Brad Feld, the Managing Director of Mobius Venture Capital and proprietor of the Feld Thoughts blog, has launched a series of posts on term sheets. If the first post is any indication, these will be very valuable.
The first post is on "Price," and Brad describes the various price positions of the investors:
In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.
The italics are mine. This sentence makes sense only if the existing investors are not purchasing their pro rata share of stock in the subsequent round. If the existing venture investors are purchasing their pro rata share of the subsequent round, they are (by definition) not being diluted.
But who should price that subsequent round? For reasons discussed below, the existing venture investors may have an incentive to obtain a high valuation, but they do not have a direct financial incentive to overprice (or underprice, for that matter) in subsequent rounds of financing. To understand why, consider Anat R. Admati & Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371, 373-74 (1994):
An important feature of the fixed-fraction contract is that although the venture capitalist purchases new securities in later financing rounds, his payoff is independent of the pricing of any newly issued securities. The pricing of new securities only affects the division of surplus between the entrepreneur and outside investors, where the entrepreneur gains if new securities are overpriced and outsiders gain if they are underpriced relative to their value given all available information. Intuitively, the venture capitalistâs incentives as a ãnew shareholderä to underprice new securities (and thereby take value away from the entrepreneur) are exactly offset by his incentives as an ãold shareholderä to overprice them (and thereby take away value from outside investors). Since he cannot gain by mispricing the new securities, the venture capitalist can be given the responsibility of pricing those securities and revealing the information he knows.
Despite this apparent neutrality, existing venture investors may not be the best people to set the price for new rounds. As observed by Jerry Kaplan in his excellent book, Startup: A Silicon Valley Adventure:
First the current investors have to commit themselves to participating in the new round. This shows that they remain convinced of the merits of the venture. However, they cannot credibly set the price, because they are usually interested in ãwriting upä the value of their portfolio to improve the rate of return they can report to their own investors. Therefore the price must be established by a new investor, called the lead. The lead is responsible for negotiating terms with the company. Then, in order to spread the risk÷and give the lead investors confidence that they arenât going to look like fools if the company goes bust÷the deal is syndicated to the other interested parties that the company has been courting.
The bottom line is that existing venture investors have an incentive to overprice subsequent rounds, but that incentive has nothing to do with dilution, as long as the existing investors are exercising their preemptive rights and purchasing their pro rata share of the new round.
By the way, Brad prefaces his remarks about price with this: "In general, there are only two things that venture funds really care about when doing investments: economics and control." Gee, only those two things? I am just teasing because those two things comprise pretty much the whole deal. Take away provisions of the term sheet not dealing with economics or control, and there isn't much left other than the name of the investors.
Posted by Gordon at January 4, 2005 12:55 AM | TrackBack