Yesterday a debate erupted on Twitter between VCs over whether term sheets should express a company’s valuation in pre-money or post-money terms and whether that even matters. This started with a blog post by Rob Go from Nextview on why post-money valuation term sheets have become more popular. That led to a somewhat combative tweet by Jerry Neumann that post-money term sheets pit entrepreneurs against their existng early stage investors
VCs who offer post-money term sheets get moved to the bottom of my intro list
This kicked off a strong debate with Roger Ehrenberg. Later Marc Andreessen subtweeted the whole debate by asserting that
HOT TAKE: Pre-money and post-money term sheets are equivalent.
So what is this all about? If you have read Rob’s post you can skip down to the second to last paragraph below (my explanation covers substantially the same points).
In every financing there are three numbers that matter, the valuation, the amount raised and the dilution taken. There are only 2 degrees of freedom here. Once you pick any two of these the third one is just math. Since pre-money and post-money valuation in turn are in theory connected to each other by the simple formula of post-money = pre-money + amount raised why does the choice of valuation in the term sheet matter at all? Put differently, Marc is right that in theory it shouldn’t matter …
In practice of course there are two important complications. The first comes from potential renegotiations over the amount raised after the term sheet has been signed. The second comes from the existence of convertible notes which sometimes have a poorly understood impact on effective valuation.
Let’s consider the amount raised first. A quite common scenario is that as soon as existing investors (and sometimes new investors, possibly ones who competed for the deal) find out that a term sheet has been signed they want to get some or more money into the deal. Some entrepreneurs sticking to the original deal but others then come back and say I just want to raise $x more — and so the bargaining starts. And that’s where specifying pre-money versus post-money start to diverge. With a term sheet that has specified the pre-money it is a lot easier as an investor to find oneself in a situation where the round size expands and the post money moves up.
The case of convertible notes in some ways is similar except that the extra money in question has already been given to the company. Here the question becomes exactly at what valuation the notes get to convert into equity. In theory there should be no doubt about this but in practice there is both unclear language in some note documents and most importantly misunderstanding between founders and note holders about the valuation they are entitled to. Again bargaining between all parties will ensue and again the starting position for that bargaining is meaningfully impacted by whether the term sheet specifies a pre-money or a post-money valuation.
Why does a change in the post money valuation matter from an investor perspective? Well it is the denominator in determining ownership with the numerator being the amount invested by the investor. If the post-money goes up then the ownership percentage goes down. Or put differently, the price paid has just gone up. This last statement is sometimes confusing to people because in these situations the *per share* price stays the same. But what matters from an investor perspective is not the per share price but the percentage ownership acquired for a given investment amount.
So what is best practice here? I have taken to being explicit about our ownership percentage. So while the term sheet may specify pre- or post money valuation, increasingly both the “handshake” emails that precede a term sheet and the term sheet will specify an investment amount and an ownership percentage. This means there is no uncertainty over the effective price paid. That doesn’t mean there cannot ever be subsequent negotiations — life is uncertain and there can be legitimate circumstances under which to renegotiate terms — but it does firmly establish the original intent.
Finally, I should add that a proper discussion during a financing of the post money valuation is always a good exercise. This number is much more important than entrepreneurs often think as it establishes the hurdle that needs to be cleared with a subsequent financing (if the company needs more money). Here is my previous post on what I call the post-money trap.
