Flybridge’s Jeff Bussgang has a nice blog piece where he coins a new word in the venture lexicon: the “promote” (not the Prestige). Entrepreneurs too often fixate on their pre-money valuation (the “pre”), instead of focusing on what their equity is worth after the venture check has hit the bank account. For Jeff, the “promote” is where an entrepreneur should focus: the founding team’s equity ownership percentage multiplied by the post-money valuation. In other words: after you’ve received a venture capital investment, what is your share of the company worth?
Two factors are important: the amount of capital raised, and the size of the option pool. Let’s look at both using some simple math (and assuming all other terms are equal).
Term Sheet 1: Company raises $4M on a $6M pre (so $10M post-money valuation). However, the terms include a unallocated option pool of 25%. So the VC owns 40%; the Option Pool has 25%, and the Founders own 35%. The founder’s share is worth $3.5M (35% of $10M post-money).
Term Sheet 2: Company raises $3M on a $5M pre (so $8M post-money valuation). The terms include an unallocated option pool of 12%. So the VC owns 38%; the Option Pool gets 12%, and the Founders own 50%. Their share is worth $4.0M (50% of $8M post-money).
Too many entrepreneurs prefer the first term sheet: they raise more money at a higher pre. But after the dust settles, under the first term sheet they own barely more than one-third of their company and their shares are worth less than the investment. In the second term sheet, the founders own 50% of their company, and even if its valuation is lower, their share is worth almost 15% more.
The sheer complexity of term sheets can be difficult to unravel, but the most savvy negotiators are almost never about the pre, and always about the terms.