This article is the first in a series of articles that will delve into the most important terms in investment Term Sheets for early-stage companies.

A Term Sheet is a non-binding legal document which sets out the key terms under which an investment is to be made. For early stage companies, receiving a Term Sheet from an investor is a significant event. Although it does not guarantee that an investment will be made, a Term Sheet is an important step forward in the financial relationship between a start-up and a prospective investor or investors.

One of the principal items on a term sheet is not a legal term, but a financial term: the Valuation.

For pre-revenue companies where investments are by their nature high-risk and long term (such as early stage companies or even certain biotechnology companies), valuation has been dubbed "part art and part science"1. This is because it is difficult to value a company where early cash flow is negative, there is high risk of failure, and the timing and prospects of rewards to investors are uncertain. As a result, in for early stage companies, deciding and agreeing on valuation is less about what the company may be worth, and more about deciding what share of the company the investor(s) will obtain for their investment.

Valuation is often a key point of negotiation between a company and a prospective investor. Aside from the importance of reaching agreement on the company's value, an early-stage company should consider the following:

  • Valuation Method. Investors, including venture capital firms, may use multiple valuation methods to assess a company's value. The "Venture Capital Method"2, a useful method to determine pre-money valuation using terminal value (anticipated selling price) and expected rate of return (which for early stage investors can, for the main part, be anywhere from 20% to 70% depending on the stage of investment) is popular, but the "Berkus Method", the "Scorecard Valuation Method", and the "Risk Factor Summation Method" are also used. Understanding how an investor is valuing your company can better equip a start-up for negotiations.
  • Pre-Money vs Post-Money Valuation. Early stage companies should be aware of and clarify whether the valuation they have received is the post-money valuation (the valuation of the company applicable after the financing) or pre-money (the value of the company obtained by subtracting the financier's new investment from the post-money valuation). Although investors often provide the pre-money valuation, if a post-money valuation is provided and perceived to be a pre-money valuation, this may affect an entrepreneur's assessment of the percentage of the company being given up for the new investment. In the end it often comes down to a negotiation.
  • The Option Pool. As an entrepreneur it is often helpful in negotiations to consider what size of the option pool is necessary for future growth (importantly, by way of incentives to employees and management). Often, investors will calculate the size of the option pool based on a percentage of the post-money valuation, but include the option pool in the pre-money valuation, effectively lowering the overall pre-money value of the company and diluting existing holders. As a result, entrepreneurs should spend time considering what size of option pool is necessary for their needs, how inclusion in the pre-money valuation affects the company's overall effective valuation, and whether there is any combination of valuation and option pool size that will best spur growth and meet operating requirements.
  • What the Investor Bring to the Table. Valuation of an early-stage company is often contextual. The intangible skills and knowledge that an investor brings to the table, including management or sector expertise or relationships, may affect the valuation that an entrepreneur is willing to accept on behalf of his or her company.

There is generally no "right" answer as to what valuation an entrepreneur should agree on with its investor. However, what is important is to ensure that the entrepreneur understands how the valuation is being defined and give full consideration of how that valuation will contribute to the growth of the company and the overall 'pie'.  The experienced investor will generally recognize the importance of incenting the company management for the achievement of the financial success of the venture. 

Footnotes

1 William A. Sahlman, Harvard Business School, "A Method For Valuing High-Risk, Long-Term Investments" (Rev: October 1, 2009)

2 Ibid.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.