VCs tighten terms when capital is scarce to reduce their risks. Consider these three most popular terms to ensure you’re not giving away too much.
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By Erik Stettler
Verified Expert In Finance
Erik is the co-founder and CEO of a global fund for venture capital. The fund has invested in more than 50 startups, which have raised over $500 million. Erik has also achieved six exits. He is Toptal’s chief economist.
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When global economic forecasts are uncertain, raising funds is only the first part of the battle. To reduce their risks, VCs who continue to invest in startups often require more aggressive term sheets. Term Sheets from reputable VCs are unlikely to be predatory. However, during a recession, worst-case scenarios will more often occur, and founders may be forced to pay a higher price. cap-table modeling and financial modeling are two ways to avoid giving up more equity than necessary.
I’ve sat at the same table with founders just like you a number of times. I can tell that VCs are interested in your success because it’s what they do. A gloomy economic climate makes people more risk-averse and tight-fisted. This means that you should expect to see additional conditions attached to your investment.
Value is a hot topic, but the preferred equity investors receive can lead you to a bad deal. It can be difficult to price these terms because they are only relevant under certain circumstances. In a healthy economy, dilution protection kicks in only during a round. It can be the difference between your business’s survival and its demise in a volatile economy.
To price conditional terms, the most accurate method is to simulate possible outcomes using your financial model. Then calculate the impact of proposed terms on your table of caps and average the results. This can be expensive and require specialized software as well as significant statistical expertise, which you may not possess.
A much easier yet still reliable option is to perform scenario analyses using your c financial modeling. You can use scenario analysis to compare different financial outcomes.
This article does not cover the best way to price preferred terms, but it provides a guideline for some of the most important and common terms. I will also show you how accurately to value these terms to avoid accidentally giving too much away of your business.
Position yourself for negotiation
Do your homework before you go to the table. Make sure you have your startup’s finances in order.
You will be able to build your cap table and estimate the value of your company.
Get Your Value Right
When you are at the stage of negotiations, the valuation is less important, but it’s still necessary to present a convincing case for your numbers.
This is where creative thinking comes in. Quantitative tools can be used to assess the financial strength of a start-up. However, you will likely not have enough cash flow information to make a fair value estimate at this stage. Triangulation is a better way to approach the matter.
Financial Model
You can still start with a basic model, even if you don’t have much historical data. To do this, perform a discounted cash flow using your financial models and whatever information you may have. Use the standard venture rate of return (20% to 25%) as the cost of capital and see what the present-day value implies. Then, working backward, determine the amount of cash flow growth required to reach your goal valuation. It will help you identify the milestones that need to be born to create a plan for achieving your target valuation and demonstrate to investors a return on investment.
Recent relevant transactions and/or exit
Even in normal market conditions, it is difficult to find recent comparable deals between direct competitors or peers. The public information about transactions does not include essential aspects of the deal structure or terms.
By expanding your search for recent relevant transactions–those within your industry or technology area–you can provide investors with convincing context to support the multiple of your revenue.
Direct peers are hard to find because startup funding agreements are confidential. You can get more data by taking a more comprehensive approach.
Aggregate Market Trends
Pitchbook provides a significant amount of data for free on trends in private market valuations and deal sizes across funding stages. This data can be skewed if a few “mega rounds” at high valuations are included. It can also hide a wide range of outcomes. In general, however, demonstrating that your implied valuation is consistent with other deals can help you justify your asking price.
Consider it a warning sign if an investor insists on a lower valuation. Investors should focus on their returns. I had a client who was able so convincingly to show that they could expect a 70% growth rate every month that the issue of lowering their valuation never came up.
Dynamic Cap Table
The valuation discussion is centered around your financial model. Your cap table is the real battleground for negotiations. This is where you can track the equity breakdown in your company. You must model the terms of your investors using three key features in your cap-table format.
