Death, Taxes, and Series A Cap Tables

A couple of weeks ago I was invited to give a keynote address at the monthly Rockies Venture Club meeting. Sitting down to dinner I noticed they had preset the table with both dessert and salad. How’s that for the ultimate New Years resolutions test.  It turned out to be a great segue as my keynote subject was New Years Resolutions for Entrepreneurs.  One of my favorites was “I resolve to give away 50% of my company in a Series A round, and smile while I am doing it”. As I wandered real-time into an explanation of this oddly immutable law of Series A, it dawned on me that it I had no idea why this always seemed to be the case. I figured I’d find an explanation for this and that it might make a great follow up to Angels and Demons, the first of my articles in the Startup series. So, grab some salad and cake and read on…

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Death, Taxes, and Series A Cap Tables

As Benjamin Franklin once quipped, “In this world nothing is certain but death and taxes” (Oh, the irony if he paid his taxes with 100 dollar bills). Well Benny, I think I found a third one: post-Series A cap tables.

In the last 9 years I’ve been involved in funding a number of early stage venture rounds. I’ve done them as co-founder, angel investor, and in a few cases as venture fund advisor. What I’ve come to notice is that there are some basic laws of physics by which most venture deals work. While some of these deals were done in the bubble (and thus didn’t adhere to these dynamics), I feel this period was a sort of glitch in the VC matrix (if you see the same PowerPoint slide appear twice in a row, immediately take the blue pill). Leaving those deals out for the time being, let me focus on the steady state that I think the venture market has been oscillating towards in the last 5 years.
The percentage you’ll give away in a Series A deal will almost always end up being 50%.

“But I didn’t even tell you how much money I want to raise”, you say cagily. Well, I’m here to tell you that it doesn’t appear to matter. Oddly enough for the inquisitive type of guy I am, I have always sort of accepted this law of venture capital without much questioning. Perhaps I’ve just resigned myself to looking at the final cap table as half full and not a half empty. Perhaps I have just been more distracted by the real challenge of building the company and never stopped to ponder why. But since I promised I’d attempt to explain this phenomenon in my last post, Angels and Demons, I’ve done a bit of thinking on the topic. Here is best explanation that I have been able to come up with so far.

50/50
Let me start by getting everyone back on the same page. As I wrote about in Angels and Demons, and with the appropriate caveats that there are exceptions, your Series A will be 3 on 3, 4 on 4, or 5 on 5. No, I’m not talking about pickup basketball or obscure French porn plotlines, I’m talking about pre-money and cash. Without regurgitating my previous post (check it out it if you’d like a deeper technical explanation of the jargon), what this really means is that no matter the amount of money you raise (3, 4, or 5 million), you’ll end up giving away about 50% of the company. This means your pre-money valuation will be 3, 4, or 5M million, and oddly enough, it will be end up being paired at the same number as the amount of money you’re raising.

Size Matters
One of things I sort of implied in Angels and Demons, but did not state directly, is that Series A rounds are almost between 3M and 5M. That goes, according to the 50/50 rule, for both valuation and amount raised. Just watch the steady stream of deals on Venture Wire and you’ll see this data point over and over again. While some of the reasons for this are tied into the rest of the explanation around the 50/50 phenomenon, here’s the basic thinking.
Deals that are less than 3M don’t really allow a syndicate of investors to put any serious amount of money to work. Considering even a two-way syndicate, that means there is less than 1.5M a piece for each player in the round. For most firms, this investment isn’t big enough to hit the radar. I explain this in a bit more depth below.

For deals over 5M, valuations start to get based on silly things like real business metrics. Revenue multiples, product development and market entry costs, M&A costs, sales team growth; these annoying numbers all start to infest your valuation conversation like a bad case of the bed bugs. There is sort of an odd fantasy/reality threshold that you pass over when you start talking numbers bigger than 5M. Above 5M, what was a justifiable (and yet completely fictitious) 4M pre-money valuation, based on nothing but the idea, team, bravado and some good salesmanship, starts getting scrutinized in this new way. At 5M or less, this doesn’t seem to happen. As I’ll explain later (apparently all the good stuff is at the end of this blarticle), the valuation swing between 3M and 5M is really mostly driven by demand for the deal.

Part of the problem with the business metrics conversation is that Series A deals tend not have any. While two sales data points do make a line, no good VC will extrapolate an average sales price or sales cycle from only a couple of sales experiences. Thus there aren’t any real business metrics to use. If you try to push this point, the conversation will quickly devolve into the VC telling you war stories of every one of his companies that started the way you have and then realized they could only sell the product for 35 bucks and a bag of bagel chips. Trust me, you don’t want to end up here. Hence the upper and lower ceilings on A rounds almost always end up being 3, 4, or 5 (both money and valuation).

Ménage-a-VC
The first thing to understand about the 50/50 law is that pretty much every VC doing Series A deals will demand a syndicate of investors. The venture optimists would say “with more investors around the table, there is more money available for an inside round in the future”. The venture pessimists would say “No VC wants to be the first penguin off the iceberg”. Well, as far as the entrepreneur is concerned, the answer is likely somewhere in between. From an entrepreneur’s perspective, it can be well worth the up-front effort to build out a syndicated round.

As an example, Newmerix just closed its third round of funding. This round was an inside round (only existing VCs) and the whole syndicate played their part. It was, by far, the easiest round of money I have ever raised in my life. The flip side is that Ed and I spent about 8 months on the front end, running around the country, trying to find a third player for a three way syndicate. We talked to over 72 venture firms in the process. It was grueling, time consuming, and unfruitful in the end (although I am basking in frequent flier miles). In the end, we were able to convince Mobius and IDG that if they did the A round, Ed and I would promise to get a third player for the B (insert appropriate childhood flashback to pleading with your parents to get you a dog based on the promise that you’d walk it every day). Well, Mobius and IDG took our word for it, put in the Series A money, and Ed and I walked the dog every day until we found a third player for the B. Siemens Ventures came into Newmerix’s B-round and, most recently, all three funded our last round. Next to Cadbury Cream Eggs, it was as close to heaven as I’ve ever gotten.

Percentages versus Absolutes
The second thing you need to remember is that venture deals are driven by percentages and not absolutes. Let me illustrate with an example. Most firms doing early stage deals will insist on a post-round position of about 20% of the company. There are two main reasons for this depending on the fund’s actual underlying investment strategy. For larger funds, they expect to keep doing their pro rata along the way and they will budget enough money to stay at their 20% position throughout the life of the deal. For smaller firms, they want to take a bigger position at the outset, play a round or two, and then hope the later stage rounds have smaller dilution. Using this strategy, they can keep a relatively large percentage (call it 10% by exit) without having to pony up a huge amount of cash throughout the life of the company.

So, if we follow this logic and do some back o’ the envelope math, in a syndicated deal, that ends up being 20% to VC #1, 20% to VC#2 and a third, usually smaller VC, taking the remaining 10-15%. Different numbers of players in the syndicate and sizes of their funds will many times determine the small perturbations around the 50% phenomenon.

Alphabet Soup
One of the most fun things about raising Series A, is that as soon as you close it, you get to start worrying about Series B. Hence, when you first fund a deal, both you and the investor have to think through all the rounds you’ll be doing. Each VC, based on the size of their fund, allocates up front a total amount of money they want to invest in your company. Even though they are only ponying up a fraction of it at the start, they already are thinking about what the next check will be. A large VC fund (500M+) is generally going to want to put to work 10-15MM in each deal they do. The reason has nothing to do with money (well, sort of), it has to do with time. Partners at the firm can only sit on so many boards at one time (lets call 10 the absolute max – there is much debate on this threshold in the VC community). That means in a firm of 5 partners putting 10M total into 10 companies each (thus 10 boards per partner), you’ve got 10x5x10 = 500M in money invested. Hey, I like how those numbers worked out. A 500M fund just isn’t going to put 5M to work over the life of a company and either have 10 partners (there is only so much management fee and carry that partners want to divvy up) or have each partner sit on 20 boards. They just can’t add any value that way. A 50M fund however isn’t going to be able to put 10M to work on each company and only make 5 bets for the life of the fund. Hence, a smaller firm’s total planned investment over the life of the company will be smaller which is why you many times see syndicates with two big players and one smaller player.

If you have a big player who is investing in an enterprise software company (historical rule of thumb says 25M goes into this kind of company when all is said and done), you’ll most likely see a three way syndicate, and expect to do 3-4 rounds. In the first round, firms will put in 1-2M a piece (depending on their size), the second they’ll put in 3-4M and the third they put in 4-6M. So that’s 10-12MM or so for each. With a three way syndicate that’s about 25M over the life of the company. As a side note, if you consider these numbers you can see another data point on how the A round will end with about 3-5M going into the deal.

The Physics of Spaghetti
Oddly enough, no individual dynamic I have described explains the 50/50 phenomenon standalone. To understand it, you have to consider the intertwined spaghetti of each dynamic. VCs want a certain percentage of the final cap table. But they also need to put a certain amount of money to work. But they won’t put it in all at once. And they would prefer to syndicate the deal. And you don’t have enough data points to provide a metrics-based approach. Its mind boggling, I know. Rest assured though that when the system becomes stable, the end result is going to be 50% to you and 50% to your new wealthy friends.

Run Your Horses in a Pack
This still leaves one lingering question, “How do I get my deal from a 3M pre-money to a 5M pre-money with nothing but a PowerPoint?” Well, some of the things I have mentioned help a bit: team, idea, market, technology. But in reality, you have no real leverage with these items. It’s very easy for a VC to discount any one of them in a conversation if they feel like it. Try this conversational snippet on for size.

You: “Here are my pro forma projections for the next three years.”

VC: “I don’t believe you.”
(excerpt taken from actual author experience)

You see how this becomes painfully academic very quickly. The only real leverage you have in a Series A deal is actually completely artificial. This is a lesson that few first time entrepreneurs learn before they do their first venture round. The only sure-fire thing you can do to increase your valuation, past materializing a code base with paying customers, is to get all your VC horses running together in a pack.

Remember, VCs only hate two things in life: making a bad investment and missing a good one. This is the finesse of the process. No interest from other VCs means it’s a bad investment. As opposed to the deals they invest in, VCs generally don’t believe in first mover advantage from an investing perspective. On the other side of the coin, lots of interest must mean it’s a good investment: “I must be missing something if Hummer and KP are looking at it, right?” If you can time it so that a number of firms get interested in your deal at the same time, you’ll be able to negotiate some leverage to push that pre-money up from 3M to 5M solely due to demand. It’s like putting English on a pool shot. It’s not easy to learn, but once you get good at it you can position yourself on the table very after any shot.

As a closing thought, let me tell you the one guaranteed opportunity you will have to try this out. In any VC presentation, the inevitable question will get asked, “Who else are you talking to?” What ever you do, don’t fall for this. This question is akin to another recent favorite of mine, “Do you know why I pulled you over?” Our fore fathers fought hard for your Fifth Amendment right to get out of speeding tickets and revealing VC questions. Take advantage of it. You just don’t need to tell them. Until you’re ready that is. I can tell you that I have never seen a VC hit the hibernate button on his ThinkPad and storm out of the room when getting no response to this question. If you feel really pressed, just give em a sly grin and say, “You know me, the usual suspects”. It works every time.

Comments

[EsperanzaLITTLE]

People deserve wealthy life and home loans or college loan would make it much better. Just because freedom relies on money state.

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It's really not fair to list this one because the site I'm referring to is still in development. It should launch in the next few weeks. I list it because it's going to be very "top 5" worthy when it launches.

[Michael S. Cann Jr.]

Just came across this now, nearly four years after you wrote it. Until now I had not done much serious and structured thinking into explaining this phenomenon, but you have pieced it together well.

[Chris Law]

Terrific post. Makes me wonder if our company shouldn't even bother trying to get early traction and just raise our round early!

[paul]

We need a new type of Series A investor for Web 2.0

http://pauledmondson.blogspot.com/2006/01/web-20-vc-please.html

[Chris Bauman]

So, with the 3 on 3, 4 on 4, .... should a company just accept any offer that is close to this or continue to negotiate for a lower percentage for the VC?

I kin the findraising effort to that of a romance. Contact, dating, courtship, engagement, marriage. Assuming the deal is agreed upon at the engagement and the funding at the marriage, when should the numbers get thrown into the mix? Courtship? Dating?

-Curious & Un-Funded.

[Charles Zedlewski]

Nice post Niel.

One suggestion. How do you raise $5 million in your series A round? Raise $2.5. If you keep the target size for the round small enough to only accomodate 1 investor, you create a lot more urgency to eventually get 2 investors and grow in the round to $5 million.

The best response I've heard to "who are you talking to?" is "a select number of tier 1 investors who 'get' this space." LOL