Valuation Posts

Is it fair for founders to own about 100% of a startup while employee #1 only owns a few percent? Are founders 10-1000x more valuable than employees?

The answers are

  1. Yes, it is fair.
  2. Value doesn’t matter, timing does.

In fact, many employees get better equity deals than the founders. There are two cases.

1. The founders are not intrinsically fundable

When the founders start the company, it is worth approximately $0. So their equity is worth $0.

Let’s say the founders work for 6 months, make progress, and then raise money at a $10M post. Then employee #1 joins and gets 1% of the company. So his shares are worth $100,000.

So each founder got $0 of stock when he joined the business. The employee got $100,000 of stock when he joined the business.

Every employee that joins the business gets more stock than the founders did. Not in shares, or as a percentage of the company. But in the only metric that really matters, the dollar value of stock at the time the employee joins.

That’s why some people say that anyone who joins a company before they raise money is a founder. In other words, anyone who joins the company before the stock has value to a third party, is considered to be a founder.

2. The founders are intrinsically fundable

Some founders can raise money with nothing to show other than their smiling faces.

Let’s say the founders raise money at a $10M post-money, simultaneous with founding the company. In this case, the market is valuing the founders’ contribution at $10M.

Then the company identifies employee #1 and tries to hire her. The company will have to compete with every company in the world for that employee, and therefore the market, not the company, is setting the employee’s compensation.

Continued in Part 2.

Addendum

Measuring your stock in dollars is not at odds with measuring your stock in percentages. They’re just different views on the same data. If you’re an employee at Facebook and the stock price is monotonically increasing, look at the dollar value of your stock. If you’re joining a company today and you’re trying to figure out what you get if the company sells for $100M, use percentages.

(Note: This is the first time I’m testing this argument. Be gentle.)

Chris Dixon, serial entrepreneur and seed-stage investor:

“… You should try to answer the question: what is the biggest risk your startup is facing in the upcoming year and how can you eliminate that risk?  You should come up with your own answer but you should also talk to lots of smart people to get their take (yet another reason not to keep your idea secret).

“For consumer internet companies, eliminating the biggest risk almost always means getting ‘traction’ — user growth, engagement, etc. Traction is also what you want if you are targeting SMBs (small/medium businesses). For online advertising companies you probably want revenues. If you are selling to enterprises you probably want to have a handful of credible beta customers.

The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone [emphasis added]. Building a product is only accretive in cases where there is significant technical risk — e.g. you are building a new search engine or semiconductor.”

Read the rest of Chris’ What’s the right amount of seed money to raise? Also see our post, How do we set the valuation for a seed round?

If I had to stuff my answer to this question into one sentence, I would say: “As much as possible while keeping your dilution under 20%, preferably under 15%, and, even better, under 10%.” Raising as much as possible is especially wise for founders who aren’t experienced at developing and executing operating plans.

“Financings are blowing up, terms are being renegotiated, venture lenders are getting more conservative, and existing investors are stepping up to fill the gaps…

“I guarantee that there are some financings happening right now that are getting done at valuations which would have made sense nine months ago but don’t make sense right now… I also guarantee that there are some financings happening right now that are getting done at valuations at half or even less of what they would have commanded nine months ago, even though the public markets have only gone down about 33% year to date.

“You can look to the public markets for some clues, and everyone I know is doing that, but it will only help so much. We are going to have to make up a lot of this as we go along. But I know one thing for sure. Capital has gotten more expensive in the past month (actually it started getting more expensive late last year) and we all had better reflect that in our plans and strategies.”

Fred Wilson, Union Square Ventures

This is consistent with my observations and discussions with investors. Investors are looking at the public markets and renegotiating terms or pulling offers altogether. Their argument goes along the lines of “Google is worth less today and therefore so are you.” If you were a smart-ass, you would reply, “We didn’t come up with that valuation, you did.” But that won’t get you far if you don’t have leverage.

A reader asks:

“My question is how do we value a company with no sales? I understand it’s an arbitrary valuation but is there anything we can possibly base it on? Is there a “default” valuation for companies in a seed round?”

We’ll answer this question with some questions (and answers) of our own:

  1. How much money do we need?
  2. How do we set a valuation from this budget?
  3. How do we express our valuation to investors?
  4. What’s the range for seed round valuations?
  5. How low do seed round valuations go?
  6. How much money can we raise in a seed round?
  7. How much dilution should we expect in a seed round?

1. How much money do we need?

First, figure out how much money you need to run at least two experiments*. Then tack on 3 more months of runway so you can raise another round before you run out of money. This is the minimum amount of money you should raise. For example, let’s say you need $100K.

* Your experiments should be constructed such that a positive result will let you raise more money at a higher valuation.

2. How do we set a valuation from this budget?

Now decide what percentage of the company you will sell for $100K. Pick a number between 10% and 20% of the company’s post-money. You can go below 10% but that probably means your valuation will be too high or you will raise too little money.

For example, let’s say you’re willing to sell up to 15% of the company—that’s your bottom line dilution. This implies a bottom line post-money valuation of $666K.

3. How do we express our valuation to investors?

Finally, tell investors that,

“First, we think we can make the company significantly more valuable if we raise $100K—that’s our minimum. Second, we’re willing to sell up to 10% of the company.”

10% is your aspirational dilution. It’s the lowest dilution you can justify. It’s the lowest dilution you can say with a straight face.

Notice that you didn’t explicitly state your valuation. Combining the dilution (10%) with the minimum amount you’re raising ($100K) implies a minimum post-money valuation of $1M. But the valuation is not explicit. This gives you room to raise your valuation if you raise more than $100K (and we suggest you raise as much money as possible).

4. What’s the range for seed round valuations?

If $25K buys 1% of company, your post-money is $2.5M—that’s on the high end.

If $25K buys 5% of company, your post-money is $0.5M—that’s on the low end.

5. How low do seed round valuations go?

Y Combinator has set new lows for seed round valuations. They get away with it because they also set new highs for helping seed stage companies.

According to the YC FAQ, they buy about 6% of a company for $15K-$20K. So the post-money valuation of their investments is $250K-$333K.

But don’t fixate on valuation. Low valuations aren’t bad if you keep the dilution down too. 6% dilution is very low if the company makes a lot of progress with $15K-$20K.

6. How much money can we raise in a seed round?

If you sell 20% of your company at a $2.5M post-money, you raise $500K. That’s about the maximum for a seed round. Beyond that is Series A country.

7. How much dilution should we expect in a seed round?

Take as much money as you can while keeping dilution between 15-30% (10%-20% of the dilution goes to investors and 5%-10% goes to the option pool).

Compare this to a Series A which might have 30%-55% dilution. (20%-40% of the dilution goes to investors and 10%-15% goes to the option pool.)

A seed round can pay for itself if the quality of your investors and progress brings your eventual Series A dilution down from 55% to 30% (for the same amount of Series A cash).

Don’t over-optimize your dilution. Raising money is often harder than you expect, especially for first-time entrepreneurs.

Smart investors don’t over-optimize dilution either. They want to buy enough points to own a good chunk of the company. But they want to leave the founders with enough points to keep them highly motivated to build a lot of value for the founders and investors alike.

Finally, if you’ve made it this far, please enjoy the following presentation:


Q: What’s the biggest mistake entrepreneurs make when they’re raising money?

Entrepreneurs focus on valuation when they should be focusing on controlling the company through board control and limited protective provisions.

Valuation is temporary, control is forever. For example, the valuation of your company is irrelevant if the board terminates you and you lose your unvested stock.

The easiest way to maintain control of a startup is to create good alternatives while you’re raising money. If you’re not willing to walk away from a deal, you won’t get a good deal. Great alternatives make it easy to walk away.

Create alternatives by focusing on fund-raising: pitch and negotiate with all of your prospective investors at once. This may seem obvious but entrepreneurs often meet investors one-after-another, instead of all-at-once.

Focusing on fund-raising creates the scarcity and social proof that close deals. Focus also yields a quick yes or no from investors so entrepreneurs can avoid perpetually raising capital.

Q: What’s the biggest mistake VCs make?

The biggest opportunity for venture firms is differentiation. VCs compete for deals, and differentiation is the only way to compete.

Most firms offer the same product: a bundle of money plus the promise of value-add. And the few firms that are differentiated don’t communicate their differentiation to entrepreneurs. Y Combinator is an example of differentiated capital with excellent marketing communications.

Venture firms that thrive by investing in game-changing businesses have barely begun to differentiate themselves, let alone changed the rules of their own game.

Note: These excellent questions are adapted from Ashkan Karbasfrooshans’s Venture Hacks interview.

Image Source: Despair.

As this nuclear winter of venture hacks continues, I thought you might enjoy our thoughts on Paul Graham’s The Equity Equation. Paul says,

“Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before….

“In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 – n) [Ed: This is the equity equation].”

Read the rest of The Equity Equation first; it is great. As usual.

We have some additional thoughts. As usual. =)

Summary: 1. You have to pay market rates regardless of the equity equation. 2. Consider the opportunity cost of spending shares on employees and investors. 3. Offers from top-tier firms increase your valuation.

You have to pay market rates regardless of the equity equation.

In practice, you raise money or hire an employee because you need to, not because you want to. And you have to pay a market rate no matter what the equity equation says.

Say the equity equation tells you to pay a prospective hire above market. You should still pay the hire a market rate and save the company some equity.

Say the equity equation tells you to pay a prospective hire below market. The hire will simply argue that the market values her higher, and that you should pay her a market rate. It’s tough to fight this normative leverage.

When you’re hiring, first figure out the market rate for the position. We previously posted a table of market rates for employees. When you evaluate a candidate, ask yourself whether she is likely to increase the next round’s share price (include the dilution of her market rate options). If the answer is yes, she is a possible hire. If no, she is a no hire. This approach forces you to think about building value, not filling a position.

# Consider the opportunity cost of spending shares on employees and investors.

“One of the things the equity equation shows us is that, financially at least, taking money from a top VC firm can be a really good deal. Greg Mcadoo from Sequoia recently said at a YC dinner that when Sequoia invests alone they like to take about 30% of a company. 1/.7 = 1.43, meaning that deal is worth taking if they can improve your outcome by more than 43%. For the average startup, that would be an extraordinary bargain. It would improve the average startup’s prospects by more than 43% just to be able to say they were funded by Sequoia, even if they never actually got the money.”

You need to consider the opportunity cost when you spend equity. You should only give out equity if it increases your share price optimally. You can buy a lot of things with your equity—buy things that increase your share price the most.

Is selling 30% of your shares to a top-tier firm the most effective way to spend your shares? What if another investor will give you the same terms for 20%? Should you take it? Could you spend the remaining 10% on killer developers and sales guys? Could you spend the savings on great advisors? Could you spend the saved equity on the best board members money can buy?

Entrepreneurs should think about unbundling money and value add. Get money on the best terms and get the best value add.

Would you hire an investor to serve on your board if he didn’t bring money with him? If the answer is no, his value add is literally worthless. If the answer is yes, then put a price on that value add and adjust their offer (in their favor) so you can compare it to other offers apples-to-apples.

(Note: This is not an argument not to take money from top-tier firms, we have raised money from top-tier firms.)

Offers from top-tier firms increase your valuation.

“The reason Sequoia is such a good deal is that the percentage of the company they take is artificially low. They don’t even try to get market price for their investment; they limit their holdings to leave the founders enough stock to feel the company is still theirs.”

When a top-tier firm offers to invest, the market price for your company immediately goes up. Firms tend to invest in herds and everybody wants to steal a deal from a top-tier firm.

The last-and-final offer from a top-tier firm will be slightly less than market. They will argue that they should pay less because they bring a lot more value than their competitors, they have a brand, et cetera. But overall, an offer from a top-tier firm increases your valuation.

Top-tier firms try to avoid increasing your valuation when they make an offer. For example, they may give you an exploding term sheet. But, in practice, in this market, we rarely see exploding offers from any firm.

Many firms add lots of value and help like crazy. But entrepreneurs should understand that the top firms pick the best companies, they don’t make the best companies. They say so themselves.

The top firms are mainly in the business of making money for their limited partners by picking the startups that are going to succeed with or without their value add.

I would love to hear your thoughts…

Summary: A cap table lists who owns what in a startup. It calculates how the option pool shuffle and seed debt lower the Series A share price. This post includes a fill-in-the-blank spreadsheet you can purchase to create your own cap table.

A capitalization (cap) table lists who owns what in a startup. It lists the company’s shareholders and their shares.

This screencast walks you through our cap table:



The cap table is free

We used to charge for the stuff but now it’s free.


“This is great; we (probably like many other entrepreneurs) tried our hand at hacking up a similar spreadsheet on our own but this is a far more flexible and easy way of visualizing various scenarios. Thanks for putting this together.”

– Drew Houston, Founder of Dropbox

The cap table shows you what you really own

Many entrepreneurs think their pre-money valuation determines their percentage ownership of the company. They forget about the option pool shuffle. They forget about seed debt and its discount. Then they blame their lawyers.

Use this cap table to sketch out how much you will really own after the financing. Find something else to blame on your lawyers.

This cap table is simplified

Our cap table includes the major economic levers of a Series A: common stock, preferred stock, options, and convertible debt. It doesn’t include warrants, vesting, debt interest, liquidation preferences, dividends, the Series B, et cetera.

Cap tables can be a little tricky to understand if you’ve never worked with one before. So we kept it simple.

Your lawyer or accountant will deal with the details that aren’t included in this cap table. They will maintain the company’s official cap table.

Disclaimer — read this

Use this spreadsheet to learn more about cap tables and what your cap table might look like. Then hire a lawyer to maintain the company’s official cap table.

This cap table is provided as-is, with no warranties. It is not legal advice. We make no representations that this cap table is accurate in any way or is fit for any purpose.

We do not take responsibility for anything that results from using this cap table, including, but not limited to, losing all your money and going to jail.

We are not lawyers. Get a lawyer.

Do you have any suggestions or questions?

Please leave your suggestions and questions in the comments and we’ll improve the cap table.

I read, like, and regularly disagree with a great blog called Ask the VC . They recently answered a question about supra pro rata rights—here are our thoughts on the topic.

Q: Can you explain what supra pro-rata is? It seems to be showing up in some VC term sheets now. What’s the impact on the entrepreneur? How hard should one try to negotiate it out? If a VC insists on this term, should the entrepreneur walk away?

A: First, read Ask the VC’s response—we agree with them. Here are our additional thoughts.

An investor with supra pro rata rights wants the option of increasing his percent ownership in the next round. He probably told you “We like this company so much we might want to buy more of it!”

Investors who want to increase their ownership drive down your valuation.

Investors who want to increase their percent ownership try to drive down the next round’s valuation. Whether or not they have supra pro rata rights.

They are at odds with the founders and management who are trying to increase the next round’s valuation. These investors can exercise their protective provisions to veto everything but the lowest valuation offer. Or they can signal the “correct” valuation to new investors:

If the current investors want to increase their percent ownership, the valuation is too low. If they don’t want to increase their percent ownership, the valuation is too high. This makes it harder to get a high valuation since the new investors often believe the current investors have a better sense for the right valuation.

You want investors who maintain their percent ownership.

You prefer investors who make it a policy of maintaining their percent ownership in the next round. This incents them to increase the next round’s valuation.

These investors don’t try to increase their percent ownership because they know it puts them at odds with the founders and management. They know it incents them to use their protective provisions to veto good offers. They know it forces them to signal their sense of the correct valuation.

Your response to supra pro-rata rights is:

“Everybody around the table should be working together to get a high valuation in the next round. Investors and management shouldn’t be at odds with each other in the next financing—let’s create alignment, not mis-alignment.”

Investors who try to decrease their percent ownership in the next round are also bad news. They signal that the valuation is too high. (Angels and seed stage funds are an exception. They’re not necessarily expected to maintain their percent ownership since they may not have a lot of capital.)

What are your experiences with supra pro rata rights?

Use the comments to share your experiences and questions about supra pro rata rights—we’ll discuss the most interesting ones in a future article.

Summary: Seed investors often argue that debt doesn’t incent them to (1) help the business and (2) increase the share price of the eventual Series A. Actually, (1) debt does incent investors to help the business and (2) equity may also incent investors to decrease the Series A share price. That said, you can make your debt much more attractive to investors with a few concessions.

Although convertible debt is often the best choice for a seed round, investors often argue that debt does not incent them to contribute to the business:

If I buy debt and contribute to the business, the share price of the eventual Series A goes up and the number of shares I get for my debt goes down. Debt doesn't incent me to help the business and increase the price of the Series A.

Debt holders are incented to help the business.

Your response to an investor’s claim that “(1) debt doesn’t incent me to help the business”:

“If you buy $100K of debt, you get $100K worth of shares in the Series A, plus some shares for your discount. You’re not losing money by contributing to the business—the Series A share price may go up but your share value remains $100K, plus a discount.

“And… as you contribute to the business, the company’s risk goes down, opportunity goes up, and the net present value of your debt goes up. You’re still incented to help the business when you buy debt.”

That said, equity incents an investor even more. If an investor buys $100K of equity in the seed round and locks in his share price, he makes a paper profit if the share price increases in the Series A.

Note to entrepreneur: You don’t need to make this argument on your investor’s behalf.

Equity holders are also incented to decrease the Series A valuation.

Your response to an investor’s claim that “(2) debt doesn’t incent me to increase the eventual share price of the Series A”:

Rational investors are

  1. Insensitive to the next round’s price if they plan to maintain their percent ownership,
  2. Incented to increase the next round’s price if they plan to decrease their percent ownership, and
  3. Incented to decrease the next round’s price if they plan to increase their percent ownership.

(We’ll explain how the math works in the comments.)

Some seed stage funds maintain or decrease their percent ownership in the Series A. These funds tend to focus on seed stage companies.

Other seed investors try to increase their percent ownership in the Series A—if the company is doing well. These funds tend to invest in most stages of a company’s growth.

Ask your investors about their track record and strategy for follow-on investments. If they like to increase their percent ownership in their best investments, they have an incentive to drive down your Series A valuation whether they buy debt or equity in the seed round.

Make your debt attractive to investors.

Rather than debating the finer points of your investor’s incentives, you can make your debt much more attractive to investors with a few concessions (ordered from small to large):

  1. Don’t let the company pre-pay the debt. Your investors don’t want you to repay the debt just before you raise a Series A or sell the company.
  2. Anticipate a potential sale before the Series A and negotiate your investor’s share of the sale price. Your debt investors want to make money if you sell the company before the Series A.
  3. Increase the discount by a fixed amount and/or 2.5% per month, up to a maximum that can range from 20% to 40%. A higher discount yields a higher return for your investors. For example, a 40% discount guarantees your investors a 1.7x return on paper when the Series A closes.
  4. Set a maximum conversion price for the debt.
    The debt could convert at the lesser of (1) $X/share and (2) the actual Series A share price. This cap effectively sets a maximum valuation for your debt investors and protects them from a high Series A share price. This is a great way to maintain the benefits of convertible debt while rewarding your debt investors for investing early. The maximum conversion price can be significantly higher than any valuation you could negotiate easily.

How have you made debt attractive to investors?

Use the comments to share your experiences and questions on making debt attractive to investors. We’ll discuss the most interesting comments in a future article.

Summary: Convertible debt is often the best choice for a seed round. It is convenient, cheap, and quick. It lets you close the financing quickly and turn your focus back to your customers—that’s good for the company and its investors.

When your business is very young, raising a seed financing ($50K-$500K) via convertible debt is a great alternative to selling equity. Convertible debt is also known as a bridge loan since it ‘bridges’ the company to its next financing.

Convertible debt (debt for short) is not like getting a loan from a bank. A bank expects to get its loan back. With convertible debt, the lender and your company both expect to convert the debt into equity when you close the Series A. Read Yokum Taku’s series on convertible debt for a primer on this lovely financial instrument.

Seed stage debt rounds are much simpler than equity rounds, especially if your investors are angels. There isn’t a lot to hack in these agreements. You need to be more careful if you raise debt from venture capitalists, but a debt financing with a VC is still much simpler than an equity financing with a VC.

Why is debt a great alternative to equity in a seed round? Convenience, suitability, control, cost, and speed.

1. Convenience

Debt agreements are easy to understand and hard to screw up, two great benefits if you’re raising the first financing of your life.

A debt term sheet is no longer than one or two pages and the closing documents are no longer than ten pages. There aren’t many terms to negotiate in a debt agreement.

Compare this to a Series A term sheet which is as long as all of the closing documents for a debt round. Negotiating and closing debt is good practice for the negotiation of the 25 terms in a typical Series A term sheet.

2. Suitability

Who knows how to determine a suitable valuation and investor rights for a seed stage company?

The company’s valuation and leverage is changing quickly as it goes from nothingness to product, users, and revenue.

The founders are unlikely to negotiate a valuation that meets their high minimum expectation since there isn’t much competition to invest in the young and risky business.

But a valuation that does meet the founder’s minimum expectations may be too high and result in a down round in the Series A. The down round leaves the founders feeling like they lost money even though the company made progress, the angels feeling like they took risk but got squashed, and the Series A investors feeling like they are dealing with unsophisticated operators.

Finally, it’s tough to reach a high Series A valuation soon after setting a low or moderate valuation in a seed round. Your Series A investors won’t want to pay a much higher share price than seed investors who bought stock just a few months ago.

Raising debt avoids setting a valuation, delays negotiating detailed investor rights, avoids the option pool shuffle, and gives the seed stage investors an upside through a discount and/or warrants.

3. Control

Founders usually continue to control a company after a debt round.

They control a majority, or all, of the board seats. Debt investors, especially angels, don’t necessarily want board seats. Seed stage equity investors, especially venture capitalists, often do. Controlling the board reduces the burden of reporting to the board and diminishes the likelihood of disagreements between the board and management.

The founders also control a majority of the company’s common stock. There is no preferred stock. They can sell the company for $10M, give $2M to the debt investors, and take home $8M. Try doing that with equity investors who have preferred stock with protective provisions that allow them to veto a sale of the company. In particular, venture capitalists often have big funds and they’re looking for big returns, not $10M exits.

Finally, if you raise debt, you can create and run a profitable business that doesn’t need an ‘exit’. Angels may be happy getting a big dividend from your company every quarter, whether they bought debt or equity. Venture capitalists aren’t looking for a quarterly dividend—they need to sell or IPO a company to return a profit to their investors (their limited partners). Raising debt from VCs maintains the option of building a ‘non-exiting’ business—you can always pay their debt back when it comes due. That said, we don’t recommend taking debt from VCs with the plan of building a ‘non-exiting’ business—that’s disingenuous.

4. Cost

You can negotiate a debt term sheet and close the money for under $10K in legal fees. There are very few terms for the lawyers to discuss—they will barely have to modify their boilerplate documents.

Negotiating a Series A term sheet and closing it can cost $20K-$60K in legal fees. Why would you or your investors want to spend that much money on legal fees when you’re raising a $100K seed round?

You can further reduce your legal fees by reading our convertible debt hacks and Yokum’s convertible debt articles while you work with your lawyers. (Venture Hacks is not legal advice!)

5. Speed

Once your investors are ready to talk terms, you can negotiate a term sheet in one week and close the deal one week after that. The documents are short and simple—there isn’t much to discuss. Compare this to an equity financing which can take two weeks to negotiate and 4-6 weeks to close.

Debt is often the best choice for seed rounds.

Convertible debt is often the best instrument for a seed round. You can close the debt cheaply and quickly and then turn your focus back to your customers. That’s good for the company and its investors since speed is a major competitive advantage of a startup. If you or your investors are veering away from convenience, low cost, and speed, you are missing the point of seed stage debt!

The seed stage is the worst possible time for the founders to negotiate an equity financing. The company is nebulous, the founders are inexperienced, and the company is starved for cash and time. The team should be testing hypotheses about their business, not negotiating complicated term sheets.

Investors who market themselves as ‘business partners’ should agree that they can add a lot of value to the business by doing the financing quickly and letting the team get back to their customers.

What do you think about the benefits of debt vs. equity?

Use the comments to share your thoughts and questions on the benefits of debt vs. equity. We’ll discuss the most interesting comments in a future article.

Our next convertible debt hack shows you how to compare the economics of debt vs. equity.

Thanks to Brian Norgard, Zach Coelius, and many others for suggesting this article. And apologies to “ds” for stealing a little bit of his language.