Protect Your Angel Investors

Background Reading:

A lot of writing, including my own, breaks the world of startup  funding “players” into 2 broad categories: founders and investors. While that is helpful, it’s also important for founders to understand that within the investor category, there’s an important distinction between angel investors and institutional investors; in terms of incentives, behavior, and their overall relationship with the company.

Institutional investors are sophisticated (… usually), repeat players who are working with large amounts of other people’s money; and those other people expect (demand) great returns. They have their own lawyers (and therefore usually negotiate harder), have much deeper pockets, and usually invest much later in the game than true angels; when the company is a much more attractive investment from a risk-adjusted perspective.

Angel Investment: faster, easier, but more exposed. 

Angel investors are investing their own money.  Seed funds / angel groups do work with a broader pool of money, but they are more accurately described as an organized group of angels than a true institutional fund.  Angels often do not utilize their own lawyers in executing deals (because the check sizes don’t justify it), which means they rely more on trust in the team, and on standard, more lenient terms. Their money goes in much earlier in the stage of the company, so at a point where the company is much riskier. Angels are accurately described as betting as much on a founder team as they are on the business.  Prominent angels also regularly serve as “social proof” for gaining the interest of VC funds.

Because angels invest much earlier in a company (than VCs), usually without lawyers, and usually on standard documents with minimal investor protections, their relationship with founders/management is often much more informal and trusting, and less about “the numbers,” than the founder-VC fund relationship. Accelerators usually also fall in the same category. This is all very much a good thing. It’s what allows seed investments to move quickly, at a time where the company doesn’t need or want to spend a lot of hours going back and forth on deal nuances when they could be building the foundation of the business.  But it also means that angel investors are exposed to gaming by later investors (or, sometimes, bad actor founders) who take advantage of key inflection points to push the angels’ investment away from the “deal” they thought they were going to get. 

The broad context in which this happens is fairly simple: an angel round has been closed for a while – usually convertible notes or SAFEs, but sometimes seed equity – and the company is raising a Series A. After negotiation and modeling, the parties have not aligned on numbers. The VC doesn’t like the terms that the angels are ‘getting’ in the round (from their notes/SAFEs), because after accounting for his own share, too much of the cap table is taken.  So he makes his check contingent on the founders going back to their angels and convincing them to accept modified terms.

The angels, not happy about it, are exposed because their money is already sunk, and much worse things could happen if the deal dies. So they cave; accepting worse terms so that, effectively, the new money can get better ones.  Requiring earlier seed money to raise their valuation caps is a common way to make lower Series A valuations more swallowable.

But to be totally honest here, sometimes the gaming is not led by the VCs, but by the founders. They see what the angels are getting in the deal, and might collude with the new money to force a change. I’ve never had one of my personal clients play that sort of game, but I have seen it happen.

There are situations, of course, in which terms simply need to be re-negotiated; usually because the company’s path took a number of unexpected negative turns, and things just won’t work if a reset doesn’t happen. Those situations should be distinguished from the ones in which a deal really can close, but someone is just using the exposure of angels to get more of the pie.

Reputation is capital. Don’t waste it.

The job of company counsel is not to do whatever founders / management want; it’s to advise on what is best for the company and all of its stockholders long-term. On a whole host of issues, people who’ve seen the life cycles of companies play out over time (like VC lawyers) can bring a long-term perspective that a fresh team may not understand intuitively.

My advice to founders, which I put down in Burned Relationships Burn Down Companies, is that relationships matter. A lot. Especially with your early money, which often acts both as your cheerleaders in the market, and as a safety net if things get rough. Putting aside the purely ethical aspects of gaming angel investors (which are important, mind you), burning your early investors is bad for the company.  It’s also just bad for founders personally, whose relationships can mean a soft landing if their company fails, or support for their next venture. 

As a startup and new team, you don’t have buckets of money, or a rock-solid reputation, to insulate you from everything that can go wrong with a company. Your reputation and social capital are some of your most valuable assets; don’t waste them. If anyone is asking you to hurt your social capital, stand your ground. They’re asking you to incur a cost, but for their benefit.

In fact, real chess players sometimes want to burn your other relationships, because it reduces your optionality, which increases their leverage. Always think multiple steps ahead.

Pro-rata rights are core economics.

And on a final note, it’s important for founders to understand that when angel/seed funds request “pro rata rights” for future rounds, those rights are not a nice-to-have that is independent from the economics of their existing investment. Successful angel investment depends on the ability to double down on winners (put in additional investment), because the vast majority of an angel’s investments are losers. That’s the core economics of angel investment. If you deny angels their pro-rata in a Series A, you are taking away a part of their deal that allowed them to invest in you in the first place. The long-term consequences for a company and a founder team are usually not worth the near-term benefit.

Promising Equity v. Issuing Equity

Background Reading:

An underlying theme of a number of SHL posts has been the common misunderstanding among young, first-time founders around what startup/vc lawyers in fact do. As I wrote in Legal Technical Debt, a mindset has emerged from certain startup circles suggesting that virtually anything legal that startups do at early-stage, from forming their company to raising seed financing, can be automated with software.

That confused mindset leads founders to (i) assume that all lawyers are just luddites over-charging startups for effectively filling in forms, and (ii) results in founders accruing an enormous amount of compounding ‘legal technical debt’ from badly drafted documents, mis-matched contracts, missed legal steps, etc. For companies that fail fast, the debt never comes due. And yes, there is a clear correlation, from my experience, between founders who arrogantly think lawyers are worthless and those that never build anything of significance.  Dumb people believe and do dumb things.

For those founders that do end up building a real business, however, the 10x cleanup cost of legal technical debt (relative to what it would’ve cost to do it correctly from the start) is often brutally painful. There are a lot of very interesting new tools out there being built to streamline and optimize how tech/vc lawyers work, and you should certainly look for lawyers who are using them. But if you think for a second that you’re going to build a real tech company without needing serious lawyers who can safely manage significant legal complexity, you are, without question, deluding yourself.  

A significant source of “automation confusion” arises from founders not understanding the difference between promising equity and actually issuing equity. I’ve noticed this from how many of our own (very early stage) clients will randomly e-mail us a set of contracts executed over a period of several months with a short message like: “we went ahead and *issued* some equity on our own.  just FYI.”  This blog post will save me from having to write the same e-mail 30 times in the future.

Promising Equity 

I can promise someone equity in 5 seconds, and 1 sentence.

“I promise to issue you 10,000 shares.”

See, it’s not hard. Promising equity is exactly as easy, and as automatable, as it sounds.  Anyone who automates a contract for promising equity, which usually means filling in numbers into a static template, doesn’t deserve the slightest bit of praise for innovation. It’s been do-able for decades.

Sure, people still make mistakes in promising equity all the time. They calculate the number of shares incorrectly, or they get the vesting schedule wrong (or don’t offer one at all), or they simply grabbed the wrong form to begin with.  But the point is that, perhaps with a little guidance from educational materials and a boilerplate form, promising someone equity is do-able as a DIY project.

Reality Check

The problem, of course, is that promising equity is 2% of the much more complicated process needed to actually issue equity. To correctly accomplish the issuance of equity from your company and into the hands of the intended recipient, a web of highly contextual legal analysis needs to occur. Just a short (non-exhaustive) example:

  • What kind of entity are you? That influences the type of equity you can issue.
  • Stock? Option?
    • If Stock, at what price?
    • If Option, at what price? To an employee, or a contractor?
  • Vesting schedule? 83(b)? Acceleration?
  • Was the price set correctly to avoid tax consequences?
  • Enough authorized shares?
  • Correct class of equity?
  • Is it being issued under an equity plan?
  • Was the plan adopted correctly?
  • Are there enough shares in the plan?
  • Is the recipient eligible to receive the equity under securities laws and tax rules?
  • Any state-specific rules/filings to comply with?
  • Any contractual approvals needed?
  • Any cap table adjustments needed, like anti-dilution?
  • Approved by Board?
  • Anyone else that needs to be notified about the Board action?
  • Any spouses we need to worry about for community property purposes?

I could go on, but you get the idea.

Want to try automating that? Good luck to you. Medical care will be fully automated before complex legal work is. Why? Because there’s far less variability in biology than there is between the legal structures of companies. You simply cannot automate (not in a commercially viable way, at least) in an environment where every use case has a totally different starting point, context, and history, in an infinite number of combinations. Even less so where high-stakes errors are cemented in ways (via contract execution and enforceability) that do not allow for quick and easy bug fixes. That is precisely the world in which serious VC lawyers operate.

Believe me, I empathize deeply with the disdain for lawyers held by many entrepreneurs, and share some of it myself. As someone who manages recruiting for our firm, I constantly find myself fighting a sense that the legal field is a magnet for people who think that perfecting their punctuation matters more than learning to actually advise clients on the what, why, and how of startup law.

But there are lawyers in the market who know how to get things done efficiently and correctly. I hire those lawyers. You can either (i) pay them now, (ii) pay them 10x later, or (iii) assume your company will fail before the debt comes due.

Don’t Rush a Term Sheet

TL;DR: No matter how many blog posts and books are out there (many of which I recommend) attempting to explain the mechanics of VC term sheets in simple terms, the reality is that VC term sheets are complicated, both in terms of how their math works and in how the various control-related provisions will impact a founder team over time. Take time to understand them, and don’t rush to sign, even if investors make you feel like you have to.

Background Reading:

Similar to the ‘automation delusion’ that I’ve written about in Legal Technical Debt, which has led some very confused founders to think that most of what startup lawyers do is getting eaten (as opposed to supplemented) by software, there’s a sentiment among parts of the founder community that VC deals have become so standardized that the only kind of analysis needed before signing a term sheet should look something like:

“$X on a $Y Pre?”

“5-person Board, with 2 common, 2 Preferred, and 1 Independent?”

“Great, here’s my signature.”

Take this approach, and you are going to get a lot of ice cold water splashed on your face very quickly, and not at all in a good way. I’ve seen it many times where founders run through a VC deal, so excited about how awesome their terms were, only to realize (sometimes at closing, sometimes years later when things have finally played out) that there were all kinds of “Gotcha’s” in the terms that they failed to fully appreciate. Having solid, independent, trustworthy advisors to walk you through terms before signing is extremely important, and it needs to be people whose advice you take seriously. See: Why Founders Don’t Trust Startup Lawyers and Your Best Advisors: Experienced Founders. 

Some simple principles to follow before signing a term sheet are:

A. Fabricated Deadlines Should be Pushed Back On – It is very common for a term sheet to end with something like “this term sheet will expire on [date that is 48 hours away].” That deadline is very rarely real. It’s just there to let you know that the VC expects you to move quickly.

It is unreasonable to sit on a VC’s term sheet for weeks without good reason. By the time they’ve offered you a term sheet, they’ve likely put in some real time diligencing your company, and the last thing they want is for you to take their term sheet and then “shop” it around to their competitor firms to create a bidding war.  Doing so is not how the relationship works, and will almost certainly burn your deal. So expecting you to move somewhat quickly in negotiating and then signing is fair, but if a VC is pressuring you with anything remotely like “this needs to be signed in 24/48 hours, or the deal’s gone,” what you have there is a clear picture of the kind of power politics this VC is going to play in your long-term relationship.

Move quickly and be respectful, but make sure you’re given enough time to consult with your advisors to fully grasp what you are getting into. It should be in everyone’s interest to avoid surprises long-term.

B. Model The Entire Round – VC Lawyers are usually the best people to handle this because they see dozens of deals a year and will be the most familiar with the ins-and-outs of your existing capitalization, but having multiple people running independent models is always a good idea, to catch glitches. You want to know exactly what % of the Company your lead VC expects for their money, before agreeing to a deal.

I have seen many situations where founders get distracted by a ‘high’ valuation, but when everyone is forced to agree on hard numbers they realize that the VC’s definitions were very different from what the founder team was thinking.  This is absolutely the most crucial when you have convertible notes or SAFEs on your cap table, because how they are treated in the round will significantly influence dilution. The math is not simple. At all.

C. Understand The Exclusivity Provision – Most term sheets will have a no-shop/exclusivity provision “locking you up” for 45-60 days, the amount of time it typically takes to close a deal after signing a term sheet. This is reasonable, assuming it’s not longer than that, to protect the VC from having their terms shopped around. But it also means that if you are talking to other potential VCs, the moment one term sheet arrives, everyone else should be told (without disclosing the identity or terms of the TS you have in hand) that it’s time to put forth their terms, or end discussions. Because once signed, your job is to close the signed term sheet.

D. Focus on Long-Term Control/Influence Over Decision-Making – Thinking through the various voting thresholds, board composition, and consent requirements is extremely important. Will the board be balanced, with an ‘independent’ being the tie breaker? Then being extremely clear on who the independent is, and how they’ll be chosen, is crucial. Will one of the common directors have to be the CEO at all times? Then understanding exactly how a successor CEO will be chosen is crucial, because usually at some point it’s not a founder.

If X% of the Preferred Stock is required to approve something, then you need to know (i) what %s of the Preferred will each of your investors hold, and (ii) who will the other investors be? Usually the Company gets discretion as to what money gets added to the round apart from the lead’s money, ensuring there are multiple independent voices even within the investor base, but some VCs will throw in a provision requiring that only their own connections fund the round. That heavily influences power dynamics.

There will be many situations in the Company’s life cycle where everyone on the cap table doesn’t agree on what’s the best path for the company. Ensuring balance on all material decisions, and preventing the concentration of unilateral power, is important, and yet not simple to understand without processing terms carefully. 

E. Shorter Term Sheets are Not Better – There is debate within the VC/VC Lawyer community as to whether shorter, simpler term sheets are better than longer, more detailed ones. I fall squarely in the camp that says you should have clarity on all material terms before signing and locking yourself into exclusivity; not just the economic ones.  That means any sentences like “the Preferred Stock will have ‘customary’ protective provisions” (meaning they will have the right to block certain company actions) should be converted into an exact list of what those provisions will be. I can guarantee you your counsel’s perspective on what’s ‘customary’ is going to differ from their counsel’s.

The view among those who prefer shorter term sheets is that you should sign as soon as possible, to avoid ‘losing the deal’ (as if VC investment is that ephemeral). I don’t buy it. The moment you sign a term sheet, you are going to start racking up legal fees, and you are now bound by a no-shop/exclusivity. That means your leverage has gone down, and you are much more exposed to being pressured into unfavorable terms to simply ‘get the deal closed.’ Politely and respectfully negotiate a term sheet to make it clear what all of the core economic and control terms are. The alignment and lack of surprises on the back end is well-worth the extra time on the front end. 

In short, the core message here is know what you are signing. Make sure your VCs know that you are committed, and aren’t going to play games by shopping their terms. But also make sure you are talking to the right people to ensure that the deal you think you’re getting is in fact the one in your hands.

Founder Compensation: Cash, Equity, Liquidity

TL;DR: Before investor money shows up, founders should pay themselves very little, if anything. As the company reaches milestones, including fundraising milestones, founder compensation increases as a % of market comp, although it rarely reaches full ‘market’ until a Series B/C or later. As a general matter, investors want founders (i) focused on the long-term success of the company’s stock and not on a lofty cash compensation arrangement, but (ii) also comfortable enough financially to pay their bills and not be distracted by financial worries.

Background Reading:

As with many things, how different parties assess and calculate appropriate founder compensation is far more of an art than a science.  One thing to keep in mind is that all comp numbers at each stage are heavily influenced by (i) location and cost of living, (ii) industry, and (iii) life circumstances of the founders.  Older founders with families tend to have slightly higher salaries than younger single founders. The same goes for founders in more expensive cities, and for founders in industries (like biotech, energy) where the founder team is made up of seasoned executives that have taken very large pay cuts to join the venture.

There are also tax nuances involved that are not the scope of this article. That being said, the below is an outline of the overarching common principles that I’ve observed among companies along the various stages of their life cycle.

Pre-Seed: Cash In, Not Out

Money in should be documented as a Founder Note or SAFE. Paying yourself a salary  at this stage makes little sense, unless there’s substantial revenue. If you need to get some money back, a small bonus upon raising a larger ($2MM+) round is sometimes kosher. 

If a startup is currently bootstrapped and not running on a sizable amount of customer revenue, paying founder salaries amounts to taking cash from one pocket and placing it in the other, while allowing the IRS to take a percentage of it. It is very rarely rational. Keep what you need to survive in your own bank account, and only fund the company with the rest.

Contributions of capital from founders beyond minimal amounts should usually be documented as a founder convertible note or SAFE (see articles above), with the expectation that it will convert later into preferred stock, providing that founder a “little extra” on the cap table and eventually in a liquidity event. It should not, however, be expected to be paid back.

However, occasionally founders will put in such a large amount of money that they really need to get some of it back much earlier than in an exit. In those instances, discussing a small ‘performance bonus’ with your seed or Series A investors can often work, as long as the amount isn’t too large of a percentage of the overall round. I’ve seen founders get a $50K ‘performance bonus’ upon raising a $2MM+ Series A, with the logic being that they were taking barely subsistence salaries for the past year and need something to help cover deferred expenses. Sometimes it works. Sometimes it doesn’t. Usually founders with personal obligations, like student loans or families to support, are able to make a more credible case for an early cash bonus. 

I would also put “Friends and Family” round territory in this category, although it depends. If you’ve raised $250K or less, which is usually what I see for F&F, paying yourself any kind of salary often doesn’t make sense. For larger F&F rounds that are meant to last for over a year, very small founder salaries can work. As a general matter, however, anyone looking to build a company without at a minimum 6-12 months of cash reserves to live off of should re-consider whether they are in the right position to start a company.

Seed/Series A: Enough to pay the bills

Founders get paid ‘subsistence’ salaries; enough to cover expenses, but low enough to where they’re still hungry for growth. 

Once investors are on the cap table and/or the company is generating real revenue, discussions about founder salaries start to make more sense. The core principle to understand in this stage is that investors will want to avoid paying founders such high salaries that they’re no longer hungry and are just enjoying the ride. The vast majority of a founder’s long-term payout should come from their equity stake in the company, and investors want founders laser focused on turning that stake (and the investors’ stakes) into cash with a successful liquidity event.   That being said, most investors also do not want founders to be so desperate for cash that they are worried about paying their mortgage, or their kids’ schooling, which will be distracting from company matters. 

While this is an extremely rough benchmark and there are all kinds of variations, if you assume 100% as being the aggregate cash compensation of a C-level executive in a respectable, matured middle-market company in a startup’s industry and geography, seed-stage founders will often get paid 20-25% of market, and Series A founders bump up to something like 35-50%. So, as an example, if $250K is ‘market’, a seed-stage founder CEO might earn $50-60K a year, and $85K-$125K at Series A; with the universal understanding that industry, cost of living, and the personal circumstances of founders will push it in either direction.

At this stage, any discussions of founder liquidity (taking some money off the table via a secondary sale) will be non-starters, and even send a negative signal to investors that the founder isn’t as bullish as he/she should be on the company’s long-term prospects. If a founder needs more money (often family circumstances), cash comp, like a special bonus, should be the focus.

Series B/C and BeyondEdging Toward Market, Liquidity

Now we’re running a real enterprise, with the market compensation to prove it. 

It’s at true “growth” rounds when cash compensation starts to edge closer to ‘market,’ and when discussions about some small founder liquidity start to make more sense.  A ‘growth round’ would generally mean that the company has found strong product-market fit, growth is going strong, and they just need gasoline (cash) to propel the rocket ship. At this stage, founder cash comp would usually be closer to 75-100% of market for the founders’ position in the company, which may still be C-level, but might not be. See: Rich v. King: The (Core) Founder’s Dilemma.

A dynamic that starts to arise at the growth stage of a company is the feeling among a founder team (and, frankly, their spouses and families), that even though the company hasn’t exited yet, they’ve ‘made it.’ They’ve made it through the sleepless nights, the chaotic weekends, and the strained personal lives, and have built something with sustainable, sizable market value… but the ‘big pay day’ may still be years away.

It’s at this stage that a spouse might ask a question like, “So… you’ve been at this 5 years and your company just raised $20MM. Why can we still not afford to buy that house I told you about?” Those types of thoughts, which are often not unreasonable, prompt discussions about founder liquidity; meaning the sale of a portion of a founders’ common stock for cash beyond an amount that would be reasonable as a cash compensation package directly from the company.

Some VCs, when prompted by a founder looking to take a little money off the table, will respond bluntly, “absolutely not.” The logic being the conventional “I want you to be hungry” mindset. Over the past few years a counterpoint to that perspective has emerged that is reflected in It All Changes When the Founder Drives a Porsche and Some Thoughts on Founder Liquidity. The logic goes something like this:

  • Once a founder has built demonstrable enterprise value and their equity stake represents a life-changing amount of money, personal psychology and (often) family dynamics can lead them to become impatient toward converting that stake into cash;
  • This impatience can lead founders to become overly conservative in company decisions, edging toward smaller, but earlier exits (early acquisition), when a little more patience and longer horizon could achieve a significantly larger outcome (larger acquisition, IPO);
  • Therefore, allowing founders a small amount of liquidity in growth stage – enough to bring something significant home to their spouses/families/friends to reflect their achievement and calm the financial impatience, but not enough to take their eyes off the much larger pot at the end of the rainbow – can maximize the value of the company, and the eventual payout to investors, in the long run. 

You’ll still often run into both the “keep them hungry” and “let them take a little off the table” mindsets within a single cap table, but I would say the latter view, that some founder liquidity (think 5-10% of their stake) in true growth rounds can push founders to achieve bigger exits, is winning out. It depends a lot on the context, and on the particular investors.

So to summarize, while there are wide variations in the market, some reasonable, rough guidelines for founder comp are:

Pre-Seed / F&F: All equity, minimal or no cash comp, liquidity impossible.

Seed: 20-25% of market cash comp, liquidity impossible.

Series A: 35-50% of market cash comp, don’t ask about liquidity.

Series B-C+: 75-100% of market cash comp, small liquidity possible in right circumstances.

Did you get a “good” valuation?

TL;DR: What a “good” valuation is depends highly on context: geography, industry, timing, size, team experience, value-add of money, control terms, and a dozen other variables. Be careful using very fuzzy guidelines/statistics, or anecdotes, for assessing whether you got a good deal. The best valuation for your company is ultimately the one that closes.

VC lawyers get asked all the time by their clients to judge whether their financing terms are good, fair, etc; especially valuation. And that’s for good reason. There are very few players in ecosystems who see enough volume and breadth of deals to provide a truly informed assessment of a financing’s terms. Executives have usually only seen their own companies. Accelerators see only their cohort’s. Most advisors/mentors have even more limited visibility.

But VC lawyers/firms with well-established practices see deals that cross geographic, industry, stage, etc. boundaries.  In addition to a firm’s internal deal flow, there are third-party resources that can be subscribed to with data on VC valuations across the country and the world. Those resources tend to be expensive (5-figure annual subscriptions), and only firms with deep VC practices will pay for them. Given how much you’ll be relying on your lawyers for advice on your financing terms (for the above-mentioned reasons), ensuring that they are objective (and not biased in favor of your investors) is crucial. 

The above all being said, founders should understand that determining valuation at the early stages of a company (seed, Series A, B) is far far more an art than a science. It is for the investor making the investment, and it is for the people judging whether the terms are “good.” That’s why relying on broad metrics like “median Series A valuation is X” is problematic; there are simply too many variables for each company that could justify deviating from the median, in either direction (lower or higher).

What some people call a seed round, others might call a Series A. Some companies raise a Series A very early on in their company’s history because the nature of their product requires serious capital expense to even get to early milestones. Other companies bootstrap for a decade and only use a Series A as true growth capital (the way others would use a Series C or D). I saw a $150MM ‘Series A’ once. I’ve also seen $500K ‘Series A’s. And everything in between as well. So whenever someone asks me “what’s a good Seed or Series A valuation?” the answer has to start out with: “it depends.” 

Below is a break-down of the mental analysis that I might use in assessing a company’s valuation. Remember, it is an art, not a science. There are widely varying opinions here, and this is just one of them. Consider it a set of suggested guidelines, not rules.

1. What was the last valuation a professional investor was willing to pay, and what progress has been made since then?

The easiest answer to “what is X worth?” is “whatever price someone was willing to pay.” While not entirely helpful in the VC context, it certainly is relevant. If you’re doing a Series A and you have institutionals who invested in a convertible note at a $5MM cap a year ago, the obvious question then is “how much progress has been made since then?” This, btw, is why it’s dangerous for companies to set their own valuations without a true market check from professional investors. Your earlier valuations will influence your later ones.

2. What city are you in?

Location. Location. Location. One of the strongest determinants of valuations is the density of startup capital in the city your company operates in; because density means competition. Silicon Valley valuations are not 2-3x those of the rest of the country because the VCs there are just nice guys who are willing to pay more. It’s a function of market competition. SV has the highest valuations. NYC follows. And then there’s the rest of the country, with variations by city. Austin valuations are generally higher than Atlanta’s, which are generally higher than Houston’s or Miami’s. General deal terms are also more company-friendly where there is more investment density.

While the entire concept of “founder friendly” investors does have an important moral/human dynamic to it, people who play in the space enough know that at some foundational level it is a form of self-interested brand differentiation. The ‘friendliest’ investors are the ones in the most competitive, transparent (reputationally) markets. Why take our money over theirs? Because we’re ‘founder friendly’… which can mean a whole lot of things; some of which are relevant, and others which are nonsense.

Yes, online networks are breaking down geographic barriers and you are seeing more capital flow between cities/states, but the data is still crystal clear that if a Silicon Valley VC is investing in an Atlanta or Austin company, they are going to want to pay something closer to Atlanta or Austin (not SV) prices. Much like all the Ex-Californians buying up Austin homes, they likely will pay slightly above the local market (and in both cases, it pisses off local buyers), but not much. 

3. How much is being raised?

Valuations can (and often do) vary widely between markets, while the actual dilution that founders absorb doesn’t vary as much. How is that? Because founders in markets with higher valuations raise larger amounts of money, and founders in markets with lower valuations raise smaller amounts of money; in each case getting the VCs/investors to their desired %. A $1MM raise at a $4MM valuation produces the same dilution as a $5MM raise at a $20MM valuation.

You should never close any round without modeling (lawyers often help here) the actual dilution you are going to absorb from the round, including any changes required to your option pool. Many investors focus first on their desired % and then back into the right valuation and round size. Smart founders should focus on %s as well. It’s not intuitive; especially if you have multiple rounds involved.

4. Who are the investors?

Value-add, known-brand institutional VCs and professional angels that will be deeply engaged in building your company after the check hits are (obviously) worth a lot more than investors who just bring money. And they will often price themselves accordingly (lower valuations). Some money is greener.

Diligencing the valuations your specific investors were willing to pay for their past investments is a smart move. Again, it still requires discussions about the differences between companies, but it can help address any statements like “we never pay more than $X MM for Series A.”

5. What are the other terms?

A $4MM valuation with a 1x non-participating liquidation preference looks very very different in an exit from a $6MM valuation with a 2x participating liquidation preference. So does a $3.5MM valuation with investors getting 1 out of 3 Board seats v. a $5MM valuation with them getting 2/3. The non-valuation terms matter. A lot. Juicing up valuations by accepting terrible ‘other’ terms gets a lot of companies in trouble. 

6. Other Business-Focused Variables

  • What are valuations within this specific industry looking like over the past 12 months?
  • What are the obvious acquirers paying for companies they buy?
  • Where is the company in terms of revenue? Revenue-multiples generally don’t have a place in early-stage, but a $25K MRR v. $300K MRR absolutely influences valuation.
  • Any serial entrepreneurs on the team? Good schools? Other de-risking signals?
  • What’s growth look like?
  • Size of market?
  • etc. etc. etc.

Obviously, multiple term sheets are a great way to have a very clear idea of where your valuation should be, but in most non-SV markets that is a privilege bestowed on a small fraction of companies.

Take-homes:

A. If your friend’s startup got X valuation for their Series A round, that can be totally irrelevant to what valuation you should get,

B. Other terms of the financing matter a lot too, as well as who is delivering them, and

C. If you have in your hand a deal that isn’t exactly at the valuation you wanted, remember that there are thousands of founders out there who got a valuation of $0.

Over-optimizing for valuation can mean under-optimizing on a host of things that matter far more for building your business. Get the best deal that you can actually get, given your business, location, and investors, and then move forward. And ignore the broad market data, particularly the Silicon Valley data, that isn’t relevant to your own company.