Term Sheets 2.0 (The Entrepreneur’s Perspective) - Price

Welcome to “Term Sheet 2.0″ - Term Sheets from an Entrepreneur’s perspective. This week we discuss pricing.

As an entrepreneur, you are not just building a company, you are building your dream. But a strong will and a good heart is sometime not enough. In most cases, you need someone to fund it. This is where our beloved or reviled (depends on your perspective) venture capitalist comes in to take a stake in your dream.

As you grow the business with the leverage of VC funds, your stake in it reduces in size and the price of your stake becomes more and more important. The VC cares about economics and control and more importantly, so do you. Since the more you go down the private equity river, the less and less control you will have so you need to focus on the economics of the deal to you come out ahead.

They always say “would you rather have 100% of a million dollars or 1% of a billion dollars”? I would be happy with either, but the choice is obvious, and in this case, you should figure out how to retain that extra few percentage points. It could mean all the difference in the world.

This is where pricing comes into play on the term sheet.

As an entrepreneur you are focused on building your product, getting customers and proving to VC’s that people will actually pay for what you are making. So when the time comes and you have a term sheet in front of you, the focus will be on terms like “pre-money” and “post-money” which you have probably never heard of before.

Brad Feld explained it best: “The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount.”

It impacts stock valuation for those who previously invested, employee stock option pools, stock warrants and your own common stock. This is the biggest topic of discussion when you are talking to multiple VC’s especially when each of them place a different value on you. If you are lucky that multiple VC’s are interested in you, you need to evaluate many factors as to which one you should go with. For now, let’s stay with the topic at hand.

From my previous experience I was always asked “what do you think the company is worth”? Some VC’s will read this as secret code for “does this guy really know his value and if he is low, I can really take advantage of him”. Others in the more honest camp will read this as “has this guy done his homework and if so, would this be a good investment for my fund”?

You should do your homework, but almost always you should negotiate a higher pre-money valuation. If the VC is interested in you, they can work down with you as part of the negotiation process, but they do not work upward. The sticky wicket is if you placed a tremendously high valuation on your company and handed out options and warrants based on that valuation. If you don’t have a back up plan to correct this equity error (you most certainly will) your early supporters could leave you high and dry and in your first management crisis before the first official board meeting.

When you are building your company and in the early stages of financing, you will have a lower valuation price so there is enough to keep for yourself and for employees. As things progress, you are going to be playing the “cap table game”. This game is based on the magic chess match of using the capitalization table to leverage all your chess pieces without being in a position of checkmate.

For some people, building a company is about the greater good, but many of you out there dream of wealth and fame. I am here to tell that that while focusing on just money should not be your primary concern, there are moments it is extremely important. Pricing on a term sheet is one of those moments.

You need to feel like you are getting a good deal and that the VC is really investing in you and not here to steal your company. You are both partners, like spouses, so neither wants an ugly divorce. Their primary motivation is to return something to their limited partners just like you want to reward those who work hard for you.

In the end building a company is about creating something of value where nothing existed before. But make sure you do your homework, know what your company is worth and don’t be a butthead when you think you are the only one on the planet with your revolutionary idea. One VC told me this and it has stuck with me forever “if I didn’t hear the same idea 20 minutes ago, I am pretty sure I will hear it 20 minutes from now”.

For a VC’s perspective, read Brad Feld’s write up here.

Tagged as: Finance and Funding, Term Sheets 2.0, Venture Files