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Anatomy of a Term Sheet: Valuation

For more information on this post contact Scott Preece.

This is one of the most important sections of the Term Sheet to a VC. The valuation provisions set out how much the VC is willing to invest and how much ownership he will receive in return.  The valuation will often dictate the rest of the term sheet for a VC.

Entrepreneurs often concentrate too much on valuation. The deal should be viewed as a whole — What value-add will you receive from the VC? Will the VC micro-manage the company? What are the economics on an exit? It is all very well negotiating a fantastic valuation, but it will make no difference if you have ceded all of the economics and control in the process.

Pre-Money Valuation

The pre-money valuation is the value of the Company immediately before an investment. The value refers to the capitalisation of the Company on a “fully-diluted basis”. Fully-diluted ownership takes into account shares of ordinary shares to be issued upon conversion of all convertible securities (for example preferred shares) and the exercise of options and warrants granted or reserved for issue under the employee option pool, in addition to all other shares in issue. 

Entrepreneurs should look very carefully at the effect of the option pool on the pre-money valuation. As part of the investment, it is fairly common for an option pool to be either established or the number of shares available under the option pool to be increased. It is important to agree that the establishment or increase of the option pool will occur pre- or post-investment. If the option pool is to be established/increased pre-investment, the pre-money valuation of the company is effectively reduced which will result in further dilution to the shareholders (sometimes referred to as the option pool shuffle)*. 

For example, Smart Money Ventures proposes a £2,000,000 on a £10,000,000 pre-money valuation with a 10% option pool to be established immediately prior to the investment. 

The effective pre-money valuation is actually £8,800,000.  A £2,000,000 on a £10,000,000 pre-money valuation results in a £12,000,000 post-money valuation (see below). 10% of £12,000,000 is £1,200,000. 

The effective pre-money valuation is, therefore: 

£12MM post — £1.2MM option pool — £2MM investment = £8.8MM effective pre 

Entrepreneurs should try to negotiate that the new pool should be established post-investment so that the dilution is borne by all parties. If this is not possible, entrepreneurs could try to argue that only a part of the pool is established pre-investment. The remainder can then be put in place if the pool does not prove big enough.

Post-Money Valuation

The post-money valuation refers to the value of the Company on a fully-diluted basis immediately after the investment. 

For example if Smart Money Ventures wish to invest £2,500,000 for 25% ownership: 

  • the post-money valuation is £10,000,000 ((2,500,000/25)*100) 
  • the pre-money valuation is £7,500,000 (Post-money valuation (£10MM) — Investment (£2.5MM).

Always ensure that the Term Sheet includes a pre- and post-investment capitalisation table. This ensures that all parties are in full agreement from the outset. A capitalisation will also highlight the impact of any new option pool. Your lawyer should be able to help you put together a capitalisation table reflecting both the investment and any change to the option pool.

The Anatomy of a Term Sheet series can be found in full here

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