Monday, July 20, 2009

In VC deals, It's Pre Money + Option Pool Size That Matters

Jeff Bussgang of Flybridge Capital has a great post up about the nuances of early-stage VC financings. For first-time entrepreneurs, there is a lot of confusion about what financing terms really matter in the term sheet.

via Seeing Both Sides: In VC deals, Price Doesn't Matter - But The "Promote" Does

Jeff talks about the "Promote", which most entrepreneurs really don't consider. He says, "The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation."

An example:
This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs.  I learned it the hard way in the first term sheet that I put forward to an entrepreneur.  I was competing with another firm.  We put forward a “6 on 7” deal with a 20% option pool.  In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company.  The founders would own 34% and we would set aside a stock option pool of 20% for future hires.  One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company.  But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%.  The entrepreneur chose the competing deal.  When I asked why he looked me in the eye and said, “Jeff – their price was better.  My company is worth more than $7 million”.

In this example, the "promote" works out to be about $4.5M in either case, so the offers are exactly the same from the "promote" perspective.

However, the better response for this entrepreneur would have been to go back to the VC with the $9M pre-money valuation and argue that the option pool of 30% was way too big (and, it really is -- what the hell are you going to do with a 30% option pool in your Series A timeframe? Really?). Reducing the option pool to 15% would have made the "numbers" side of these deals a lot more palatable, and resulted in a "promote" of $6.75M. Clearly the better deal.

Many thanks to Jeff Bussgang for this excellent article.

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