Month: September 2008
(Brad) In response to the post Compensation In A Very Early State Company I got the following question:
Q: If comp is at say 50% with 2x equity vesting over a standard term, then in 6 months a series A is completed and there’s more comfortable level of cash in the bank, salary can be renegotiated but options cant, so the scale doesn’t shift accordingly; to, for example, 1x comp and 1x equity. How can the shareholders in the company not overextend their cash capability, but without over-diluting investor stake? Have you any experience where a balance was made to make both investors and early hires content?
A: I don’t think this is a reasonable concern for the founders to take. Specifically, the reason the early employee is willing to make the trade discussed is because he is taking the risk that the financing isn’t going to get raised in any reasonable period of time.
One way to manage this is to set expectations with the person getting this trade that it will last for a specific period of time (say – one or two years.) This addresses the "hey – we raised money faster than expected." Alternatively, you can put a structure in place where if compensation goes up in some period of time a certain amount of the equity granted gets canceled. I personally don’t like these approaches because they both (a) create weird incentives and (b) generate additional complexity. If someone is willing to take a risk like this early one, reward them!
Q: How do I do multiple closings on a single round work? In our case, we have an investor wishing to give us headstart, certainly I imagine not an uncommon case in friend and family scenarios, though here we’d have multiple rounds of angels, without kicking up the gears to flush out a full seed round with other investors before that money changes hands.
A (Brad): There are several ways to do this. Let’s break it into two cases: #1: You are doing a convertible debt round. #2: You are doing an equity round.
#1: Convertible Debt: This is the easiest case. For a convertible debt round, you can keep it as simple as issuing a promissory note for each investor. This promissory note can contain any special conversion terms, including what happens on a qualified financing (including the definition of the qualified financing), what happens on a sale of the company, and what happens if the company fails. You can do as many closings as you want by simply issuing a separate promissory note for each investor.
#2: Equity Round: The best way to do multiple closings on an angel equity round is to raise the early money using the convertible debt approach above with an automatic conversion into a pre-negotiated equity financing once a certain amount of money is raised. Let’s say you are planning to raise $500k and your early investor is willing to do $100k of it at a $1.5m pre-money valuation. You can negotiate the equity terms with this investor, issue a promissory note for $100k to get that money into the company, and then agree (contractually or not) to do the full round once you’ve lined up the $500k. You do run the risk that either (a) you can’t raise the full $500k or (b) some of your later investors will want different terms. If you have a good relationship with the first investor(s) you can usually manage this by including them in the process. You can also put a "most favored nation" clause in the promissory note to adjust their conversion features to match whatever the financing ends up if it is more favorable to them than the terms the negotiated.
An alternative approach to #2 is to negotiate all the equity terms with the expectation that you’ll have multiple closings on the equity round. Then, do a first closing with whatever investors are lined up and have a fixed length of time (typically 60 – 120 days) to raise more money on the same terms. Again, you should be conscious of the idea that you might have a new investor want better terms – since this is your early angel round, you should consider including a most favored nation clause so the investors that committed to you early get the same deal as later investors in the same round if the terms happen to change.
Q: Can you please explain what sort of adjustments you should expect to the price that a VC promises in a term sheet between the signing of the term sheet and signing of a final stock purchase agreement (SPA)?
A: (Jason) To answer your question, we first need to determine what the definition of "price" is.
I don’t care what price per share I pay. It’s an irrelevant number. What’s relevant is the pre-money valuation. That, along with my investment will determine what percentage of the company that I own post investment. For more on this, see this prior post.
If the question is "how often do I see the pre-money valuation change from term sheet to SPA" that answer is almost never. Only in rare cases of something material happening to the company, I tend to think "a deal is a deal." If something that bad happens to warrant a price change, it’s probably more likely that the entire deal falls apart.
The only other situation that could potentially change the valuation / price is if something is found in diligence that wasn’t known to the VC at the time of term sheet. For instance, if founders have deferred salaries or have debt that need to be paid back and a large chunk on the financing is going to be immediately used, this too might change the economics.
If you define price as the "price per share" (not having anything to do with valuation), then I would tell you that I think EVERY deal that I’ve been involved with has had a price adjustment during this period. The price per share is based on the outstanding equity of the company and rarely does this get 100% figured out until right before closing.