Compare financings

I wrote an article for Xconomy on negotiating a better Series A deal. It goes along with this calculator.

I like to talk to my CEOs about the concept of an execution multiplier. The basic idea is that the pre-money valuation of the Series B round is to a large extent determined by what you can accomplish with your Series A capital. Having more Series A capital should enable a good entrepreneur to accomplish more. The execution multiplier describes the relationship between the next round’s pre-money valuation and the increase/decrease in capital raised in this round.

Pre-money premium =
    Execution Multiplier * % change in investment

Here is an example. Say the execution multiplier is 100% and you are comparing raising $4M vs. $5M. The pre-money premium is 100%*[(5-4)/4] = 25%. What this means is that you expect the extra $1M in capital to help increase the next round’s pre-money valuation by 25%.

This becomes useful when you want to compare financing options as it allows you to model how changes in capital raised affect pre-money valuations in the future. Using the example above, a follow-on round with $16M pre-money valuation in the case where you raised $4M will be equivalent to a follow-on round with $20M pre-money valuation if you had raised $5M as $16M*(1+25%) = $20M.

This calculator shows the change in the true pre-money valuation in the next round given the effects of the execution multiplier. It can help you get a better VC deal by letting you trade-off giving up some founder ownership in exchange for raising more capital, if in fact this makes sense given your assumptions about the execution multiplier of your company.

Some businesses really know how to translate additional capital into growth. For them, the execution multiplier can be greater than 100%. Other businesses have multipliers that are less than 100%. You need to decide what’s a good guess for your business in order to know how to compare alternative financing proposals.

The equivalence execution multiplier (EEM) is the execution multiplier which makes the future effect on the founders’ share of the cap table (the true pre-money valuation) of the two different financings identical. We find EEM by multiplying the ratio of founder equity shares by the ratio of invested capital between the two financing scenarios. If in the $4M raise scenario founders own 25% and in the $5M scenario they own 20%, the EEM is (25%/20%)*($4M/$5M) = 100%, which makes the two financings equivalent.

The calculator compares between two scenarios, set up in two columns. The first section sets up a simple cap table. The option pool is assumed to be the same between the two scenarios—if too many variables are changing it becomes difficult to isolate the effect of any one of them. The second section shows the deal from a dollar standpoint and calculates the true pre-money valuation. The last section shows you the pre-money multiplier effect of the additional capital, the equivalence execution multiplier and the net effect of the trade-off between founder ownership and invested capital in the round on the true pre-money valuation in the next round.

The pre-populated example shows how raising $500K more even if it means 5% less in founder ownership and 11% lower true pre-money valuation this round, assuming a 100% execution multiplier, results in an equivalent true pre-money valuation in the next round. In other words, assuming an execution multiplier of 100%, the two financings are equivalent from the founders’ standpoint.

While the notion of a linear execution multiplier has many limitations, it helps make an emotional argument about founder dilution a little more objective while still keeping things pretty simple. The best way to use the calculator is to have a discussion with your team about what is the right range of assumptions regarding your company’s multiplier. Then play with the numbers and see how different increases in funding affect founder dilution and the adjusted true pre-money valuation. Also, use the equivalence execution multiplier calculation as a gut check in comparing financing offers. This is an educational tool first and foremost.

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