This is a grim fairy tale about a mythical company and its mythical founder. While I concocted this story, I did so by drawing upon my sixteen years of experience as a venture capitalist, plus the fourteen years I spent before that as an entrepreneur.  I’m going to use some pretty simple math and some pretty basic terms to create a really awful situation in the hopes that entrepreneurs reading this might avoid doing the same in the real world.

As I’ve seen over many years and many deals, in all but the most glorious outcomes, terms will matter way more than valuations, and way more than whatever your cap table says.   And yet entrepreneurs – often with the encouragement of their stakeholders – optimize for the wrong things when they negotiate their financings.  

This is my attempt to paint you a picture of why this is such a bad idea.  The situation I present is fake, but the outcome is remarkably similar to those I’ve witnessed.  Don’t let this happen to you.

Let’s start with our entrepreneur, whom we’ll call Richard.  He’s founded a breakthrough company.  Let’s call it Pied Piper.

Richard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount.  

With his $1 million, Richard builds a small team of people, rents an Eichler in Palo Alto, and gets to work.  Once he is able to demonstrate his product, he heads to Sand Hill Road.  He’s in a hot space in a hot market.  He nails his pitch, and the term sheets roll in.

Because Richard is extremely sensitive to dilution (after all, he’s seen The Social Network) he wants the highest valuation possible.  (Early in my career, another venture capitalist called valuation ‘the grade at the top of the paper’ – and I’ve never forgotten that.)  The highest valuation, $40 million pre-money, comes from an emerging venture fund, let’s call them BreakThroughVest (BTV).  BTV is excited about this deal, but has ‘ownership requirements’ of at least 20%, so they insist that to support that valuation they need to invest $10 million. Plus, they want a senior liquidity preference of 1x to protect their downside since they feel the valuation is rich given the stage of the company.  

Richard is thrilled with the valuation and the fresh capital for only 20% dilution.  The prior investor, Peter, is stoked that he is getting his $1 million investment converted into roughly 20% of this super hot company, and now with the validation of an external term sheet he can mark his position up to $10 million, a 10X!  This helps Peter validate his position as a savvy angel and solidify his syndicate following on AngelList.  

Term sheet signed. Champagne popped.  A few weeks later, funds wired.

With the $10 million, Richard rents space in SoMa on a seven-year lease, hires lots more people, and within a few months he is able to roll out the minimally viable product to test the market. Awash in the buzz of his fundraise, a feature in Re/code, and some early user traction, Pied Piper is perceived as the emerging leader in a nascent, winner-take-all market. While they are not yet monetizing their users, the adoption metrics are off the charts.  

Pied Piper attracts the attention of a tech giant we’ll just call Hooli. Hooli’s consumer group wants access to Pied Piper’s data. With Hooli dollars behind Pied Piper, Pied Piper could inundate the market with consumer facing advertising to build their user base and upend competitors given the massive network effect of the product. Hooli approaches Richard with the idea of a large strategic round. In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli’s ad platform. They float the magic “B” valuation. Richard goes to sleep dreaming of rainbows and unicorns.

Richard fantasizes about being named a member of the Unicorn Club by the press.  His employees calculate the huge paper gains on their options – they will all be instant millionaires – and since no one is more than ¼ vested, they are all highly motivated to stay in spite of long, long work hours.  BTV is thrilled with the 20x markup on Pied Piper, since they are about to hit their LPs up for a new fund.   The original investor, Peter, has achieved legendary status – his $1 million has turned into approximately $200 million on paper.  He’s on the YC VIP sneak preview list, he’s been offered a spot on Shark Tank, and Ashton just called to try to get into his next deal.

Of course, that $200 million for 20% stake also comes in with a senior 1x liquidation preference in order for Hooli to create sufficient downside protection and thereby justify the $1 billion valuation to their board.  

Richard, Peter and BTV all agree it is worth doing. With $200 million to spend on the most massive consumer-facing ad campaign in this sector’s history, the $1 billion valuation will seem low in retrospect.