Why the valuation is so important when negotiating a term sheet
When negotiating a term sheet, one of the most important (if not the most important) considerations will be a company’s valuation. This week, we will discuss some of the basic concepts around startup valuations, some of the business elements it can affect, and a high-level overview of valuation methods. In the coming weeks, we will do a deep dive on several valuation calculations, and I will update this post with links to all of those.
What is valuation?
A company’s valuation is merely determining the “worth” of the business. It sounds simple enough, but we need to differentiate between pre-and post-money valuations regarding term sheet negotiations.
- Pre-money valuation: refers to the value of a company before investing in the latest round of capital. Most valuations are an attempt to determine this valuation.
- Post-money valuation: refers to the company’s value immediately after the latest investment round of venture capital.
These determinations are important because the company’s valuation helps us calculate our price per share when investing. By knowing our price per share, and the value of our investment, we can conclude exactly how much equity we have in a startup. Determining whether we are talking about pre- vs. post-money valuation can significantly change the percentage ownership.
A quick example: If VC-1 is investing $2M in Startup-A at a $10M pre-money valuation, VC-1 will own 16.7% of the startup.
- $10M pre-money + $2M invested = $12M post-money
- $2M investment / $12M post-money = 16.7% equity
If, however, VC-1 is investing $2M in Startup-A at a $10M post-money valuation, VC-1 will own 20% of the startup!
- $10M post-money – $2M invested = $8M pre-money
- $2M investment / $10M post-money = 20% equity
Entrepreneurs and VCs will want to ensure they are on the same page and using the same language when negotiating this term. It has many implications for the capitalization table and equity ownership going forward.
Why do valuation and equity matter?
We have to remember that our goal as investors is to generate a return on our investment. To accomplish this goal, we need to own a significant equity stake in an asset or security that grows in value and eventually creates liquidity. In startup investing, we own shares in a company, and we want each share to increase in value over time. Because valuation determines our price per share, we want to see a company’s valuation continue to go up. How does that happen? In general, a company grows its customer and revenue base over time to become profitable and return value to shareholders eventually.
It’s important to note that the above is an ideal scenario. A company’s valuations can decrease over time (called a down round). Additionally, as more VCs invest in a company through its lifecycle, more shares are created, and equity gets diluted over time. VCs can have anti-dilution preferences in a term sheet, but we will save that for another day.
How to determine a valuation
Determining a startup valuation can be a bit of an art and a science, particularly in the early stage. For more established companies in mature markets, valuations tend to be easier because there is typically a history of revenue, and several companies we can compare. For startups, however, there are few metrics to go off of, and they can sometimes be creating brand new marketplaces (Airbnb and Uber did this).
For early-stage, pre-revenue companies, some things to consider when evaluating a company are:
- Management Team
- Total Addressable Market (TAM)
- Product-Market Fit
- Customer Acquisition Channels
- Intellectual Property
- Barriers to Entry
- Exit Opportunities
As mentioned before, I will go through each of these individually over the coming weeks, but below are some quick valuation methods used for companies. There are a lot of ways out there, but below are the most popular.
- Discounted Cash Flow (DCF)
- Comparable Companies Analysis (Comps)
- Precedent Transactions Analysis (PTA)
- Venture Capital Method
- Chicago Method
- Berkus Method
- Risk Factor Summation Method
Valuations are probably the most critical negotiating term of a term sheet because they determine a company’s price per share and equity ownership during each financing round. Also, with increased shareholders, dilution will affect how much equity is owned by each party over time. In venture capital and startup investing, the goal is to grow a company’s value over time and consider dilution of ownership over that time frame. We want to own a smaller slice of a bigger pie. Startup valuations can be difficult to determine given that they sometimes do not have hard metrics to go off of, and VCs can use many different methods in this process.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.