The Series A
Now let’s assume that it’s 2 years later and Sweet Co. needs to raise more money. Let’s assume two scenarios:
1.) Things are going great
2.) Things aren’t going so great
Let’s assume that things are going great with Sweet Co. and the company raises money at an “up round” valuation (VC translation: pre-money valuation of the upcoming round is higher than the post money valuation of the last round). However, before the new investor puts in money, it wants the employees to “re-up” the options pool back to 10% post-money (meaning after they make the investment, the option pool is once again equal to 10% of the total number of shares).
Notice that the founders continue to get diluted. They started with 100% ownership before receiving funding, then held 75% after the Seed Round, and only hold 31.5% after the A round. A lot of founders get hung up on dilution, but what they should care about is the value of the shares they own (vs. the % of the company they own). Check out lines 31-33 in the model. The founder’s ownership decreased by 43.5% from the Seed to Series A, but the value of the shares the founders own actually went up by $860k!
Down Rounds (ouch)
Let’s assume now that things aren’t going so great and the company has to raise money at “down round” valuation (VC translation: the pre-money valuation of the upcoming round is lower than the post-money valuation of the previous round).
Down rounds are bad for two reasons:
1.) They’re bad for existing investors because the value of each dollar invested in the previous round created less than $1 of value (which is bad). Conversely, each dollar that the new investor puts in, buys it more shares of the company than the existing investors got for the same amount of money invested. That means that the existing investors and founders get diluted more than in an up round (not good).
2.) But wait – it gets worse. There is a widely used clause in VC term sheets that states that in down rounds, the previous round investor gets issued additional shares so that the effective price per share the previous round investor pays falls in between the new round price per share and the previous round price per share. The math behind that calculation is pretty complicated, so I’ll spare it from my model. The important point is that down rounds can be painful.
Check out the attached workbook to play around with up round and down round scenarios.
Next week, I’ll tackle returns modeling!