Later-stage rounds and “setting the bar too high”

I recently had a number of conversations with CEOs of later-stage startups (generating significant revenue) that went something like this. They want to raise more money, and VCs are offering them money at a high valuation. The CEO is worried that taking money at that valuation will “set the bar too high” and make it difficult to sell the company – if the time comes when he/she thinks it makes sense to sell – at a price that isn’t a significant multiple of that valuation.

These CEOs are worrying too much. VCs know what they are doing and almost always invest with a financial instrument – preferred shares – that protects them even when the valuation is very high. Preferred shares behave like a stock on the upside and a bond on the downside. The only way investors actually lose money is if the company is sold for less than the amount of money raised (which is generally significantly lower than the valuation).

Here is what the payout function looks like for common stock (for example, what you get when you buy stocks in public markets):

And here is what the payout function looks like for preferred shares:

So, to take a concrete example, Dropbox reportedly raised their last financing at a $4B valuation*. If you think of this as a public market valuation of common stock, you might think this means the VCs are betting $4B is the “fair value” of the company, and will lose money if Dropbox’s exit price ends up being less than $4B. But in reality, assuming the standard preferred structure, the last round investors’ payout is as follows :

Scenario 1: Dropbox exits for greater than $4B ==> investors get a positive return (specifically, exit price divided by $4B)

Scenario 2: Dropbox exits for between $257M (total money raised) and $4B ==> investors get their money back (possibly more if there is a preferred dividend)

Scenario 3: Dropbox exits for less than $257M ==> investors lose money

If reports are true that Dropbox is profitable and generating >$100M in revenue, then scenario 3 – the money losing scenario – is extremely unlikely.

Will investors be thrilled with scenario 2? No, but they are pros who understand the risks they are taking.

Going back to the entrepreneur’s perspective, in what sense is a high valuation “setting the bar high”? In the preferred share payout model, there are two “bars”: money raised and valuation. I don’t see any reason why entrepreneurs shouldn’t be as aggressive as possible on valuation, especially if they are confident they won’t end up in scenario 3.

An important point to keep in mind is that, in order to maintain flexibility, entrepreneurs shouldn’t give new investors the ability to block an exit or new financings. Investors can get this block in one of two ways – explicit blocking rights (under the “control provisions” section of a VC term sheet) or by controlling the board of directors. These are negotiable terms and startups with momentum should be very careful about giving them away.

* Note that I have no connection to Dropbox so am just assuming standard deal structure and basing numbers on public reports. I am making various simplifying assumptions such as not distinguishing between pre-money and post-money valuation.

Anonymous

With too many deals in the seed stage do you think founders are worried about overcrowding? Do they fear that getting higher valuation will become unlikely since investors might spread out the deals?

http://www.cdixon.org chris dixon

Not sure what you mean exactly. Generally I think with the macro economic situation the way it is, everyone should realize there is a possibility that valuations could drop significantly.

Anonymous

I mean with too many micro deals (500 startups, ycombinator, etc). maybe founders fear the average size of deals will come down. This means that those with higher valuation might get priced out of the investment market. Hope I am making sense.

http://www.cdixon.org chris dixon

In this case I’m talking about companies that are fielding actual VC offers at high prices. But the overcrowding could definitely hurt them later when it comes time to exit.

http://twitter.com/BrentHurley Brent Hurley

I generally agree. However, another scenario worth mentioning is the possibility of a down round when an aggressive valuation has been set but, for whatever reason, an exit isn’t possible or ideal.

http://www.cdixon.org chris dixon

True, but you can also make this more palatable by not giving in on anti-dilution provisions.

http://www.christinacacioppo.com Christina Cacioppo

I’d love to see a blog post on anti-dilution provisions: what they are, what they mean to the entrepreneurs, and strategies to negotiate them out of higher-priced financings.

http://www.cdixon.org chris dixon

Happy to write about that. I feel like these “technical” blog posts are less interesting to people. Maybe the material has been covered before enough already? Probably more interesting than the “what is it?” are, as you say, the strategies for negotiating each term.

http://www.christinacacioppo.com Christina Cacioppo

yeah, much more interested in the negotiation from the entrepreneur’s perspective. a “here’s what this *actually* means to your life”-sort of take.
Anonymous

That’s a double catch 22. People are less interested in technical blog posts… until they read them and then realize just how critically important they are to their financial health, but they can’t read them unless you write them. Be a star and write them.

http://www.elieseidman.com Elie Seidman

I’d be interested in hearing your thoughts about to think about this when your next stage is not a sale but rather another financing. (beyond the one currently being contemplated)

http://www.cdixon.org chris dixon

You could always give the investors “full ratchet” instead of the more market “weight average” anti-dilution protection. This let’s them completely reprice their round at a lower price in the event of a future downround. Although if it’s a lot lower that can lead to massive dilution…

http://www.5o9inc.com/ Peter Cranstone

The perks of a “liquidation preference”. Valuation is more for dilution, the real action is the LP (pun intended). They get their money back first and then they all convert. That’s why you should think of VC money as debt – like your mortgage you have to pay it off first before you really get to enjoy the house.

http://www.cdixon.org chris dixon

“They get their money back first and then they all convert.” note that is only for “participating” preferred, which is not market right now. most deals now are “standard” preferred meaning the investor chooses to convert to common stock or not (gets either a bond or a stock but not both).

http://www.5o9inc.com/ Peter Cranstone

Well said – spot on.

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Anonymous

Great summary, Chris. What about a Scenario 2b that arises in the event the pref shares have a participating liquidation preference. This changes the graph a bit.

I generally see participating prefs used in exchange for a higher valuation – preferably with a vaporizing cap of 2x or 3x. This mechanism arises when the entrepreneur is confident he can hit it out of the park and wants the higher valuation in exchange for more downside protection for the investor.

http://www.cdixon.org chris dixon

I haven’t seen participating preferred since the early 2000′s, but I do almost only early stage deals and only see later stage deals when our companies get to that stage, so have limited exposure to the current later stage market. Personally I think when you get too fancy with participation, 2x 3x etc you start risking having different classes of shares with very divergent interests.

http://www.christinacacioppo.com Christina Cacioppo

One related area worth exploring, I think, is the argument — often made by investors — that raising at a higher valuation makes the company a less attractive acquisition target.

While that’s certainly true for some valuation range, I think it’s less true in today’s later stage market, where valuations seem stratospheric and a company’s value appears unique.

http://www.cdixon.org chris dixon

But does the acquirer really care about the valuation? I think what they care about is the prices the CEO indicates they are willing to accept, which if the situation changes can easily be different than the last round valuation.

http://www.christinacacioppo.com Christina Cacioppo

No, but I’ve heard of and seen investors talk about valuations as if acquirers do care.
http://about.me/jelpern Jordan Elpern-Waxman

I agree w/ Christina. Acquirers care b/c last-round valuation is a heuristic for the floor price of acquisition offers the company will consider, and they don’t want to waste their time pursuing targets that are too expensive.

Also, that candid conversation in which the target CEO indicates a range of prices to the potential buyer is much rarer and harder to arrange than you make it sound.

http://twitter.com/JessiDarko Jessica Darko

Remember this: VCs are taking much less risk in their investment than earlier investors, and vastly less risk than the founders. Therefore, if anyone should be getting preferred shares, its the founders.

If you give VCs preferred shares, you’re an idiot. This is just another one of the ways that VCs try and take more than their fair share of a company.

They’re saying that just putting up someone else’s dumb money should earn a larger return than those who put their own lives into the company.

You no longer need large amounts of capital, and if you’ve got revenue, get profitable, and then you dictate terms.

If you sell part of the company to an investor, then every %1 they own should have exactly the same rights as the %1 that every OTHER investor owns, including the founders, who were the original investors.

Any investor who wants special rights is trying to cheat you.

The only reason they try is most founders are too spineless to stand up to them.

http://www.cdixon.org chris dixon

Whether we like it or not the early stage deals today are generally either convertible notes or preferred equity financings and later stage deals are almost always preferred equity. I think fancy stuff like multiple liquidation preferences and participating preferred is highly questionable, but there are reasonable arguments for standard 1x preferred.

In the end it’s a negotiation. Dropbox could probably have sold common and not preferred shares but the valuation would likely have been lower. So by selling preferred shares they are getting more on the upside and less on the downside.

http://about.me/jelpern Jordan Elpern-Waxman

How many late-stage investors would take common? This would not only mean worse economics but also ceding control to earlier investors (assuming they took preferred).

http://www.repeatablesale.com/ Scott Barnett

I haven’t been in the chair of a late-stage profitable startup CEO, so maybe I’m missing something, but this makes perfect sense to me. Isn’t the rule of thumb that VC’s are looking for a possible 10x return in a Series A, 4-5x in Series B and 2-3x or so in Series C+? I mean, more is always better, but each round should in theory be taking less risk off the table for the VC, hence less upside return. In Dropbox’s case, if they sold for $10B that would be a “home run”?

http://www.cdixon.org chris dixon

Yeah VCs are usually looking for a 10x in early stages and probably a minimum of 3x in later stages. The reality is they tend to care about cash-on-cash returns more than IRR or multiple. So if they had a lot of money invested and it returned 2x relatively quickly, they’d probably be pretty excited.

Anonymous

But by your own explanation, doesn’t “setting the bar high” kind of screw the entrepreneur? Sure, the investors won’t lose money unless totally unexpected disaster strikes, and they still have upside. But if they invest at a really high valuation, doesn’t that increase the likelihood that the founders will make less (or no) money from an exit?

Is it the responsibility of the founder to care solely about the return to the investors, or should he also care about his own return?

http://www.cdixon.org chris dixon

In the case of a good outcome (scenario 1), by getting a high valuation the founders will (all other things being equal) have taken less dilution and make more money from the sale. On the downside, assuming 1x standard preferred, the founders are affected by amount raised more than valuation.

I am assuming here the founders is looking out for everyone – founders, employees and investors. Certainly not assuming they are optimizing solely for investors – if anything leaning the opposite way.

Anonymous

For sure, the founders should be looking out for everyone involved (investors wouldn’t want to be involved if the founders only cared about themselves). But for the founder, isn’t it in their interest to keep the “scenario 2″ outcome as narrow as possible?

What I mean is, if the founder minimizes the gap between “amount raised” and “total valuation”, they minimize the space where the investor makes back his money and the founder basically gets nothing.

Of course, that essentially entails getting heavily diluted, doesn’t it? Am I thinking about this all wrong?

http://www.cdixon.org chris dixon

In scenario 2, the founder would only get nothing if the exit price were at the very bottom of the range. If, say, Dropbox sold for 2B and all investors kept their preferred stock (didn’t convert), then founders+employees would get 2B-257M (!).

Anonymous

Ah, I see. I think I was confused by the wording of Scenario 2: “Dropbox exits for between $257M (total money raised) and $4B ==> investors get their money back (possibly more if there is a preferred dividend)”. It just seemed like this was only considering the investors’ outcome, which made me think the founders were getting nothing in this entire scenario.

Since that’s not the case, then yeah, I agree with you.

http://www.cdixon.org chris dixon

yeah I should have been clearer. this post seemed to cause a lot of misunderstandings.

Anonymous

No worries. I’m glad I asked!

http://twitter.com/JsonCulverhouse Jason Culverhouse

Your post leaves me with a couple of questions:

What about employee X (could be number 1) who doesn’t hold preferred shares, doesn’t a raise like this effectively wash him out?

Also at the take over, at least of a Delaware corporation, I believe that the Board has a fiduciary responsibility to place the interests of the Common shareholders in front of the Preferred shareholders. Seems like the preferred would have to convert to get money or just accept a junior preferred position in the acquiring company. This could ultimately lead to some legal issues.

Would you mitigate this by allowing all employees to sell into the round, thereby providing a opportunity to trade off risk?

http://www.cdixon.org chris dixon

A higher valuation means less dilution for employee X. If you got the higher valuation for trading for other things like participating preferred, though, that could be worse in the end.

IANAL, but I know companies get sold all the time where preferred doesn’t convert, so somehow that works consistently with DE (and CA) law.

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http://about.me/jelpern Jordan Elpern-Waxman

The explanation of why total money raised is more important than the valuation for allocating the proceeds of an exit is useful, but I don’t think it hits the core issue here. VCs aren’t in the business of investing for the downside. Regardless of liquidity preference they may block an exit that is below their target return, unless they think they can’t continue to grow the company and get a higher offer later (Josh Kopelman’s “Unintentional Moonshot”).

I would also respectfully challenge your assumptions that a) a money losing scenario is unlikely; and b) that VCs know what they are doing. Dropbox may be a case where late round investors are unlikely to lose their money, but that’s not always going to be the case. Investing at too high a valuation may also force the unpalatable choice b/w selling under duress and accepting a crushing down round, as @twitter-28882615:disqus points out.

It’s great if you can get a quality late round investor without giving them blocking rights, board control, or anti-dilution. I’d love to hear your thoughts on how to negotiate this. Perhaps aim for a really high valuation and then at the last minute give in on price in exchange for a concession on these terms?

Chris Dixon