When I first started out as a VC nearly 9 years ago, most early stage company valuations were expressed as pre-money valuations. That is, the valuation of the company prior to the investment of new capital. Most term sheets talked about the valuation in these terms, and you added the dollars invested to get a post-money valuation. Founders also had to do a little math on the new option pool to really understand what their ownership would be post investment, since it was typically taken out of the company pre-money.
Today, nearly all early stage term sheets I see are expressed as post-money valuations. The main reason for this, I think, is that there has been such a proliferation of convertible notes, SAFE’s, and other instruments that it becomes tough for a new investor to feel confident that they fully understand a company’s cap table prior to an investment. On top of this, the rise of multiple seed rounds prior to an early stage investment further complicates matters, since you might have multiple notes stacked on top of each other, each with different discounts, caps, etc.
So, the simple answer is that new investors have come to really fixate very little on the actual valuation of a company, and much more on what their ultimate ownership will be post investment. Founders really should be mostly fixated on this too, much more than some abstract number about what their company is worth (since ultimately, this number is relatively meaningless early on). There are, however, some practical implications of this change.
First, it creates a natural dis-incentive for a founder to raise more money than originally planned. If there is a fixed post money on say, a $5M series A round, if the founder decides that they want to take on a bit more new capital, the existing shareholders eat all of the additional dilution. The new investors don’t really care, because their ownership is effectively fixed. This creates a dis-incentive to raise more than you intended.
In the old world, this additional dilution would end up being shared, since the pre-money was fixed. Usually, there was a maximum amount of new capital raised specified in the term sheet, but on the margins, there was often some flexibility on the maximum round size in the event of excess demand. This is particularly important because early on, I find that almost all rounds that have a strong lead end up getting over-subscribed. It may take a while to find a lead, but there end up being so many followers in seed and series A rounds that with some momentum, founders have been able to raise more money than they expected once things started to gain steam. But with a fixed post-money, you would be less likely to take advantage of this, or would be eating all the incremental dilution yourself.
My advice here is that if the additional dilution is material, and you feel like there is a strong argument to take more money, you should go back to your lead investors and try to argue to share in the dilution together. Maybe adjust the post money a bit as well, so that you don’t bear the entire burden. Worst case, they say no. Best case, they compromise. They might even just invest the additional capital themselves, so as to keep themselves whole (especially if it’s a relatively large fund that cares more about ownership at this stage than an incrementally larger investment).
The second implication is that you will need to really be on top of your own cap table before you really start negotiating. It’s amazing to me sometimes how some founders don’t have a great grasp of what their ownership looks like, and what their ownership will look like after a funding round, especially if there are a few rounds of notes that are going to be converting. Take your time in your negotiation. Do the math yourself and corroborate that with what your attorneys show you. Go through the extra step up front to really understand how this all works, and internalize the impact of different scenarios. Seriously, this sounds trivial and straightforward, but I’ve found that even pretty experienced entrepreneurs (and investors) get tripped up once there is more than one or two layers of complication in a valuation negotiation. This will help you negotiate more crisply and with greater confidence and yield a better outcome for you overall.
Overall, I think this move towards post money valuations in term sheets is a good thing. It simplifies things considerably, and makes it more clear exactly what a new investor is trying to achieve with their investment. It’s also just the natural result of an early stage funding market with more atomization (as my partner Dave puts is) and more non-equity instruments that makes early funding rounds a bit less straightforward. I don’t expect this changing any time soon.
*** Addendum ***
After this post was published, Jerry Neumann made a good point, which is that the drawback of a post-money term sheet is that it can put the founders directly at odds with their existing investors for their pro-rata rights. There are merits to this argument in my opinion, but some may disagree.
This actually highlights a more important takeaway, which is that prior to signing a term sheet, founders should have a transparent discussion with their potential new investor about the goals that everyone is trying to achieve post financing. The elements to consider are:
- What notes/SAFEs are converting? Post conversion, is everything going to shake out ownership-wise as expected? How about the additional option pool?
- What is the new investor’s ownership target?
- Does this contemplate other new investors in this round? How much should be allocated to them?
- Will the pro-rata rights of the existing investors be honored?
- Approximately how much of the pro-rata will actually be taken (this is hard to know 100% up front)
- What the end result would be for the founders and team in terms of their ownership, and is that acceptable?
I think talking through these things is often standard practice. The trouble arises when investors or founders are surprised. And surprises happen because of 1) lack of preparation and familiarity with the cap table, 2) deals try to get cut too quickly because a deal is hot and moving really quickly with a price that is getting bid up, 3) founders do a bad job disclosing/understanding the impact of note conversions on the new round.
As in all things, reasonable people with transparency will usually lead to good decisions that everyone will feel good about later. It actually won’t matter whether you are talking about post-money or pre-money valuations if you do this prior to signing a term sheet.