with a one-year cliff, sometimes with credit for time already worked. Single-trigger acceleration vests shares on a sale alone. Double-trigger acceleration requires both a sale and your termination without cause, or resignation for good reason, within a set period, and investors and buyers generally prefer it because it gives key people a reason to stay.

A no-shop clause bars you from negotiating with other investors for a set period, often 30 to 60 days, while the investor finishes diligence and documents. Along with confidentiality, it is one of the few binding parts of most term sheets, so keep the period short.

SAFEs and convertible notes

Before a priced round, many startups raise money on SAFEs or convertible notes, which turn into preferred stock later. A convertible note is debt, with an interest rate and a maturity date. A SAFE, the simple agreement for future equity that Y Combinator introduced, has neither.

Both usually convert at a valuation cap, a discount to the next round’s price, or both, in which case the holder gets whichever price is lower. Y Combinator’s post-money SAFE, now widely used, measures the cap after all SAFEs but before the priced round’s new money. A $1 million SAFE with a $10 million post-money cap therefore converts into at least 10 percent of the company at that point, and each additional SAFE dilutes the founders rather than earlier SAFE holders.

Keep a running total of everything raised on SAFEs and notes, so conversion doesn’t reveal that you have sold more of the company than you thought.