Valuation on your term sheet is not what your company is worth
Your startup just received $500,000 from an investor with a post money valuation of $3M. Congrats, your company is worth $3M!! Except it’s not. In the news we see headlines that say something like:
“Awesome Startup just received $5M in funding, valuing it at $35M”.
However, this statement is completely false and its due to the fact that the person who wrote the article doesn’t know anything about fundraising, term sheets, or startup valuations. But if a valuation on a terms sheet doesn’t mean value of the startup, that can be very confusing. And it is, but don’t worry we will clear it up. ⛅️
Here is how it works
Let’s say a startup has 30M shares authorized. Out of the 30M, let’s give 27M to the founders and let’s assign 10% or 3M to Employee Stock Ownership Pool (ESOP). Here is what the cap table looks like:
Now, let’s say this startup has gone out and is looking for $2M in outside funding. A VC is interested, but due to the risky nature of this investment, they want 25% equity stake. This is what the cap table will look like:
So, what’s the valuation?
Let’s add another column to this cap table to start talking dollars. If the VC gave this startup $2M in return for 10M shares, the VC bought each share for $0.20. Thus, the Price Per Share is $0.20. Using this Price Per Share, here is what the Amount column equates to:
Hooray, we have a valuation! For this scenario, this startup has a post money valuation of $8M. But this is not the value of the startup. Say whaaaat! 😲 If this VC wanted 30% equity stake instead of the 25%, the Price Per Share would have been $0.16 and the cap table would look like this:
The post money valuation for this startup is $6,665,630 in this scenario. As you can see, the post money valuation changes based on what the investor determines is the appropriate equity percentage based on investment risk.
But I thought the Price of Share is determined based on a valuation and then the appropriate equity percentage is given out to the investor?
Yes, you thought like everyone else in the world. But that is not correct. The investor looks at the investment’s risk level, waterfall for payout, and other factors to determine the equity percentage they are comfortable with. Once the equity is determined, the Price Per Share and post money valuation is a fallout of that. 💡
Can I use the post money valuation and sell my company for that price?
Absolutely not! Again, this is not what your company is worth. Post money valuation is a fallout from what the investors have determined is the appropriate percentage they require for the investment they are making. You and your team still have to execute after you receive the funding.
Think about a typical tech startup. They have an office space, which is probably leased. They have computers, which are probably leased. They have a ping pong table, which they probably own. They probably have an IP, which is of some value, but not in the tens of millions of dollars. This is why you should never look at the post money valuation and get excited that your company is worth that much. You should however get excited that you received a term sheet from an investor! Kudos!! 👍
Now that you know what post money valuation is and how it is calculated, it is your responsibility as a member of the startup community to refer others to this article, so they can learn too. Also, next time you see a tagline that says “Awesome Startup just received $5M in funding, valuing it at $35M”, ask them where they got the $35M value from. If they say that it is the post money valuation, walk away slowly from that person and don’t look back.
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