Valuation Posts

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.

Summary: Focus on your share price and the number of shares you own — metrics like valuation and percent ownership can fool you.

If valuation is your only pespective on a company’s capital structure, you can get fooled by games like the option pool shuffle which make your valuation seem large but actually depress your share price.

Focus on share value, not share quantity or valuation.

The most naive shareholders focus on the quantity of shares they own. That’s a mistake. The company can double your share quantity with a simple stock split. Do you feel rich now? We know companies that have 200M shares outstanding after the Series A just to fool their employees!

Merely uneducated shareholders focus on the percentage of the company they own. News flash: owning 99% of a company that is worth $10 is not going to make you rich.

Experienced shareholders (and Venture Hacks readers) focus on the current value of their shares and the company’s prospects. Investors in public companies with wacky capital structures don’t fancy that they own 0.0003% of a company that is worth $1B. Instead, they multiply today’s share price by the quantity of their shares to determine their share value. They track percentage ownership and valuation, but they focus on share price.

You should do the same:

Understand how any proposed change to the company’s capital structure affects the share price.

Employees should track share price too.

The number of options that new hires receive drops quickly as the value of the company increases and risk decreases. But the value of these options declines much more slowly because the increase in share price partially compensates for the reduction in share quantity.

On the other hand, if the share price is going down, the CEO and other “key” members of the management team often receive more shares to boost their share value — particularly after a new financing with inside investors.

The employees and founders who are left out of this little party should crash it.

Appendix: How to derive the share price.

These terms are negotiated in a simple Series A:

p = pre-money ($)
c = cash invested ($)
o = option pool size post-money (%)

and we hope you already know this:

x = existing shares outstanding (shares).

With these known values, it is easy to calculate all the unknowns:

value symbol equation
post-money ($) t t = p + c
new options (shares) n n = (x · o · t) ÷ (p − o · t)
share price ($/share) s s = p ÷ (x + n)
investor shares (shares) i i = c ÷ s
effective valuation ($) e e = s · x

“Follow the money card!”

– The Inside Man, Three-Card Shuffle

Summary: Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.

If you don’t keep your eyes on the option pool while you’re negotiating valuation, your investors will have you playing (and losing) a game that we like to call:

Option Pool Shuffle

You have successfully negotiated a $2M investment on a $8M pre-money valuation by pitting the famous Blue Shirt Capital against Herd Mentality Management. Triumphant, you return to your company’s tastefully decorated loft or bombed-out garage to tell the team that their hard work has created $8M of value.

Your teammates ask what their shares are worth. You explain that the company currently has 6M shares outstanding so the investors must be valuing the company’s stock at $1.33/share:

$8M pre-money ÷ 6M existing shares = $1.33/share.

Later that evening you review the term sheet from Blue Shirt. It states that the share price is $1.00… this must be a mistake! Reading on, the term sheet states, “The $8 million pre-money valuation includes an option pool equal to 20% of the post-financing fully diluted capitalization.”

You call your lawyer: “What the fuck?!”

As your lawyer explains that the so-called pre-money valuation always includes a large unallocated option pool for new employees, your stomach sinks. You feel duped and are left wondering, “How am I going to explain this to the team?”

If you don’t keep your eyes on the option pool, your investors will slip it in the pre-money and cost you millions of dollars of effective valuation. Don’t lose this game.

The option pool lowers your effective valuation.

Your investors offered you a $8M pre-money valuation. What they really meant was,

“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call their sum your $8M ‘pre-money valuation’.”

For all of you MIT and IIT students out there:

$6M effective valuation + $2M new options + $2M cash = $10M post


60% effective valuation + 20% new options + 20% cash = 100% total.

Slipping the option pool in the pre-money lowers your effective valuation to $6M. The actual value of the company you have built is $6M, not $8M. Likewise, the new options lower your company’s share price from $1.33/share to $1.00/share:

$8M pre ÷ (6M existing shares + 2M new options) = $1/share.

Update: Check out our $9 cap table which calculates the effect of the option pool shuffle on your effective valuation.

The shuffle puts pre-money into your investor’s pocket.

Proper respect must go out to the brainiac who invented the option pool shuffle. Putting the option pool in the pre-money benefits the investors in three different ways!

First, the option pool only dilutes the common stockholders. If it came out of the post-money, the option pool would dilute the common and preferred shareholders proportionally.

Second, the option pool eats into the pre-money more than it would seem. It seems smaller than it is because it is expressed as a percentage of the post-money even though it is allocated from the pre-money. In our example, the new option pool is 20% of the post-money but 25% of the pre-money:

$2M new options ÷ $8M pre-money= 25%.

Third, if you sell the company before the Series B, all un-issued and un-vested options will be cancelled. This reverse dilution benefits all classes of stock proportionally even though the common stock holders paid for all of the initial dilution in the first place! In other words, when you exit, some of your pre-money valuation goes into the investor’s pocket.

More likely, you will raise a Series B before you sell the company. In that case, you and the Series A investors will have to play option pool shuffle against the Series B investors. However, all the unused options that you paid for in the Series A will go into the Series B option pool. This allows your existing investors to avoid playing the game and, once again, avoid dilution at your expense.

Solution: Use a hiring plan to size the option pool.

You can beat the game by creating the smallest option pool possible. First, ask your investors why they think the option pool should be 20% of the post-money. Reasonable responses include

  1. “That should cover us for the next 12-18 months.”
  2. “That should cover us until the next financing.”
  3. “It’s standard,” is not a reasonable answer. (We’ll cover your response in a future hack.)

Next, make a hiring plan for the next 12 months. Add up the options you need to give to the new hires. Almost certainly, the total will be much less than 20% of the post-money. Now present the plan to your investors:

“We only need a 10% option pool to cover us for the next 12 months. By your reasoning we only need to create a 10% option pool.”

Reducing the option pool from 20% to 10% increases the company’s effective valuation from $6M to $7M:

$7M effective valuation + $1M new options + $2M cash = $10M post


70% effective valuation + 10% new options + 20% cash = 100% total

A few hours of work creating a hiring plan increases your share price by 17% to $1.17:

$7M effective valuation ÷ 6M existing shares = $1.17/share.

How do you create an option pool from a hiring plan? #

To allocate the option pool from the hiring plan, use these current ranges for option grants in Silicon Valley:

Title Range (%)
CEO 5 – 10
COO 2 – 5
VP 1 – 2
Independent Board Member 1
Director 0.4 – 1.25
Lead Engineer 0.5 – 1
5+ years experience Engineer 0.33 – 0.66
Manager or Junior Engineer 0.2 – 0.33

These are rough ranges – not bell curves – for new hires once a company has raised its Series A. Option grants go down as the company gets closer to its Series B, starts making money, and otherwise reduces risk.

The top end of these ranges are for proven elite contributors. Most option grants are near the bottom of the ranges. Many factors affect option allocations including the quality of the existing team, the size of the opportunity, and the experience of the new hire.

If your company already has a CEO in place, you should be able to reduce the option pool to about 10% of the post-money. If the company needs to hire a new CEO soon, you should be able to reduce the option pool to about 15% of the post-money.

Bring up your hiring plan before you discuss valuation.

Discuss your hiring plan with your prospective investors before you discuss valuation and the option pool. They may offer the truism that “you can’t hire good people as fast as you think.” You should respond, “Okay, let’s slow down the hiring plan… (and shrink the option pool).”

You have to play option pool shuffle.

The only way to win at option pool shuffle is to not play at all. Put the option pool in the post-money instead of the pre-money. This benefits you and your investors because it aligns your interests with respect to the hiring plan and the size of the option pool.

Still, don’t try to put the option pool in the post-money. We’ve tried – it doesn’t work.

Your investor’s norm is that the option pool goes in the pre-money. When your opponent has different norms than you do, you either have to attack his norms or ask for an exception based on the facts of your case. Both straits are difficult to navigate.

Instead, skillful negotiators use their opponent’s standards and norms to advance their own arguments. Fancy negotiators call this normative leverage. You apply normative leverage in the option pool shuffle by using a hiring plan to justify a small option pool.

You can’t avoid playing option pool shuffle. But you can track the pre-money as it gets shuffled into the option pool and back into the investor’s pocket, you can prepare a hiring plan before the game starts, and you can keep your eye on the money card.