Venture capital for your grandmother

Like many of us in Silicon Valley, I often encounter people (hi Dad!) who don’t understand venture capital. I don’t mean all the details, I mean just the basic way investment is done in a startup. Often, even employees in startups don’t understand it either. Here’s how I explain it.

Let’s say you’ve got a good idea for a company, and you have done some work on it to produce a prototype. Maybe at this stage there are two of you. You have the prototype, the team (the two of you) and a business plan. Let’s say everyone agrees it is worth $1M at this point. We’ll ignore how that valuation was arrived at, although it is somewhat like buying a house, you (seller) want a higher valuation and the VC (buyer) wants lower so the valuation depends on the going rate for that sort of company and somewhat on how desperate you are to sell and how enthusiastic the VC is to buy. So you and your partner each have stock in your brand new company worth $500K. But you can’t just sell the company at this stage, companies like that don’t have any buyers at all. You need to make it more successful first.

So you decide you need some investment money, so you can pay yourselves and hire some more employees. You convince a venture capitalist that your company is going places and he or she wants to put in $500K. Everyone agreed that the company is worth $1M before this happens. This is called the pre-money valuation. The VC wires $500K to your bank account and you give them stock for 1/3 of the company. Suddenly your company is worth $1.5M, consisting of $1M for the company as it was the day before, plus another $500K sitting in the company bank account. This is called the post-money valuation. So you and your partner each own 1/3 of the company and the VC owns 1/3 of the company. But the valuation is higher so your 1/3 is worth $500K, exactly the same as your 1/2 was worth the day before. You’ve neither lost nor gained anything.

So what have you given up? A share of the future gains. You used to own 100% of the company with your partner, now you only own 2/3 of the company. If the company suddenly becomes worth $60M then you each have $20M and the VC has $20M (the VC has a preferred stock, which is different from what you and your partner probably have, so this might not be precisely accurate but it is close enough). What you gave up was that if the company was suddenly worth $60M before, you and your partner would have $30M each. But realistically, that wasn’t going to happen because you didn’t have enough money on your own to fund the company over time. So if this scenario plays out you get a nice payout. But, of course, if the company becomes worthless then everyone’s share goes to zero. 1/3 of zero is zero.

You might assume that if the company nearly goes bankrupt and is sold for just, say, $300K that you’d have 1/3 of it, namely $100K. But that is where the biggest difference between preferred stock and your stock comes to light. The preferred stock is so called because it gets preferential treatment and in this scenario the VC gets all of the money. You have a loss of $500K but then you never put in any real money so it is a paper loss. The VC has a very real loss of $200K since they put in $500K, you spent it, and the company pretty much failed.

Tomorrow, full-ratchet anti-dilution provisions and piggy-back rights. Well, maybe not.

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