This is a grim fairy tale about a mythical company and its mythical founder. While I concocted this story, I did so by drawing upon my sixteen years of experience as a venture capitalist, plus the fourteen years I spent before that as an entrepreneur. \u00a0I\u2019m going to use some pretty simple math and some pretty basic terms to create a really awful situation in the hopes that entrepreneurs reading this might avoid doing the same in the real world.\r\n\r\nAs I\u2019ve seen over many years and many deals, in all but the most glorious outcomes, terms will matter way more than valuations, and way more than whatever your cap table says. \u00a0 And yet entrepreneurs \u2013 often with the encouragement of their stakeholders \u2013 optimize for the wrong things when they negotiate their financings.\r\n\r\nThis is my attempt to paint you a picture of why this is such a bad idea. \u00a0The situation I present is fake, but the outcome is remarkably similar to those I\u2019ve witnessed. \u00a0Don\u2019t let this happen to you.\r\n\r\nLet\u2019s start with our entrepreneur, whom we\u2019ll call Richard. \u00a0He\u2019s founded a breakthrough company. \u00a0Let\u2019s call it Pied Piper.\r\n\r\nRichard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount.\r\n\r\nWith his $1 million, Richard builds a small team of people, rents an Eichler in Palo Alto, and gets to work. \u00a0Once he is able to demonstrate his product, he heads to Sand Hill Road. \u00a0He\u2019s in a hot space in a hot market. \u00a0He nails his pitch, and the term sheets roll in.\r\n\r\nBecause Richard is extremely sensitive to dilution (after all, he\u2019s seen The Social Network) he wants the highest valuation possible. \u00a0(Early in my career, another venture capitalist called valuation \u2018the grade at the top of the paper\u2019 \u2013 and I\u2019ve never forgotten that.) \u00a0The highest valuation, $40 million pre-money, comes from an emerging venture fund, let\u2019s call them BreakThroughVest (BTV). \u00a0BTV is excited about this deal, but has \u2018ownership requirements\u2019 of at least 20%, so they insist that to support that valuation they need to invest $10 million. Plus, they want a senior liquidity preference of 1x to protect their downside since they feel the valuation is rich given the stage of the company.\r\n\r\nRichard is thrilled with the valuation and the fresh capital for only 20% dilution. \u00a0The prior investor, Peter, is stoked that he is getting his $1 million investment converted into roughly 20% of this super hot company, and now with the validation of an external term sheet he can mark his position up to $10 million, a 10X! \u00a0This helps Peter validate his position as a savvy angel and solidify his syndicate following on AngelList.\r\n\r\nTerm sheet signed. Champagne popped. \u00a0A few weeks later, funds wired.\r\n\r\nWith the $10 million, Richard rents space in SoMa on a seven-year lease, hires lots more people, and within a few months he is able to roll out the minimally viable product to test the market. Awash in the buzz of his fundraise, a feature in Re\/code, and some early user traction, Pied Piper is perceived as the emerging leader in a nascent, winner-take-all market. While they are not yet monetizing their users, the adoption metrics are off the charts.\r\n\r\nPied Piper attracts the attention of a tech giant we\u2019ll just call Hooli. Hooli\u2019s consumer group wants access to Pied Piper\u2019s data. With Hooli dollars behind Pied Piper, Pied Piper could inundate the market with consumer facing advertising to build their user base and upend competitors given the massive network effect of the product. Hooli approaches Richard with the idea of a large strategic round. In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli\u2019s ad platform. They float the magic \u201cB\u201d valuation. Richard goes to sleep dreaming of rainbows and unicorns.\r\n\r\nRichard fantasizes about being named a member of the Unicorn Club by the press. \u00a0His employees calculate the huge paper gains on their options \u2013 they will all be instant millionaires \u2013 and since no one is more than \u00bc vested, they are all highly motivated to stay in spite of long, long work hours. \u00a0BTV is thrilled with the 20x markup on Pied Piper, since they are about to hit their LPs up for a new fund. \u00a0 The original investor, Peter, has achieved legendary status \u2013 his $1 million has turned into approximately $200 million on paper. \u00a0He\u2019s on the YC VIP sneak preview list, he\u2019s been offered a spot on Shark Tank, and Ashton just called to try to get into his next deal.\r\n\r\nOf course, that $200 million for 20% stake also comes in with a senior 1x liquidation preference in order for Hooli to create sufficient downside protection and thereby justify the $1 billion valuation to their board.\r\n\r\nRichard, Peter and BTV all agree it is worth doing. With $200 million to spend on the most massive consumer-facing ad campaign in this sector\u2019s history, the $1 billion valuation will seem low in retrospect.\r\n\r\nExcept, it doesn\u2019t end up happening that way. \u00a0\r\n\r\nThe ads start running, but the conversion rate is low. Pied Piper shows Hooli the atrocious metrics and demands out of the advertising commitment, but Hooli won\u2019t budge: Performance metrics were not pre-negotiated, and furthermore the ad group that recommended the investment did so in part to prop up their revenues with Pied Piper\u2019s money \u2018round-tripping\u2019 into their coffers. The ad group is counting on that money to hit their annual numbers.\r\n\r\nPied Piper is forced to run the whole campaign, blowing through all $200 million. \u00a0The good news: \u00a0They increased their user base by 10x. The bad news: The resulting business model those users end up actually supporting equates to more of a \u2018market valuation\u2019 of $200 million. In more bad news, turns out Richard incorrectly estimated the cost of supporting those users, most of whom are taking advantage of the \u2018free\u2019 part of a freemium model. \u00a0Support costs skyrocket.\r\n\r\nWord about the poor conversion leaks out. \u00a0The advertising stops when the money runs out. Growth slows to a trickle when the advertising stops. New investors sniff around, but with the preference overhang of $211 million, they are concerned about employees being buried under that structure and therefore being unmotivated to continue. They ask prior investors to recap, but the investors don\u2019t want to give up their preferences: Pied Piper is now looking like it might be worth far less than the paper valuation, which means those preferences are very valuable as downside protection. \u00a0Furthermore, BTV is out raising their fund, and the last thing they want to do is write down their 10x markup on the Pied Piper investment.\r\n\r\nThe board is now super unhappy about the massive miscalculation of support costs, awful user conversion, gargantuan ad overspend, the lack of growth the company is experiencing, and the departure of a few key employees who\u2019ve seen this movie before and have done the \u2018overhang math\u2019. \u00a0Richard as CEO is out of his element \u2013 the problems are huge and the company needs more money, which he is incapable of raising given his lack of experience navigating waters like these. \u00a0Unfortunately, it is the CEO\u2019s job to fix problems and raise money, and if he can\u2019t do it, someone else has to. \u00a0So\u00a0the board (which now controls the company with 60% of the stock) votes to remove Richard as CEO. \u00a0They recruit an interim CEO (let\u2019s call him George) to quickly take the helm. \u00a0George says he\u2019ll take the job on two conditions: \u00a0One, that they create a 5% carve-out for him and the go-forward employees (he\u2019s done the overhang math too) and two, that\u00a0they extend the runway so he has time to either turn this thing around \u2013 or sell it.\r\n\r\nThe company is not profitable and the current investors are tapped out. \u00a0\u201cLet\u2019s extend the runway using debt,\u201d says BTV. \u00a0Maybe things will improve with time \u2013 or at least perhaps they can get their fund closed before they have to take the write down.\r\n\r\nThey lean on their good friends at PierLast Venture Bank who cough up $15 million in debt, with a senior preference and a 2x guarantee. Onerous terms to be sure, but hard to get debt with a balance sheet like this. Unfortunately, Pied Piper is burning $2 million a month on office space, cloud services, customer support, and expensive employees who are needed to build the next generation of the product. Without support they\u2019d have to shut down existing customers and revenue, yet without development of the new release that they hope will save the company, they will have nothing to sell. Since they can\u2019t cut their way to glory, they have to simply hope they can grow into their valuation.\r\n\r\nTime ticks by while the company plods forward with very slow growth. Market pressures force them to lower prices, pushing profitability off. \u00a0A few key developers leave. Once again, they are facing the prospect of running out of money in 90 days. Current investors are worried. \u00a0Not only do they not have funds to put into the deal, but once payroll is missed they could be personally liable for the damage. Not good.\r\n\r\nLuckily, WhiteKnight, a public company with a complementary product and plenty of cash, offers to buy Pied Piper. The offer is $250 million. It\u2019s not a billion \u2013 but it\u2019s\u00a0still a big, impressive number. It\u2019s not that easy to create a company worth a quarter billion real dollars to someone else. \u00a0That\u2019s huge!\r\n\r\nThe venture debt provider PierLast is very nervous about Pied Piper\u2019s balance sheet and looks to the VCs to either guarantee the loan or get the sale done. They want their $30 million. Hooli is likewise pushing to sell, after all they are guaranteed the first $200 million of any proceeds, after repayment of 2x debt to PierLast, while the company would have to be worth over a billion for them to see any further upside given that they only own 20%. Their calculus is that this is about as unlikely as seeing a real unicorn given the state of the company. \u00a0 BTV, who no longer has any capital left to invest from their original fund, has recently closed their shiny new $300 million fund, so they decide it is time to take their chips off the table. They vote to sell too, getting their $10 million back. Peter, while sad about the outcome, has developed a huge syndication following on AngelList and has recently benefitted from an early acquisition that netted him $3 million on a $250k investment. Can\u2019t win them all, but he\u2019s at peace. \u00a0Even Richard votes yes to the sale: \u00a0He still has a board seat but given the company\u2019s lack of profitability and lack of any other sources of capital, turning down this deal would mean insolvency, missed payroll - and personal liability. \u00a0George (the interim CEO) and the key go-forward employees demand their $12.5 million carve-out. \u00a0Tack on more money for lawyers and ibankers, and\u2026\r\n\r\nOh wait, that\u2019s more than $250 million. \u00a0Oops.\r\n\r\nErgo, Richard ends up with nothing.\r\n\r\nSo what can we learn from Richard\u2019s grim fairy tale?\r\nTerms matter\r\nLiquidation preferences, participation, ratchets \u2013 even the very term preferred shares (they are called \u2018preferred\u2019 for a reason) are things every entrepreneur needs to understand. Most terms are there because venture capitalists have created them, and they have created them because over time they have learned that terms are valuable ways to recover capital in downside outcomes and improve their share of the returns in moderate outcomes \u2013 which more than half the deals they do in normal markets will turn out to be.\r\n\r\nThere is nothing inherently evil about terms, they are a negotiation and part of standard procedure for high risk investing. \u00a0But, for you the entrepreneur to be surprised after the fact about what the terms entitle the venture firm to is just bad business \u2013 on your part.\r\nCap tables don\u2019t tell the real story\r\nFor any private company with different classes of stock, the capitalization table is not-at-all the full picture of who gets what in an outcome.\r\n\r\nIn the above example, each of the three investors held 20% of the stock and Richard and crew held 40%, yet the outcome was vastly different because of those aforementioned pesky terms and preferences.\r\n\r\nBefore you close on any round, you should create a waterfall spreadsheet that shows what you and each other stakeholder would get in a range of exits \u2013 low, medium and high. What you will generally find is that, in high, everyone is happy. \u00a0In low, no one is happy, and in medium (which is where most deals settle) you can either be penniless or \u201clife-changingly\u201d compensated, depending on how much money you raised and what terms you agreed to. \u00a0It is simply foolish to sell part of the company you founded without understanding this fully.\r\n\r\nThis is why it is so crazy to me that many entrepreneurs today are focused on valuation \u2013 the grade at the top of the paper. They are willingly trading terms for a high number. Before you do so, run the math on the range of outcomes over multiple term and valuation scenarios, so you fully understand the tradeoffs you are making.\r\nVenture capital is not free money. It\u2019s debt. And then some\r\nPeople mistakenly think of an equity investment as \u2018only\u2019 equity dilution. After all, if you lose everything, your venture investor can\u2019t come after you for your house like a bank lender could. However, most all venture transactions are done for preferred shares with a liquidation preference, which means all that venture money is guaranteed to be paid back first out of any proceeds before you get to make a dime. The more money you raise, the higher that \u2018overhang\u2019 becomes. \u00a0And interestingly, the higher the valuation, the higher the delta of value you need to create before the investor would rather hold on to the end instead of getting his or her money back (or a multiple thereof, as some terms dictate) in a premature sale if things are looking iffy.\u00a0\u00a0And what company doesn\u2019t go through iffy times?\r\nStacked preferences can create massive problems down the line\r\nThis one is a hard to articulate in a blog post. Plus, I am a venture capitalist who on occasion puts said senior preferences in my term sheet. They exist for a reason \u2013 again often to do with the valuation and the risk\/reward tradeoff the investor needs to make using the downside protection of a senior preference against the minimization of dilution the entrepreneur wants to achieve with a sky high valuation. They are not inherently bad.\r\n\r\nBut regardless of why they are there, the more diversity of value and terms in each round, the more you will create a situation where your investors (who are almost always also your voting board members) will have very different return profiles on the same offer. In the above example (and again I apologize for simplified math but it is directionally accurate) Hooli is getting their $200 million back on a $250 million acquisition. They own only 20% because of the high valuation they paid. So for them to instead double their return, the company would have to go public for $2 billion! \u00a0This is a case of the bird in the hand being worth more than the two in the very distant bush.\r\nInvestors are portfolio managers: You are not\r\nYou are betting usually 10 years of your life and all your available assets on your startup. Your investor is likely investing out of a fund where he or she will have 20-30 other positions. So in the simplest of terms, the outcome matters more to you than it does to them. As I noted above, when you have stacked preferences, each person at the table may be facing a vastly different outcome. But now layer onto that their fund or partner dynamics. Ever heard the expression, \u201close the battle but win the war?\u201d \u00a0I\u2019ve seen behavior that would seem crazy, until one considers what is going on in the background. For example in the above, BTV is out raising a fund and depends on that 10X markup to validate their abilities as investors. Facing a write down, a fire sale \u2013 or an extension of runway using debt (and not incurring any accounting change) \u2013 which one do you think least impacts the most important thing they are doing right now? \u00a0For our angel Peter, whose star has risen with this legendary markup, what value is there to him of taking a $1 million loss right now instead of just leaving a walking dead company out there and on his books (although this company is not technically walking dead because, since it is not profitable, it is not walking. But I digress.)\r\n\r\nMost reputable investors do not engage in this sort of optics, and many of us who have been through the dot com bust are actually rather aggressive with our write downs to accurately reflect a sense of true value in our portfolios. \u00a0Also, most investors who are also board members wear multiple hats and take their fiduciary responsibilities very seriously \u2013 I know I do. But, I bring up these behaviors because I\u2019ve witnessed them more than once out there in the real world. As an entrepreneur, you should at least think through the motivations of others, both when you are structuring investments as well as when you are considering a sale. They will on occasion matter\u2026 a lot.\r\nWhat to do\r\nNow that I\u2019ve scared you, let me reiterate that most investors I deal with are great, ethical people. If I didn\u2019t think of venture capital money as good for entrepreneurs on the whole, I wouldn\u2019t be a venture capitalist. But we VCs do a lot more deals than you entrepreneurs do, and you need to go into them with your eyes open to the downside consequences of the terms you agree to.\r\nHere\u2019s what I recommend:\r\nFocus on terms, not just valuation: \u00a0Understand how they work. \u00a0Read this book. \u00a0Use a lawyer that does tech venture financings for a living, not your uncle who is a divorce attorney, so you are getting the best advice. Don\u2019t completely delegate this because you need to understand it yourself.\r\n\r\nBuild a waterfall: Once you understand the terms being offered, build a waterfall spreadsheet so you can see exactly how each stakeholder will fare across the range of potential exit values (yes by stakeholder, not by class of stock: Investors often end up owning multiple classes, and likewise different people in the same class may have very different circumstances that will influence their behavior even in the same outcome.)\r\n\r\nDon\u2019t do bad business deals just to get investment capital: I know, duh, right? \u00a0 But I\u2019ve seen otherwise brilliant entrepreneurs get entranced by these big number deals with big corporates, only to deeply regret them later when they cannot be unwound. My advice, separate the business development contract from the equity contract. Negotiate them individually. If the business development deal would not stand on its own merits, don\u2019t do it.\r\n\r\nUnderstand the motivations of others: \u00a0This can be quite tricky, but I believe you should at least think through what might be the motivation of the others around the table. Is that junior partner going to get passed over for promotion if he writes down this deal? Is that other firm fundraising right now? If you don\u2019t know, ask. I always aim to be transparent with the entrepreneurs I work with about what my and DFJ\u2019s goals and constraints are, independent of my role as a director.\r\n\r\nAnd finally\u2026\r\nUnderstand your own motivation\r\nWhat are you doing this for? So you can see your face on the cover of Forbes? So you can have thousands of employees working for you? So you can be a member of the billion dollar Unicorn Club? Perhaps it is to do something you are personally excited about and in a reasonable amount of time, maybe take enough money off the table to live in a nice home, pay for your kid\u2019s college and your retirement. I\u2019m not saying one is more correct than the other, I\u2019m just saying that your own goals will dictate whether you should even raise venture at all, how much to raise, and what to spend it on. If you raise $5 million and sell your company for $30 million, it will likely be a life-changing return for you. If you raise $30 million and then sell your company for $30 million, you\u2019ll end up like Richard.