Tough Stuff: Understanding Valuations and Term Sheets

As a founder, being solely focused on negotiating the valuation without understanding the terms being signed is a typical approach most founders take. A good deal is signed ensuring you understand the clauses in the term sheet, and what is being agreed on as this could impact your ownership and exit in the startup going forward..

To bust some myths here: There is no magic formula to valuations. Your business is worth what someone is willing to pay for. Valuation is more an art than a science.

As there is no formula, it completely depends on how you are able to demonstrate leadership in the different categories. There are 4 broad categories to consider here:

1. Sector or industry you are in: External market dynamics

Each industry / sector has unique valuation dynamics based on size of market, market opportunity, scale possibility and amount of investments available for later rounds of funding. As a founder, do the following home work:

- Study valuations of similar startups in your space who have raised their angel round.
- Study exits that happened in this space (acquihires, M&A)
- Study EBITDA (earnings before interest, tax, depreciation, and amortization)
- Understand growth metrics in your industry (it is important to baseline your growth metrics against competitive landscape)

2. Your startup profile and your business metrics: Your internal metric

As you build a business, the amount of money you want to raise will also define how much you need to dilute, and hence impact valuation. Angel investors in evaluating the ‘value’ of your business will consider the following parameters specific to your business:

- Founding team profile (does the team have experience in the domain they are building the product, are their skills complementary, are they full time in the venture)
- Stage of the startup (the earlier you raise money, the higher you dilute)
- Will you survive the next 5 years? (Will you be able to build a company with the fund raised and continue to scale)
- Cost to grow the business (customer acquisition cost, technology costs)
- Scalability of the business (global versus local play)
- Advisory board / mentors Involved

3. Some subtle aspects to valuation

Valuation is all about negotiations. It has to finally be a win-win for both investors and entrepreneurs. Some aspects which are more subtle to be considered are:

- How desperate is the entrepreneur?
- How many angel investors are talking to you and showing interest?
- Who is the angel investor who is willing to lead your round?
- Think of a valuation that gives your investors 10x return!

Valuation is heavily skewed to equity planning. Assuming your startup will scale up and require to raise capital in subsequent rounds, it is important that at the end of a series C, the founders still have sufficient equity to stay motivated and build the Startup. As a thumb rule, don't dilute too much too early as equity correction is extremely hard in subsequent rounds.

The most important aspect here is to understand equity planning and how an angel investor gets his exit. This will help you negotiate better when you raise your angel round.

4. Understand what you are signing for in the Term Sheet

Do you think the valuation number is the only thing that matters? The answer is NO.

Clauses in the term sheet to watch out for:

-Liquidation preference (could tilt outcomes on exit - look for participating or non-participating references)
-Anti dilution Clause
-Option pool (on pre-money or post money?)
-Board composition