Charles Hudson, Precursor Ventures

Over the past few weeks we’ve provided a detailed tutorial on term sheet fundamentals, valuation, stock options, and pro rata rights (“chapter one”). Chapter Two will dive into convertible notes, SAFEs, share classes, and liquidation preferences.

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It is also important for us to bring in other experts to opine on the topics that we discuss (we are just one VC and one lawyer with certain points of view). That’s why we've decided to kick off our interview series. Following each “chapter,” we will interview a prominant VC or founder on the topics previously discussed.

We are kicking off with Charles Hudson, GP at Precursor Ventures. We asked a series of tough questions to Charles related to valuation, pro rata rights, and stock options. I think you’ll really enjoy listening to the below ⬇️ 

Video Interview (22 mins):

Questions Covered w/ Charles:

Valuation

• As a pre-seed/seed investor with minimal financial data at your disposal, how do you approach landing on valuation? Are there key qualitative factors/variables that may impact your willingness to pay?

• How do you attempt to balance hitting ownership targets and staying disciplined in line with your fund model vs. breaking the rules and not missing out on potentially generational companies?

• What is the current valuation environment like for pre-seed/seed stage investing? I.e., are larger funds dipping earlier making investing as a smaller fund in this stage harder? 

Option Pools

• Is forcing founders to re-up the option pool to 10-15% before closing an investment an acceptable norm? Or should founders feel confident coming with a built out option plan for the next few years that VCs should be open to considering? 

• How do you approach the option pool sizing in deals that you lead?

• In deals where you are the first ever outside capital, do you start the vesting clock on day one post close even if the founder has been concepting for many months? 

Pro Rata Rights

• Is there a right or wrong split for an early stage fund to have between first check capital and reserves capital? How have you decided over the years what makes sense for Precursor? 

• In deciding on pro rata investments, what are the most common factors that come into play? In addition to performance/valaution, what else? What is the most effective way that founders can increase the likelihood that you participate in pro rata?

• How do you approach messaging when you decide to pass on pro rata with a founder who may be performing quite well on paper? 

• Is pre-empting pro rata follow on a common strategy for you or do you like to let founders predominantly dictate when they raise? 

Ongoing Term Glossary

Clawback provisions: provisions that give the company the right to buy back vested shares at the original issue price or at fair market value after dismissing an employee under defined circumstances (leaving for a competitor, severe misconduct, etc)

Co-Invest: triggered when a fund raises “one-off” new capital from LPs/investors (as opposed to pulling from existing permanent fund) to unlock ability to execute an investment; associated management fees and carry (if any) typically flow back to the fund or individual who raised the co-invest capital. Funds often give major LPs prioritized “co-invest“ rights, which gives such LPs the first rights to participate in the co-invest opportunity before others.

Comparable Company Analysis: a valuation methodology that entails identifying comparable companies and transactions to the company being valued as a means of deriving multiples that can be used to generate a landed valuation

Confidentiality: prevents the startup from disclosing the terms of a term sheet to outside parties (i.e., other investors, startups). This enables both parties to negotiate in good faith.

Definitive documents:  the legal contracts between the investors and the company that detail the terms of the transaction and are drafted by a lawyer

Dilution (D): losing a portion of your ownership as the company sells equity to investors

Discounted Cash Flow Analysis (DCF): a valuation methodology that entails forecasting the future cash flows of a business and discounting the cash flows by a determined cost of capital to derive an enterprise value

Down Round: when the pre-money valuation of a future financing is lower than the post-money valuation of the prior financing; often seen as a negative sign for the company

Double-trigger: requires two events to occur to accelerate the completion of your vesting. The first trigger is the acquisition, and the second trigger is the founder or employee getting terminated by the acquirer without cause or good reason in a specified period (typically one year)

Employee Option Pool (EOP): stock that is reserved for existing and future employees to compensate, retain, and motivate workforce

Exclusivity: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days)

Exercise (options): buy options at the strike price

Fund Model: a forecasting exercise that a VC conducts to project what a successful fund will look like in terms of returns from each investment. VCs typically build a pathway to 3.0x net DPI

Lead Investor: primary investor(s) (co-leads can exist) in a funding round that set terms and typically are writing the largest check(s); often take a board seat

Legally nonbinding: refers to the nature of term sheets. A signed term sheet does not legally mandate a deal be completed

Ownership (O): the % of a company a shareholder possesses prior to or post-closing of a financing

Major Investor: refers to a participating investor in a financing that surpasses a certain check size threshold, unlocking certain rights. I.e., “all those who invest over $500k will be deemed major investors and shall receive information and pro rata rights”

Multiple: a ratio that is calculated by dividing the valuation of an asset by a specific item on the financial statements

Multiple on Invested Capital (MOIC): compares the value of an investment on the exit date to the initial equity contribution

Option pool: an amount of common stock primarily reserved in the cap table for future employees (in certain cases, options can be pulled out of the option pool for existing employees/founders as well)

Post-Money Valuation (P_O): the valuation of the company after the round size is invested by the VC(s)

Pre-Money Valuation (P_M): what the investor is valuing the company at TODAY, prior to the investment

Priced round: a round of financing in which the valuation and price per share of a unit of stock being sold is officially determined (as opposed to a SAFE or convertible note in which case the valuation is left officially undetermined)

Price Per Share (PPS): the cost of acquiring a share of company x, typically determined by pre-money valuation and fully diluted shares outstanding prior to close of financing

Pro rata rights: give investors the right (but not obligation) to participate in future rounds of financing to maintain their initial level of percentage ownership in the company.

Pro rata on a dollar-for-dollar basis: gives the investor the right to invest an amount equal to or less than the amount invested in their first round à VC Z invested 200K in the seed round and has the right to invest 200k in the Series A

Pro rata on a fixed sum basis: least common, investors get the right to continue investing an amount as agreed upon that is decoupled from the investment amount. VC Z, who invested $1M in a seed, negotiates pro rata rights up to $700K - they will be able to invest up to $700K in each subsequent round of financing.

Pro Rata ROFR: gives particular investor(s) the right to another investors voluntarily waived pro rata in a future financing  

Restricted Stock: company stock given to employees, usually as a bonus or additional compensation; does not have a strike price unlike options; usually awarded to company directors and executives and is subject to vesting

Round Size or Investment Amount (R): how much capital the founder is raising for the financing or VC round

RSUs: refers to an agreement by a company to issue employees shares on a future date. One RSU is the right to get one common share. RSUs, like options, are also subject to a time-based vesting schedule and can be trigger based; however, RSUs don’t have a strike price and are instead released directly to the recipient after vesting without any need to “exercise” or buy them; typically awarded to lower level employees than restricted stock

Single-trigger: states that only one event must occur to accelerate the vesting of your equity. If the company is acquired, you gain complete ownership over all your options

Stock options: incentive mechanisms granted to employees, advisors, and consultants. Employees joining a VC-backed startup typically receive an option grant, which allows them to acquire company common shares in the future at a certain price by “exercising vested options”

Strike Price: the predetermined price an employee pays to exercise (aka purchase) their stock options and turn their stock options into actual shares of the company owned outright. Tax regulations (IRS Section 409a) require options grants to have a strike price equal to or above the fair market value of the underlying company stock on the date that the option is granted

‘Success disaster’: employees run the risk of being harmed financially for building a succeeding business that has grown in value significantly

Up Round: when the pre-money valuation of a future financing is higher than the post-money valuation of the prior financing; often seen as a positive sign for the company

VC Valuation Method: a valuation methodology that entails projecting a company’s exit value in the future and a VC’s required MOIC in order to back into an implied valuation and ownership level at time of investment (starting with the future and backing into the present)

Vesting: the process of gaining ownership over granted stock options

Warrants: when issued/contracted, give the warrant holder the right to buy a certain number of shares of the company’s common or preferred stock at a predefined price over a specified period

P_M + R = P_O ➡️ the pre-money valuation plus the round size = the post-money valuation

P_O – R = P_M ➡️ the post-money valuation minus the round size = the pre-money valuation

P_M / FDSO = PPS ➡️ the pre-money valuation divided by shares outstanding = price per share

R / P_O = O ➡️ round size divided by the post-money valuation is the amount of ownership acquired in a financing by participating investors

D / P_O = Daniel’s O ➡️ Daniel’s investment divided by the post-money valuation is the amount of ownership Daniel is acquiring in a financing

Fundraising

Rule #1: Communicate early and consistently. Goal: build long term relationships with a roster of investors before you kick off a process.

Rule #2: Ask for help. The only way to get maximal value out of your cap table is by asking for help. Especially when times are tough, great investors can potentially be the difference between make or break.

Rule #3: Keep knocking. As hard as it is, keep communicating with rejectors and make them aware of your progress.

Is there a topic you’d like us to cover? Don’t be a stranger! Ever want to dive deeper on a topic in VC Investing or Law?

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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✍️ Written by Daniel Faierman and Chuck Cotter 

Disclaimer: The information provided in this entry does not, and is not intended to, constitute legal or investment advice; instead, all information, content, and materials available in this entry are for general informational purposes only.