How to read an Investment Termsheet: Understanding Valuations
Investment termsheets to founders are like sports cars to teenage boys — the vast majority want one, but very few really understand how one works. The aim of this series is to demystify the termsheet: to explain the jargon to watch out for, and give you practical examples and resources to understand what each term might mean for your business.
I won’t be talking about what’s “market” or “standard”, as that varies so widely between stages, geographies, and types of investor. The idea is to give you something that can give you a general steer, whatever your business and wherever you’re raising.
For the first blog in this series, there’s no point burying the lede — every founder I know will search out the valuation as soon as they see a termsheet, so let’s start there!
- “Pre” — the “pre-money valuation” of the business, the implied value of your existing equity before your investor puts their cash in.
- “Post” — the “post-money valuation”, the value including the investor’s cash.
If your investor is putting in $5 million for 20% of your business, you have a post of $25 million and a pre of $20 million. They might say they’re “putting in 5, on a 20 pre”.
- “Multiple”, “Times” or “X” (pronounced like the letter) — in this context, the relation between some other financial metric (e.g. revenues) and valuation. They’re also used to describe the relation between an amount invested and the return on that investment.
If your revenues are $5 million and your valuation is $25 million then you are raising at “a revenue multiple of five”, or “five times/x revenues”.
The valuation is so important because it tells you how much of your company your investor will own, and crucially how much dilution you will take. For certain purposes, e.g. hiring in a competitive market, the actual headline valuation may also be important. What makes it difficult is that there is no standard way to express a valuation, and in some cases you may have to put together a number of different pieces of information in order to get a clear picture of everything you want to know.
Pre-Investment New Shares
Let’s start with the clearest possible statement: “Investor will invest $5,000,000 in Company, at a pre-money valuation of $20,000,000”. That seems simple — the valuation is clearly stated in pre-money terms.
It’s simple maths to determine that the pre-money valuation plus the investment amount gives you a $25 million post-money valuation, and an investor who owns $5m of that must have 20% of your company. The existing shareholders will therefore take 20% dilution — down to 80% from 100%. So far, so good.
That might not, however, be the whole story. Often the termsheet will have an obligation on you to put in place an employee share option plan, or to convert some of the Company’s debt into equity. Those shares will usually be included in the pre-money valuation, i.e. the existing shareholders will take all of the dilution, not the investor. Here’s the difference, assuming a 6% option pool:
There are good reasons to put an ESOP in place, but that’s a significant transfer of value from the founder group to the ESOP — and fundamental to dilution of the existing shareholders. The same treatment often gets applied to conversion of existing debt, and founders have the same risks there.
Often investors include this in their valuation language: “Investor will invest $5,000,000 in Company, at a pre-money valuation of $20,000,000, including an ESOP of 6%”. You should make sure, though, that you look through the rest of the termsheet for any reference to any shares or options meant to be issued or set aside as part of the investment.
Pulling it together
There is no consistent phrasing of valuation. One particular thing to watch out for is use of the term “valuation” without (either in words or in context) any indication whether that’s pre or post-money. It will generally be pre, but given how much difference it will make to your dilution it’s better to get that clear as soon as possible!
You may also see termsheets that use formulations such as “Investor will invest $5m for 20% of the Company”, or “Investor will subscribe for 100,000 Shares at $50 per Share” rather than the clear statement of valuation that you’re expecting. Using these to determine the other relevant numbers is simple enough, but only once you know how a valuation works.
Finally, don’t forget to look at the whole termsheet to find all the relevant factors. You might see an “Investment Amount” line item, and a separate item elsewhere as to percentage or number of shares, or to a price per share. You may get a clear valuation formulation, but with ESOP or debt conversion information somewhere else in the termsheet — sometimes it only shows up on the example cap table at the back.
Once you’re confident you’ve got all the relevant numbers together, you should be able to map out all the factors that matter — your headline (pre and post!) valuation, founder dilution, and investor equity. That’s usually an exercise worth doing, and particularly if you’ve got more than one termsheet to compare.
I have set out below a full table of each element I’ve been using in my worked examples, as a guide to how those figures relate. If you’re struggling to work out any of these elements, create a table like this and plug in the figures that you have — or find yourself a calculator that will do it for you, like this one.
It’s not the most complicated topic that this series will tackle, but how valuations work (and where in the termsheet to look for all the relevant elements) is far from straightforward. This type of run-through on how valuations work is founder education that, I hope, is helpful. More than probably any other aspect of the termsheet, there’s a prevailing attitude that a startup founder ought to understand every aspect of a valuation — and people can be embarrassed to ask for clarification.
If there are any topics you’d like to see covered in future, or if you have questions on any of the above, please do let me know.