McStartup

Rich writes:

I read one of your earlier posts regarding the idea that a first round of VC funding would dilute the shareholders by 40-50% and the second round 20-30%. How are valuations calculated to make those types of determinations? Some investors seem to get into this mode of challenging your "pre-money valuation" as an opening to negotiate for an extremely large piece of the pie. Are there any tidbits of advice that you might give from your experience for how to raise money without giving up control? Any help would be appreciated.

P.S. Nice presentation at the Venture Club meeting!

Thanks for the compliment!  Those are very rough numbers, but it's something to give you a range.  You'll see A round deals of over 50% sometimes, and B round deals south of 20% sometimes.  Other times companies are further along than a typical A round company even though they haven't raised that round yet, and might get a B round type deal.  Every situation is unique.

However, what I call tell you is that the valuation is probably going to be determined as a result of the desired equity ownership for the investor, and not the other way around.  For example, if you want to raise $6M, and the VC wants 50% of the company, they're going to give you a $6M pre money valuation.   If they think they want 40% of the company, then are they going to only invest $4M?  No.  They will instead change the valuation, so that their $6M gives them 40% of the resulting company, in this case that means you would have a $9M pre money valuation, and a $15M post money.  (therefore, the $6M they invested = 6M/15M = 40%)

How does an investor come up with that percentage?  It's factored on a lot of things.  How many more rounds of funding will you need?  What are the likely exit scenarios?  What's the track record of the team?  How big is the market?  All these things will have an effect.

In the end, remember that a venture capitalist is managing an investment portfolio with a life of 5-7 years on average, and they need to return cash to *their* investors in that approximate time frame.  So if they give you money now, you grow, you raise more money (perhaps) you keep growing, and then within that time frame have an exit event, what is the magnitude of that event?  They would then get some portion of that, based on whatever the ownership is initially, diluted over time with additional fundraises, stock option grants, etc. 

It's that end number you need to think about, then work backwards to see if that delivers a good return to the investor.  Then remember they are making a bunch of these investments, and are hoping to return 30% annually to their own investors, and that a good 1/2 of the investments will probably return near zero.

Do all that math, and you'll see why they demand so much equity up front.

As far as your issue of control - let me offer you this tidbit of advice:  If you raise money from investors, you're giving up some control.  I don't care if you have 99% of the stock, or 22% of the stock - it really comes down to the rights of those shares, the makeup of the board of directors, and frankly, if you're doing a good job or a bad job.

An investor (if they know what they are doing) is not going to accept common stock.  They are going to get a preferred share which is different than the shares you own as the founder.  These shares will have certain rights associated with them, and they will be determined at the time of investment.  Even if I have just one share, it's possible to have full company control if that share has the right to dictate whatever it wants to. 

Likewise, an investor is going to negotiate the makeup of the board of directors, and probably take a seat on the board themselves.  The board is who determines who the management team is, which probably includes you as the founder.  If they have control of the board, and you are doing a lousy job, expect a pink slip, regardless of how much stock you might own.

The worry over who owns 51% is only relevant if there is but one type of stock and you control the board of directors.  It's usually a lot more complicated.  My advice to you is to put the 51% thing out of your mind for good, and instead look at what the exit opportunity is and what it will take to get there.

Good luck!

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