Over the last few months, I’ve met with dozens of people trying to get an idea off the ground. A few of them have asked me to sign a non-disclosure agreement (NDA). At first, I begrudgingly inked the boilerplate document. I felt it was easier to acquiesce than to kick-off a relationship with a conflict. But no more. NDA’s are bad for early-stage companies. In fact, founders should ask people to sign Please Disclose Agreements (PDA).
First, asking for an NDA to protect an idea signals that you think ideas matter. Ideas are the starting point. But ideas, in the end, are worth little. Everybody has ideas. I have at least 10 one-pagers in my Google Doc account. To prove the value of ideas, I will disclose one of my favorites from my one-pager archive:
InteractiveBumper (IB) aims to deliver targeted ads to one of the last remaining captive audiences: the person(s) behind you in traffic. In short, IB will deliver geo-targeted ads onto a screen located on the rear bumper of cars. For example, a car equipped with an Interactive Bumper is idling in traffic one mile before the entrance to a Wal-Mart. Wal-Mart, a customer of IB, has bought this "spot" so delivers to the back bumper a promotion for the upcoming store. The cars behind the IB, as well as the cars to right and left, will have ample time to register the message and decide to stop in at Wal-mart or not.
Any takers? It’s all yours. Reach out if you want more thoughts on the idea.
In short, I’m disclosing InteractiveBumper because execution - not ideas - matters. Forming a team, building a prototype and convincing initial customers to test and then buy the product are what matters.
Of course, if you’re past the idea stage and have compelling IP, than by all means request an NDA.
Second, and most importantly, people in the start-up community want to help. There may be a few cheats, but the odds are several magnitudes greater that you’re sitting across from an ally. The people you meet will think about your idea and give you feedback. And even better, they’ll look into their network and connect you with relevant people like future employees or potential customers. If you silence these allies with an NDA, they can’t do what they do best: help you push your idea forward.
So nix the NDA and instead bind people to disclose your idea. The more you do this, the more allies you’ll gain, and the more feedback and connections you’ll make.
Several years ago, I negotiated my first term sheet with an angel investor. At the time, I was raising money for a company I founded with Brent Ridge -- yes, the same Brent from “The Fabulous Beekman Boys”. We were fresh-faced students and first-time entrepreneurs negotiating with a first-time angel. Neither of us knew what we were doing, so the negotiation devolved into who could swing the biggest one. No shocker here: the deal fell through and our company was not funded.
During the negotiation, I remember thinking, “Why isn’t there a framework to at least start the conversation about the deal terms?” Anything was better than just throwing outrageous numbers on the wall to see what stuck.
Well, after years of experience and studying, I have learned that there is a framework for evaluating early stage deals - in fact, there are two. I have built models for both frameworks and made them available as a Google Template; also available at the bottom of this post. If you’re an early stage investor, these models will help you evaluate deals. And if you’re an entrepreneur, they will help you understand how investors should be thinking about your opportunity.
As you use these tools, please remember they are not valuating your company. Rather, these frameworks evaluate the deal. In industry-speak, the tools test “finance-ability”
And one last thing: Please note, only change the YELLOW cells.
The VC Method
The first framework is called The VC Method, which is well documented by Andrew Metrick and Ayako Yasuda. The VC Method compares the present value (PV) of a future exit with the current investment. If the PV of an exit is greater than the current investment, than invest. If it is smaller, than walk away.
Let’s look at an example. The deal on the table is as follows: $250,000 for 33% of the company. Ok, that is pretty straightforward. Now, put on your thinking caps. To understand the PV of an exit we need to know (i) the potential size of an exit, (ii) the probability chance of the exit occurring, (iii) the number of years until said exit, (iv) how much dilution will occur between today and the exit and, finally, (v) the VC cost of capital. Ok, that is a lot. Where to begin?
Exit size is obviously the biggest “what-if.” Could you have called $23B for a search engine in 1998? Probably not. So pick a reasonable number based on the market you’re entering and then adjust with a probability chance of success. For this illustration, let’s assume a 50% chance of a $10M exit. Again, the exit size and the probability chance of the exit depends on the market opportunity, strength of the team, economic conditions -- and the list goes on. Get familiar with these factors and populate the model as you like.
The next three factors are a bit easier. Time to exit refers to how long the investment will be locked away. It could be as little as one year or ten-plus years. Three to five years is a good middle ground. Retention is a measurement of dilution; more specifically, it is the stake in the company at the time of exit as a percent of the original stake. And lastly, the VC Cost of capital is the discount rate. This refers to the cost of capital on the entire VC portfolio and not this single investment. Why? Because risk was already factored in when we assigned a probability chance to the exit. Thus, the average VC is looking for a 15-20% return. This can change as market conditions change; for example, if interest rates climb, than VC cost of capital will, too.
Alright, that’s a lot of info, so let’s go back to the template. The template is pre-populated with assumptions that our $250,000 investment in exchange for 33% of the company has a 50% chance of exiting for $10M in 3 years. We also assumed significant dilution (50%) and a 15% cost of capital. Drum roll, please....Under those assumptions, it is a good investment because the expect return is $547k, which is greater than the initial $250,000 invested.
Play around with the numbers and see what you get. For example, if you lower the probability chance of a $10M exit to 20%, which is reasonable, the deal becomes unfavorable. Or, if everything is held constant constant except it takes 3-times as long to exit (9 years), then the deal becomes unfavorable.
What percent is the correct percent
In the above method, we assume that the deal is structured: $250k for 33% of the company, take it or leave it. Well, this is often not the case. What often happens is the company is looking for a certain amount of capital and the investor needs to decide what amount of equity they need in return.
The second model on the tab entitled “% of company required” calculates the minimum equity stake required for a particular deal. This model is taught by Alexander Ljungqvist of NYU Stern. If the investor gets less equity than model calculates, than they will not achieve the target rate of return -- a bad thing. But if the investor gets more, than it is all gravy.
This is a much more straight forward model, so let’s dive in. The first variable is simple: How much is the company asking for? In this illustration, let’s assume $1M. In terms of dilution, it is an early stage deal so let’s assume 50%.
Now we get to the exit, which is more difficult indeed. Again, the size and timing of an exit depends on the market opportunity, the team, the company’s competitive advantage, plus hundreds of other factors. Take all these factors into consideration and come up with a reasonable best case scenario. For this example, I assume a $25M exit in 5 years.
Ok, last part: the investor’s target rate of return. In the previous model, we used the return on the portfolio and represented risk with the probability chance of an exit. In this model, we simply use the target rate of return for this one investment. Thus, the return is greater to reflect the risk of this investment and because of the need to supplement other investments that will be dogs. A rate as low as 25% to as high as 60% is acceptable. For this model, I assume 45%.
So without further adieu, a $1M investment in a company that gets diluted by 50% and exits in 5 years for $25M requires an equity stake 38.46%, assuming a 45% target return. Again, play around with the numbers. For example, by lowering the exit size to $20M but moving the exit up 1 year, the required stake falls to 33.15%.
Lastly, I have built another tool that allows you to see what the return will be for a given equity stake. For example, if instead of getting 38.46% of the company you get 10%, the investor’s return will be 10.76%. This is well below the target rate of return and thus unacceptable.
I'm the Founder and CEO of Peak Support. This blog is my take on early-stage companies and innovation. Every so often, there may be a post about culture, networking, family -- you name it. After all, what is a blog if it isn't a tad bit unstructured.