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Lesson #3 Know The Game Part II.

Guest post by: Christopher Golis

Article Overview: The follow up to part I http://www.evancarmichael.com/Leadership/6509/Lesson-3-Know-The-Game-Part-I.html The most important lesson an entrepreneur can learn

Lesson #3 Know The Game Part II.



If you have just landed on this page and not read Part I, please do so as you will have much greater comprehension of what is about to follow.

I had asked a well-known Silicon Valley VC the following question, "Why does every VC in the valley have 3% of Tandem?”

His reply was devastating. "Well son, you should leave the industry because it obvious you have not got a cotton-picking clue what VC is about. Only a fool would ask a question like that."

Fortunately, he took pity on me and explained The Game. Understanding this model is what VC investing is all about.

First of all, fund raising is done in stages: Over a five year period a typical fund raising would go like this.

• Year 1: The company is founded with seed capital of $100,000,
• Year 2 Angels put in $500,000 for one-third of the company valuing it at $1.5 million.
• Year 3 VC investor 1 puts in a million for 25% of the company valuing it $4 million.
• Year 4 Another 3 VCs put in a million each for 20% of the company valuing it at $15 million.
• Year 5 The company does an IPO the business raising $10 million for 20% valuing the company at $50 million.

The key number is the equity dilution factor. This is what percentage equity that owned by the previous holder of equity. In the first round for example it is 67%, in the next round it is 75%, 80% in year 4 and 80% in year 5.

So for the founders the amount they hold at the IPO is 100%x67%x75%x80%x80% or 32%.

VC 1 holds 16%. The angels hold also hold 16%.

What happens (hopefully) is that:

1. For each round the valuation rises.

2. The founders raise new capital from new investors. If one investor ends up with a majority stake, the entrepreneurs become employees.

3. The current shareholders with a new capital raising, get diluted but hopefully the increase in valuation more than compensates.

Suddenly I had a moment of epiphany and now understood why everyone had 3% of Tandem. Subsequent capital raisings had diluted the original VC investors to the same level as the final VC investors.

This model is easily worked out on a spreadsheet and I regard it as the acid test of the entrepreneur. When he or she sits down at the computer and starts working out possible shareholdings with future raisings, I know my investment is potentially safe. Only the does the entrepreneur understand the Game. In my 25 years as a VC, I met some 5000 Australian entrepreneurs, yet only about two dozen understood the Game.

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Article Tags: entrepreneur, the california VC model, venture capital



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