Startup 124: Term Sheet – Valuation and Dilution

Lots of folks have asked a very common question about startups: “What is a Venture Capital Term Sheet and what do all the terms mean?”  Since there are lots of terms to discuss, I will break the answers into multiple posts to get the content out more quickly and in smaller digestible chunks.

What’s the Big Idea?

Before jumping into post-money valuations, liquidity preferences and other legal mumbo jumbo, you must first decide whether you want to go down the path of taking venture capital.

The main reason to raise venture capital is because you need money to get your company off the ground or your growth is significantly constrained by not having more cash to invest. Put more simply, cash is the biggest inhibitor to your company growth.

It turns out that in some cases, you are better off growing your business organically especially in the current world of web and software as a service in which the needs for cash are dramatically lower than ever.

The Flip Side

Of course, just because you need money to grow, it does not mean that venture capitalists will want to invest in your company.  Not only do you need to decide if you need funding but you should also do a gut check on if your company is right for the venture business.

At the end of the day, venture capitalists want to invest in great teams going after billion dollar markets through which they can return 5-10 times their investment.   If you cannot convince a venture capitalist that your idea will achieve these results, then trying to raise venture capital is an exercise in futility.

Term Sheet Basics

But let’s assume you are a good venture capital opportunity.  To start, a term sheet is just that, a sheet of usually only a few pages with various legal terms that serve as an outline for an investment in your company.  Other than the confidentiality of the term sheet itself, it is not a legally binding commitment to invest.  It is basically a letter of intent.  This point is very important to remember.  Getting a term sheet does not guarantee your funding since it is not a legally binding obligation to invest, but it is usually a big milestone towards completing a round of fundraising.

Give to Get

To get venture funding, you have to “give to get”.  And your “give” is some amount of ownership and control of the company.  The question of how much ownership and control is the essence of the term sheet.  This first post will deal with the question of valuation and ownership.  I will get into the topics of control in future posts, but it is important to remember a term sheet is primarily about legal control versus actual control.  (Read Control Freaks Are Us on how success is the best way to stay in control.)

Ownership and Valuation

While VCs use terms like pre-money, post-money, option pools, etc, the general idea for valuing and subsequently selling a portion of your company is quite simple yet with one important twist.  A VC offers to buy a percentage of your company at a certain price and valuation.  The price they pay is determined by first figuring out what is referred to as the “pre-money valuation”.  On the simplest (though not completely accurate) level, this is how much the company is worth before the investment.  This is best illustrated with an example.

Let’s say you are running NewCo, Inc. and want to raise $4 million.  If a VC wants to invest $4 million, they may offer to value the company at $6 million.  The $6 million is what is referred to as the pre-money valuation.

Post Money Valuation

The post-money valuation is, as you probably already guessed, the pre-money valuation plus the amount that gets invested.  In this example, it is a pre-money valuation of $6 million plus the $4 million investment that results in a $10M post money valuation.

Pre-money valuation + Investment = Post Money Valuation

So What Did You Have To “Give To Get”?

The first thing you have to give is some amount of ownership in exchange for the investment.  This is similar to an initial public offering in which a company issues new shares that are bought at a certain price.  The amount of the company you  give up is referred to as dilution.  To figure out the dilution those with some good math skills probably divided the amount invested by the post money valuation and it would seem you gave up 40% of the company for $4 million dollars, right?

Amount Invested/Post Money Valuation = New Investor Ownership %

$4,000,000/$10,000,000 = 40%

The Twist

Well, there is one twist that complicates this.  That twist is called the option pool.  The option pool is a set of shares that will be issued in the future to new employees, board members, advisors and others.  And the way traditional Silicon Valley style investing works, VCs require the option pool for these future grants to be part of the pre-money valuation.

As a result, by having more shares, which  no one currently owns, included in the pre-money valuation total the VCs lower what is the true valuation of the company before the financing.  You are probably thinking, “Wait, say that again?  The pre-money valuaton is not really how much the company is worth?”  Yes, that’s correct and let me explain in more detail continuing with the previous example.

In the case of NewCo, Inc, the investors offer to invest $4 million at a $6M pre-money valuaton.  In addition, the investors require the very typical early stage company option pool equaling 20% of all the shares issued to founders, employees as well as to the investors following the financing also known as the fully diluted number of shares.

That means that instead of splitting the $6 million pre money valuation evenly across all the existing company share holders (founders and employees), it is split between all the existing shareholders such as the founders and employees as well as the shares in the option pool set up for future use.

Below is a table which compares what happens to ownership stakes both without and with an option pool.

	Ownership Without an Option Pool	Ownership With an Option Pool
Existing Shareholders	60%	40%
Option Pool	0%	20%
Investors	40%	40%
Post Money Total	100%	100%

As you can see, the True Valuation (this is my term and not a common term used by VCs) is actually $4M before any effect of the financing which equates in this example to 60% dilution when you count all the shares being issued for the option pool.   In other words the calculation should be as follows:

True Valuation + Option Pool Valuation + New Money = Post Money Valuation

$4M + $2M + $4M = $10M

The term should actually be the “pre-money, post option pool valuation” but at least now you know what it really means.  When evaluating an offer for investment, be sure to calculate the option pool to determine how much ownership you truly give up, which is the company’s dilution.

Now many of you are probably thinking, “Well, why don’t we include the option pool afterwards?”  This is one of those things that simply put “just is”.  It’s the way terms sheets work and you should not spend time trying to change this.  The place to focus your negotiation should instead be on maximizing the pre-money valuation and managing the size of the option pool to accurately reflect the future needs to distribute shares.

The Art of the Deal

Some of you are probably thinking, “Great, so not only am I totally confused by all this math, but you have not helped me to figure out how to maximize the valuation of my company!”  Unfortunately (or fortunately?), there is no magic formula.  It is part science but also lots of art.

The science part is that most VCs look at what has been accomplished at the current stage of the company and have valuation ranges for each stage.  The further along you are and the more traction you have, then the higher your valuation.

The art part is economic supply and demand driven negotiation which occurs between the startup and VCs.  The greater the perceived demand to invest in what is a fixed supply of your company will increase the valuation.

Therefore, the key to maximizing your valuation is first to demonstrate why you have the best team to solve a problem and then to get as far along in terms of customer, product and market leadership.  This will help to maximize the investment demand from a set of great investors. The more investors that are interested in what is a fixed supply of your company will result in a higher valuation.  You should not go talk with every VC under the sun, but start with a focused set and work to get several of them to put forth term sheets.

Interestingly, getting a term sheet from one VC can often trigger more demand from others.  A few years ago, a friend of mine made this cartoon that jokingly illustrates this point.  Experience has shown that once you have multiple term sheets, you are in a much better position to maximize the pre-money valuation with the knowledge of what is the true money valuation of your company.

The next set of posts will cover term sheet items regarding control such as liquidation preferences (UPDATE: The next post Startup 125: Term Sheet – Liquidation Preferences is posted!), board of directors, and others.  If you like this and want an update for future posts, feel free to sign up below for email updates or follow me on twitter.  And of course, if you like this, please use the links below and share it with a friend.

Lastly, feel free to leave a question or comment if this does not make sense.  Thanks for reading.

UPDATE: I’ve posted a valuation and dilution calculator that should help make this A LOT easier!

• Startup 131: Term Sheet – Dilution Calculator

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Reference Materials

• Startup 125: Term Sheet – Liquidation Preferences
• Startup 126: Term Sheet – Anti-Dilution
• Startup 127: Term Sheet – Voting Rights and Protective Provisions
• Startup 131: Term Sheet – Dilution Calculator
• Download sample Term Sheet from National Venture Capital Association

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