If you are raising capital, be prepared to tell investors your proposed deal terms. Terms can get very complicated, especially with venture capital investors, but I’ll stick to the basics in this chapter, since most of you will be raising capital from friends, family, and / or angel investors.
Whether or not to put deal terms in your pitch deck is a matter of style. I often prepare a backup slide with deal terms, and pull it out if the pitch is going well, or if the investors ask for it. The mechanics are as follows:
- How much is the company worth today? (“pre-money valuation”)
- How much money are you looking to raise? (typically enough to get your company through at least 12 months of operations)
- How much will the company be worth the day after you raise the investment? (a.k.a., post-money valuation)
Let’s try some simple round numbers. Let’s say the company is worth $1 million today, and you are raising $500,000, so the $1 million it’s worth now plus the $500,000 cash from the financing will make the company worth $1.5 million. That means the investors as a group will be putting in $500,000 of the $1.5 million post-money valuation, so they will be buying $500,000/$1,500,000, or 33% (a third) of the equity ownership in the company.
The toughest part of this calculation is determining the pre-money valuation. I recently helped a client establish a valuation for his startup, and thought I’d discuss the topic a bit here. He hadn’t raised capital before, and his instinct was to value the startup based projections of future cash flows (i.e. Net Present Value analysis). That can work for a going concern, but startup valuations are typically derived by looking at comparables, meaning recent valuations of other startups being financed.
As I write this, most seed-stage round valuations tend to range from $500,000 to $2.5 million. Factors that determine where a startup falls along this spectrum include:
- Quality of the team. Have they founded successful businesses before, and made money for investors?
- Stage of development. Is this an entrepreneur with a business plan and nothing more? Does she have a prototype developed? Paying customers?
- Size of the opportunity. Is this a company that could, in theory, become a $10 million business or does it have the potential to be $100 million business?
- Sweat equity implications. If the valuation is too low in relation to the amount raised, the management team may own a very small stake. That’s bad for you as an entrepreneur, because you won’t have enough incentive to make the sacrifices necessary to build the company. It’s also bad for investors— they want you motivated to work hard to make the company valuable, so you both make money when the company is sold.
After considering these issues, my client and I came up with a target pre-money valuation. Our number was $1.5 million. His goal is to raise $500,000, so he’d be selling $500,000 / ($1,500,000 +$500,000), or 25% of his equity to the new investors.
Like any good entrepreneur, he was concerned about giving away too much equity, and thought he should try for a $3MM pre-money valuation. It took a bit of discussion, but I convinced him otherwise. Of course, I want the best for my clients. But if he walked into a meeting with a sophisticated investor with a valuation that’s out of line with what’s happening in the market, he could lose credibility, and blow the deal. If he were to convince an unsophisticated investor (e.g. a family member) to take the higher valuation, he could have a different problem… Down the road, if he took money from a venture capital firm, they might strike a tougher bargain, in which case (depending on terms) the unsophisticated investor could suffer significant dilution.