Options on early stage companies

I believe that what I’m about to say is accepted by venture capitalists as fact, even trivially obvious fact, yet very few entrepreneurs I meet seem to understand it.

An option on a share of stock of an early stage company is (for all practical purposes) equal in value to a share in that early stage company.  Not less, as most entrepreneurs seem to believe (and god forbid you think “the VCs have the option to put in more money” is economically advantageous to you).

Here’s why.  Black and Scholes (and Merton) won a Nobel prize for inventing the Black-Scholes model, which was the first model that somewhat accurately modeled options pricing.  Using this model, and making a few reasonable assumptions (the option is “near the money,” the maturity is sufficiently far away), the key driver of an option’s value is volatility (in fact, if you listen to option traders talk, they actually talk about prices in “vols”).   In public markets, options are usually priced at some fraction of the share price.  This is because public stocks under normal circumstances have volatilities around, say, 20% (at least they used to 10 years ago when I was programming options pricing algorithms).

The volatility of the value of a seed stage startup is incredibly high.  I don’t know if any data exists for what volatility estimate would be good to use, but for an informal analysis suppose the average volatility of a seed stage startup is 300%.  Then try putting 300% into the volatility field of a Black-Scholes calculator:

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So if your share price is $1, an option (European Call is a fancy word for options similar to what are given out in startups) is worth $0.9993 dollars.

This is good news for start up employees, directors, and advisors who are awarded stock options.  Their options are economically as valuable as stock but have better tax treatment.

Here’s the bad news.  At least since I’ve been observing early stage deals (since 2003), so-called financial innovation in venture capital has been all about creating new kinds of options for investors, each one more obfuscatory than the last.

– The first way they create options is by simply doing nothing – telling the entrepreneur “great idea, come back in a few months when you’ve made more progress.”  The logic is: why would you invest now when you could invest in, say, 3 months with more information? (as VCs say, why not “flip another card over”).  This is obviously perfectly within their rights and logical, but ultimately, in my opinion, penny wise and pound foolish.   While the VCs might be successful with this strategy on a specific deal, in the long run they are hurting themselves reputationally and also probably by letting some good deals slip away.

– Next there is tranching – this is pretty literally an option.  Even if the pre-negotiated future valuations are higher, the option has basically the same value as a share at the current price.  Try the Black-Scholes calculator but changing the strike price to 10 (simulating the idea that the seed round is $1M pre and future valuation is $10m pre):

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The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares.  (I discuss the problems with tranching in more detail here.)

– Next there was “warrant coverage.”  This is perfectly legitimate in many cases (e.g. as a “kicker” in a venture debt round, as part of an important strategic partnership), as long as the entrepreneur understands 1 warrant basically equals 1 share.  One mistake entrepreneurs often make is to focus so intently on nominal valuation that they don’t realize their “effective valuation” with warrants is much lower.  For example, if the valuation is $10M pre and you give 100% warrant coverage, the valuation is really $5M pre.

– Over the past few years with big VCs starting “seed programs” we’ve seen the emergence of situations where there is no contractual option but the signaling value of the VC’s potential non-participation gives them option-like value.  I discuss why I dislike these deals here.  (This might be one point on which Fred and I disagree…?).

– Super pro rata rights.  This is a new term that’s popped up lately.  Pro-rata rights are options, but seem like reasonable ones.  If as an investor I bought 5% of your company, pro rata rights give me the right to invest 5% in the next round.  They are arguably a reasonable reward for taking a risk early on.  Super pro rata rights mean if I buy 5% of your company now I have the right to invest, say, 50% of the next round.  This is a really expensive deal for the entrepreneur.  If an investors puts in $250K for 5% of your company now with super pro rata rights on 50% of the next round, I’d just for simplicity assume you sold ~20% (assuming the next round sells 30% and the VC does half of that) of your company for $250K.  (The actual analysis of the value of super rata rights seems tricky – maybe some finance PhD will figure out how to price them at some point).

Good VCs don’t mess around with this stuff.  They realize that real value is created when you invest in great people and innovate around technology, not finance.

Ideal first round funding terms

My last 2 posts were about things to avoid, so I thought it might be helpful to follow up with something more positive.  Having been part of or observed about 50 early stage deals, I have come to believe there is a clearly dominant set of deal terms.   Here they are:

– Investors get either common stock or 1x non-participating preferred stock.  Anything more than that (participating preferred, multiple liquidation preferences) divide incentives of investors and the entrepreneurs.  Also, this sort of crud tends to get amplified in follow on rounds.

– Pro rata rights for investors.   Not super pro rata rights (explaining why this new trendy term is a bad idea requires a separate blog post).  This means basically that investors have the right to put more money in follow on rounds.  This should include all investors – including small angels when they are investing alongside big VCs.  There are two reasons this term is important 1) it seems fair that investors have the option to reinvest in good companies – they took a risk at the early stage after all 2) in certain situations it lets investors “protect” their investments from possible valuation manipulation (this has never happened to me but more experienced investors tell me horror stories about stuff that went on in the last downturn – 2001-2004).

– Founder vesting w/ acceleration on change of control.  I talk about this in detail here.   If your lawyer tries to talk you out of founder vesting (as some seem to be doing lately), I suggest you get a new lawyer.

– This stuff is all so standard that there is no reason you should pay more than $10K for the financing (including both sides).  I personally use Gunderson and think they are great.   Whoever you choose, I strongly recommend you go with a “standard” startup lawfirm (Gunderson, Wilson Sonsini, Fenwick etc).   I tried going with a non-standard one once and the results were disastrous.  Also, when you go with a standard firm and get their standard docs it can expedite later rounds as VCs are familiar with them.

– A board consisting of 1 investor, 1 management and 1 mutually agreed upon independent director.  (Or 2 VCs, 2 mgmt and 1 indy).  As an entrepreneur, the way I think of this is if both my investors and an independent director who I approved want to fire me, I must be doing a pretty crappy job and deserve it.

– Founder salaries – these should be “subsistence” level and no more.  If the founders are wealthy, the number should be zero.  If they aren’t, it should be whatever lets them not worry about money but not save any.  This is very, very important.  Peter Thiel said it best here.  (I would actually go further and say this should be true of all employees at all non-profitable startups – but that is a longer topic).

– If small angels are investing alongside big VCs, they should get all the same economic rights as the VCs but no control rights.  Economics rights means share price, any warrants if there are any (hopefully there aren’t), and pro-rata rights.  Control rights means things like the right to block later financings, selling the company etc.  I once had to track down a tiny investor in the mountains of Italy to get a signature.  It’s a real pain and unnecessary.

– Option pool – normally 10-20%.  This comes out of the pre-money so founders should be aware that the number is very important in terms of their dilution.  Ideally the % should be based on a hiring plan and not just a deal point.   (Side note to entrepreneurs – whenever you want to debate something with a VC, frame it in operational terms since it’s hard for them to argue with that).

– All the other stuff (registration rights, dividends etc) should be standard NVCA terms.

– Valuation & amount- My preference is to keep all terms as above and only negotiate over 2 things – valuation and amount raised.  The amount raised should be enough to hit whatever milestones you think will get the company further financing, plus some fudge factor of, say, 50% because things always take longer and cost more than you think.  The valuation is obviously a matter of market conditions, how competitive the deal is etc.   One thing I would say is if you expect to raise more money (and you should expect to), make sure your post-money valuation is one that you will be able to “beat” in your next round.  There is nothing more dilutive and morale crushing than a down round.

The problem with taking seed money from big VCs

I recently met an entrepreneur who was raising money for his startup.  Six months prior, he had raised seed money (<$1M) from one of the increasingly popular seed programs big venture firms are offering (big venture firms = roughly $100M fund and larger).  As a potential investor, the first question I asked him is “is the big venture firm following on?”  The answer was no.  What this means is the entrepreneur is going to have a *really* tough time raising any more money at all, because what all potential investors think is “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?”   What the entrepreneur didn’t realize is that when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual. And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.

Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator).   This isn’t obvious if you haven’t done follow on fundraising before, but I’ve observed it first hand many times.  The reason is you won’t have the freedom to go out and get a true market valuation for your company.  Suppose you have venture firm X as a seed investor and they offer you, say, a $6M pre money valuation for your follow on round (usually called the Series A).  Suppose furthermore that if you were free to get a competitive process going that the “true valuation” for your company would be more like $10M pre.  If you now go to another firm, Y, and pitch them, one of the first questions is going to be “Is X investing?”  You say yes, X has made you an offer.  Now what Y is thinking is either 1) “I should call up X and offer to co-invest at $6 pre,” thereby keeping you at an artificially low valuation, or 2) if that’s not an option (e.g. because you already have 2 VCs in the deal, because X doesn’t think Y is a high quality enough firm to co-invest with, etc) Y is going to hesitate to offer you a term sheet, for fear of being used as a stalking horse.  This is industry lingo for when the entrepreneur uses firm Y to get a higher priced term sheet which X then matches and excludes Y.  VCs really don’t like to be used as stalking horses.  So what having a big VC in as a seed investor does is prevent you from getting a competitive dynamic going that gets you a true market valuation.

Why are big VCs doing this?   If you have a, say, a $200M fund, spending, say, 5% of your fund to get options on 50 companies is a great investment.  You could look at this from an options valuation perspective (seed stage startups have super high volatility – the key driver of options price in the Black-Scholes valuation model).  More simply, just think of it as “lead gen” for venture capitalists.  Basically big VCs are spending 5% of their budget generating captive leads for their real business:  investing $10M into a companies at the post-seed stage.

These seed programs are relatively new so we are only starting to see the wreckage they will eventually cause.  I predict in a few years, after enough entrepreneurs get burned, what I’ve said above will be conventional wisdom.  Unfortunately there are a lot of good companies that will die along the way until that happens.

Disclosure:  I sometimes compete with big VCs for investments, so I am not disinterested here.