Term Sheets: Understanding Valuation
By Laura Duggan
Term Sheets are a complex subject. Here’s a starting point to help you attract investors by considering appropriate valuation for the company.
When you are actively finding investors, the subject of valuation will always be part of the offer that you make to them or vice versa. The investors have their own way of considering the valuation that is being put forward. It is helpful for you to understand their point of view, in order to be more successful at attracting investors. Here’s how they might look at it: Why is important?
Valuation is particularly important to investors who are in multiple start-up ventures. They are aware that this is a ‘hits’ business. Only some of their investments will pay off, and the others may be a write-off. Therefore, they need to know statistically that the one which hits will be lucrative enough to cover the ones that don’t succeed. Of course, everyone is hoping yours is the one hit. But that is irrelevant to the investor, who has heard the same story from all the other businesses in his portfolio.
If you are speaking to an investor about investing $1million, and you are saying that you are offering $5million pre-money, you are saying that your business is worth $5 million before they invest. Therefore this means that if they give you the $1million, your company is now worth $6million. From the investors point of view, it means that he now owns 1/6 of your company, or less than 16.67%.
Valuation and Exit Strategy
Invariably, your investor will also ask about your exit strategy. What size business are you building? If you are asked about this from someone investing $1 million, at a pre-money valuation of $5 million, be careful how you answer. If asked if you will sell at $10 million, you may have just lost an investor. Why? Because when you sell the company at $10 million, the guy who owned 1/6 of your company just netted less than $2 million back. In other words, for all his risk and the time elapsed, he barely doubled his money. If the exit expectations are low, then the valuation coming in should be low, so that the investor is getting a larger percentage of the company for his investment.
What do investors want?
Investors look for a return of greater than 10 times their initial investment to make it worth their while. This figure takes into account the number of their investments which won’t succeed, and the length of time (often 5 to 7 years) that their money is tied up in your company.
Another concern that investors have is the dilution of their investment. Over time, how much additional money is your company going to need in the future. If it is going to need a lot of capital, the initial investor’s share, (in our example, 1/6) will get diluted. Therefore, when it seems that there will be future dilution, again there is a great deal of caution about the initial valuation. While it may also happen that your share price goes up, the investors take in to account dilution. The result is that they will either want a lower valuation, or they will need to invest more in the beginning.
Compensation for Time and Effort
Often an angel investor adds time and effort to help you succeed in the early stages, in addition to investing their capital. How do they get compensated for this? If all the early investors are angels, and all participating, again, you might make the valuation lower. If only some of the investors are putting in extra time, and you have one valuation for everyone, then, you might consider alternative compensation. For example, the angel may be offered options, or be put on the board and get board compensation. It’s all a balancing act.
Determining Fair Valuation
In a really early stage of a venture, the valuation is somewhat arbitrary. It is a function of four factors:
- Opportunity size: how big can your company get?
- Progress made toward it: what can you show for the current money and time invested?
- Team: Is the team complete? Have they done it before? Do they have great domain experience?
- Market condition: Is money being readily invested right now?