Term Sheet – Valuation and Dilution
Lots of folks have asked a very common question about startups: “What is a Term Sheet and what do all the terms mean?” In general, a term sheet is a non-binding letter of intent that outlines a potential investment in a startup. Since there are lots of terms as part of a term sheet, I will break the discussion of the terms into multiple posts to get the content out more quickly and in smaller digestible chunks.
Term Sheet – 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.
Startup Term Sheet Basics
But let’s assume you are a good venture capital opportunity. To start, a startup 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.
http://thevc.com/strips/strip08.html
The next set of posts will cover startup term sheet items regarding control such as liquidation preferences (UPDATE: The next post Startup 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!
Reference Materials
- Startup Term Sheet – Liquidation Preferences
- Startup Term Sheet – Anti-Dilution
- Startup Term Sheet – Voting Rights and Protective Provisions
- Startup Term Sheet – Dilution Calculator
- Download sample Startup Term Sheet from National Venture Capital Association
Previous post Control Freaks Are Us on how success is they key to control
Check out thevc.com for more comic stip humor on raising money
Money picture by TracyO
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Startup Life 103: Love
Successful startups (or any other successful company or adventure) cause memory loss. Yes, memory loss. It’s fascinating how success tends to make all the late nights, struggles, frustrations, fears, anxiety and stress fade away. Yet the fact is that startup life is hard and not for the faint of heart.
Failure is the norm
Let’s face it, most startups fail. Not just 50% but probably more like 90 or even 99% fail. I remember reading somewhere from a reputable venture capital firm that they would get about 10,000 (yes ten thousand!) business plan submissions in a year. And would invest in 2 to 5. And of the investments, odds are that 1 out of 10 is successful. in a way that employees and founders make reasonable money as opposed to simply the investors. The math on that is 5 plans out of 10,000 get funded and 1 out of 10 of the 5 is a success. 5/10,000*.1=0.00005 or in other words a failure rate of 99.995%.
So as Tina Turner asked “What’s love go to do with it?”
Love
As part of thinking about success and happiness in all aspects of your startup life, it’s important to be sure that you love it. You have to love the challenge of building great teams, creating killer products, competing with other aggressive startups or corporate behemoths and figuring out how to make a sustaining and profitable company. And you need to be able to demonstrate a lot of grace under considerable pressure. Startups are an emotional roller coaster. In any given month, week or even day, the highs are high and the lows are low. As a CEO or founder, the stress level is very high as I was always thinking about the families of the team and what it would mean for them if we failed. As a member of the team, the expectations are high and the demands on your time can be overwhelming. So be sure you love all the positive aspects of startup life and can “forget” the tough parts.
Steve Jobs gave a great commencement speech at Stanford titled “You’ve got to find what you love”. You can watch it below or read the text here. He talked about how he was fired from Apple at the age of 30 and that his love for building products and companies kept him going. And it was that love that made it possible for him to stick it out and keep going even though he was totally embarrassed and felt like he had failed. He ended up acquiring a little known company from Pixar from George Lucas and turning it from a software company into the world’s largest animation studio later acquired by Disney. And he started Next, which in a strange turn of events, was acquired by Apple and he then ended up leading Apple’s renaissance. The idea is find what you love and do it. It’s not easy but you should never stop looking or settling.
Many of you are probably saying, “Well, sure that sounds nice but its easy once you’ve made a gazillion dollars like Steve”. And yes that’s true, success makes loving startup life a lot easier. And in these difficult if not harrowing economic times it’s even more challenging as many of us are simply concerned about keeping or finding a job, never mind whether they love it. And in the short term, “Maslow’s hierarcy of needs” takes precedent over everything. You have to have food and shelter.
However, in the long term you should never stop searching for what you love. And if working in a startup, make sure you love it. If you don’t love startup life, you might not be cut out for that kind of work. It’s a shame when people join a startup for the sole goal of the proverbial pot of gold at the end of the rainbow. Considering that most startups fail, it’s important to enjoy the “journey” which is often times the only destination.
Steve Jobs speech summarized it best when he said:
“Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do.”
In summary, to be happy in all aspects of your startup life, keep in mind the ideas from previous posts about startup life as a marathon, the importance of leadership and this post about loving what you do.
Feel free to sign up for email updates on future posts (I promise no spam!), leave a comment, or drop me a note.
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It’s the people, stupid.
A common question I am asked is what made (and still makes!) Vontu a successful startup, company, team, division, etc. The answer is simple. People. Great people. It is one of the most important (and defensible) competitive advantages a company can have. It’s the same core belief that made Microsoft, Google, and so many other companies, sports teams, non profits, political campaigns, and others successful.
Some people argue that having a great idea is what makes a successful company. But how does a company create great products or ideas? Great people create great products.
Some people argue that having great sales execution or marketing campaigns are what make a successful company. Here too, great people ensure you have great sales and marketing.
A common quote used to describe this idea is “People first, strategy second”. Maybe it is even better to say, “People first, and EVERYTHING else second.” Why does this make sense?
Well, think about this question for a moment:
Would you rather have a great team with the wrong strategy, or the wrong team with a great strategy?
Clearly, it is a far easier to have a great team come up with a new strategy (or marketing plan, customer service effort, product feature, etc.) than it is to replace a mediocre team…
And what about customers first? You guessed it, without great people it’s hard to get great customers and even more difficult to keep them.
It really is the people, stupid.
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