Ignoring Key Economic Terms Beyond the Pre Money Valuation

In many term sheet negotiations, there is a huge focus on the pre money valuation, but many other deal terms can have a very big impact on the economics of the deal yet do not receive the focus they deserve.  For example, important terms include:

• Option pool – what is the increase in the size of the option pool, and is the increase created out of the pre money (the entrepreneur suffers the dilution) or the post money (the entrepreneur and the investor suffer dilution together)?
• Liquidation preference – none, 1x, participating, etc.
• Dividends – what is the rate, and are dividends converted to cash or can they be converted to stock?
• Debt that will be converted at the time of the financing – is it included in the pre money valuation?

Below are two scenarios that show how the option pool treatment can significantly impact the economics of a deal:

Modifying the treatment of the option pool decreased the share price by 17%, dropped the founder’s percentage ownership from 60% to 56%, and increased the investor’s percentage ownership from 25% to 29% (while keeping the pre money valuation constant).  This basic example is a good illustration of why comparing pre money valuations (without considering other key economic terms) can create an apples to oranges comparison when evaluating investment offers.  At Osage we certainly consider the pre money valuation but ultimately focus more on share price, post money valuation, and post financing ownership.

Some terms have a very meaningful effect on how the exit proceeds are distributed, but these effects do not show up in comparisons of valuation, share price, and percentage ownership.  So when evaluating a term sheet it’s also helpful to run a waterfall analysis at various exit scenarios to understand the impact of these terms, particularly the liquidation preference and dividends.

Most investors understand how to navigate the various terms because they do several deals per year.  For entrepreneurs, negotiating these terms can be complex and confusing.  To break through the clutter, consider the pre money valuation to be a starting point… and evaluate the post financing cap table and waterfall scenarios to understand what an investment offer means at the end of the day.

There are certainly many other important factors to consider when deciding on a term sheet (such as board composition, protective provisions, company/investor chemistry), but that is a topic for another post.