You Just got a Term Sheet for a Down Round — Woohoo!

…Said no one ever, at least at first.

Let me try to get you to a happier place about this — and also keep you from making the biggest mistake I’ve seen other entrepreneurs make in down round negotiations.

You’ve toiled away since the last round. It’s been a super choppy market, but you took the right actions, and persevered. What an insult to be valued at less than you were before all this work, right?

No! Not right!

First, congratulations, seriously. Because anyone wanting to put additional capital behind your venture is a positive signal. Most startups have business models that require some amount of capital before they can make the trade-off between growth and cash-flow positivity, and if you are in that phase, this new capital is essential to survival. As my partner Emily Melton likes to say, “must be present to win.” Down rounds are better than no rounds.

Second, valuations reflect not only your internal accomplishments, but also the macroeconomic environment we are in. With many public SaaS and tech company valuations down 50–70% since a year ago, it is not surprising that private company valuations are likewise deflated. It’s not your fault and there’s nothing you can do about that.

Third, and probably most important, this valuation will likely prove to matter only a small amount in your ultimate outcome. That’s where we need to dig in, because the math can be a bit complicated and non-obvious.

When I first became a VC, another VC said to me “valuation is the grade at the top of the paper.” It’s what people focus on and boast about at cocktail parties.

However, the reality is, that barring major outliers, the usual valuations we see along the course of a successful company’s multiple rounds do not have as large an impact on the financial returns to the various shareholders as one might think.

What can really change the outcomes though are the terms at which you take that new money — especially in medium-success outcomes, which is where many liquidity events end up settling.

Valuation Nostalgia

What I’ve seen happen in prior downturns, and I’m starting to see this happening now, is that entrepreneurs feel demoralized by down rounds and fight to get something above the last valuation — I call this “valuation nostalgia”. The new lead investor does not feel the higher valuation is merited, but they want to do the deal, so in order to hit the number, they compensate by putting in various forms of downside protection, such as making their round senior in preference, putting a guaranteed multiple on their capital (IE a liquidation preference greater than 1) and/or including an annual guaranteed percentage capital appreciation. (There may be even more in there such as ratchets and control terms, but I don’t need to complicate this further to make my point, so let’s leave them out for this illustration.)

I’m not saying any of these things are evil! They are all terms that have been agreed upon in the past to bridge the gap between what the investor wants and what the entrepreneur wants. Nobody’s being a bad person here. But these terms are generally trade-offs between added downside protection in exchange for a valuation not currently supported by the market.

And, while they are not evil, they can be very problematic. You as the entrepreneur need to consider the actual cost/benefit of these tradeoffs before you ask for them.

Most entrepreneurs initially see these terms as ‘free giveaways’ because they generally only matter in downside scenarios — and what entrepreneur ever thinks that they are going to deliver a less than awesome outcome where downside protection comes into play? Entrepreneurs are by nature optimistic, if they weren’t they couldn’t survive the trauma of being an entrepreneur! But home runs are still outliers, and smart entrepreneurs should also want to ensure they can get a good return even in a middle-of-the-road outcome.

So Now Let’s Do Some Math

[NB: I apologize that this is a long post. There is no short way to do this analysis. But I believe what you will learn is worth it, so I hope you’ll read on! Also, huge thanks to Arpit Mittal and Becka Ogilvie, my teammates at Threshold, for the model building and analysis used here.]

History shows us there are plenty of not-home-run outcomes. These can still be good for the founder, employees, customers, and investors, even if they don’t end up on the cover of Fortune. But these are the very outcomes where the terms have the biggest impact on who walks away with what.

Let’s start with a prototypical cap table for a company out raising a B round today. Prior to now, this company did a $5 million seed round at a $30 million post-money valuation, and then did a $15 million series A at a $75 million post-money valuation. Now they are in market for a $25 million B round.

Unfortunately, the market is sucky, and even though they’ve made progress against their business plan, they just received a term sheet for that $25 million, same terms as prior rounds, but the valuation is 10% down. The entrepreneur really wants this to be an up round, so they go back to the VC and suggest that they will trade downside protection in the form of a 2x liquidity preference instead of the 1x the prior rounds had. The VC agrees that with that extra downside protection they are willing to offer this round at 10% up. Is this a good trade?

What the following chart shows is what percent of the outcome goes to the common shareholders if the company is sold at various valuations. [The detailed analysis is at the bottom of this post.]

Notice that there’s only a few percentage points of difference between a 10% down round and a 10% up round across the outcomes when all the terms are the same, a simple 1x preference.

However, turn your attention to that last scenario. If the entrepreneur traded a liquidation preference to get that higher valuation, their outcomes are dramatically diminished in what are still positive, preference-clearing sales in the mid-range of potential outcomes. And though most entrepreneurs are going for those unicorn outcomes, history indicates that most outcomes end up in a more moderate range.

There’s Even More to Consider, Especially with Senior Multiple Preferences

There’s another hidden problem in making these sorts of tradeoffs. When you give different investors different terms, this often results in different motivations about when they will want to compel you to sell. I’ve written other posts that go into this in greater detail here and here, but to anchor in a simple extreme example, if your last round is senior and has a 2x preference, those investors are doubling their money in any scenario that clears even their own round of preferences, while the investors below them could walk away with nothing. And so could you. (And yes, this is where everyone starts using blocking rights, legal threats, and other tactics to force others to compromise, but the starting point is pretty ugly and deviations from the stated waterfall can have legal consequences as well.)

It’s hard enough to be an entrepreneur when all your investors are aligned. It is way harder when they are not! In the aftermath of the dotcom bust, I saw some financings that resulted in cap tables with stacked preferences where those on the top had senior guaranteed 3–5x multiples! When the going got rough, many of those investors were happy to push for any deal that would allow them to bank their 3–5x — even a fire sale that left nothing for anyone else. I don’t know about you, but I never want to go there again!

Again, my advice is not that you shouldn’t do any of this, just that you should do your own analysis of the terms and valuations you are considering across the reasonable set of outcomes and see what has the greatest impact for your specific case. While every case is different, in my 23 years as a VC through multiple down cycles, The most misery I’ve seen entrepreneurs experience is in companies where terms became lopsided in order to cling to a non-market valuation, and then that results in investors who end up being motivated to push for very different future transactions depending on where they sit in the preference stack.

So do the math on that down round, fight for terms you decide are best after your analysis, and toast your good fortune when the round closes!

— Heidi, Arpit and Becka

For those of you who want to further geek out on the numbers, what follows are the detailed analyses that resulted in the summary table above. Enjoy!

Here are the four scenarios:

Scenario 1: 10% Down Round, 1X Liq Pref

• Series A Price Per Share (PPS) was $1 and the Series-B PPS offer is $0.9 for a $25M round. Common Share ownership will get diluted from 67% after Series A to 49% after Series B.
• 1X LP means the exit outcome of the company will first provide $25M cash back to the Series B investor (assuming no future financing).
• The exit outcome has to be at least $45M (Seed, Series A, and Series B) for all prefs to clear. $45M onwards common start participating and $97.6M onwards, all $ get cleared. Assuming the outcome is an $85M exit, then 43% of the exit value will flow to common shareholders (usually founders and employees). The percentage increases to 46% at $100M, $200M, and $1B outcomes. The key point here is that for a modest outcome between $85M-$100M, founders and employees will still keep a large part of the pie.

Scenario 2: Flat Round, 1X Liq Pref

• Series A Price Per Share (PPS) was $1 and the Series-B PPS offer is the same as $1 for a $25M round. Common Share ownership will get diluted from 67% after Series A to 50% after Series B.
• Here also, the offer is 1X LP

Scenario 3: 10% Up Round, 1X Liq Pref

• Series A Price Per Share (PPS) was $1 and the Series-B PPS offer is $1.1 for a $25M round. Common Share ownership will get diluted from 67% after Series A to 51% after Series B.
• Here also, the offer is 1X LP

Now let’s look at Scenario 4 in detail

Scenario 4: 10% Up Round, 2X Liq Pref

• Series A Price Per Share (PPS) was $1 and the Series-B PPS offer is $1.1 for a $25M round. Common Share ownership will get diluted from 67% after Series A to 51% after Series B.
• With a 2X LP, the exit event will first provide $50M cash back to the Series B investor.
• The exit outcome has to be at least $70M (Seed, Series A, and Series B) for all prefs to clear. $70M onwards common start participating and $203.1M onwards, all $ get cleared.
• For an exit outcome of $85M, only 18% of the exit value will come to common shareholders (usually founders and employees). The percentage marginally improves to 30% at a $100M outcome. The key point here is that because of 2x Liq Pref, for a modest outcome between $85M-$100M, the founders and employees give up a large part of the pie even though it’s a 10% up round.

On paper, a 10% up-round might seem favorable, but with skewed Liq Pref provisions, founders and employees would get the short end of the stick.