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What Every Entrepreneur Should Know About Valuations

August 30, 2013
URL: http://www.entrepreneur.com/article/228154

Getting your first term sheet from a venture-capital firm is among the most exhilarating moments that you'll experience as an entrepreneur. It probably sits up there with the college acceptance letter in the pantheon of milestones. Getting a call from an entrepreneur who has just received a term sheet is one of the highlights of my day. The excitement is palpable. But unlike the college acceptance letter, a venture term sheet can quickly be followed by the dread of trying to understand the gobbledy-gook that you've been presented with. To manage that inevitable angst, you'll quickly need to wrap your head around what matters a lot, what matters less and what doesn't really matter in a term sheet.

So, what really matters in a term sheet? In a series of articles, starting with this one, I will try to give you an insider's look at the things that really matter by deconstructing a venture term sheet. So it's fitting that we start with valuation, arguably the single most important thing in a term sheet.

Valuations are driven by a handful of variables. The first thing you'll want to consider is whether the valuation in the term sheet is presented as a "pre-money valuation" or a "post-money valuation." You will want to make sure that there's no confusion about the valuation being presented. A $20 million valuation on a $5 million investment could mean either a $20 million pre-money valuation and a $25 million post-money valuation, or a $15 million pre-money valuation and a $20 million post-money valuation. The amount of dilution of your ownership will differ vastly under these two circumstances.

The second thing you'll want to consider is the manner in which the pre-money valuation and the price per share that the venture investors pay is being calculated. In the venture world, we arrive at the price per share investors pay by taking the valuation and dividing it by the "fully diluted" outstanding share count. What gets included in the fully diluted share count, which is the denominator, will affect your price per share.

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The second thing you'll want to consider is the manner in which the pre-money valuation and the price per share that the venture investors pay is being calculated. In the venture world, we arrive at the price per share investors pay by taking the valuation and dividing it by the "fully diluted" outstanding share count. What gets included in the fully diluted share count, which is the denominator, will affect your price per share.

So what should go into the denominator? Certainly all of the outstanding equity should be included. But what else? In venture term sheets, an option pool reserve, ranging typically from 10 to 20 percent, is almost always included in the pre-money valuation. This is a common market practice designed to ensure that the venture investors aren't diluted by equity grants to future hires.

While there's little value in debating the inclusion of this market term in your term sheet, you're within your rights to have a discussion about the size of the pool that's being calculated. Obviously, a larger pool means a larger dilutive impact on the founders, which effectively means that your pre-money valuation is lower. So when you think about valuation, you should always consider the size of the option pool.

A recent and evolving trend in the determination of price is the inclusion of bridge notes and other convertible securities in the pre-money, fully diluted calculation. Convertible notes are a very common and popular mechanism for raising seed capital. Historically, these bridge notes converted side-by-side with the new venture money. But given the significant amounts of capital that many companies have been able to raise in their seed rounds using convertible notes, many venture investors are increasingly taking the view that these securities should be viewed as a completed financing round, and therefore, should be included in the pre-money calculation.

Obviously, the inclusion of your bridge financing notes in the pre-money calculation will have the net effect of reducing your valuation. Therefore the inclusion or exclusion of these notes is simply a price issue that is important to consider when you think about the valuation in your deal.

These are the issues that you should think about when considering the valuation in your term sheet. In my next article, we will dig into one of the more prominent features of the preferred stock that is typically issued to VCs: the liquidation preference.

Related: 4 Ways to Blow It When Pitching for Venture Capital