Startup valuation is a very nuanced topic that we consider both an art and a science.
But at the end of the day, the value of a startup is the price at which founders and investors are willing to sign a term sheet. And while it helps to have an understanding of valuation methodologies to some degree, it’s shortsighted to focus all your attention here. Your term sheet will have several other important terms that affect the “implied valuation” (more on this below), as well as the economics of an exit that do not relate directly to your startup valuation.
Investors have their own incentives and ways of thinking about valuation. Ultimately, the valuation will be influenced to a large degree by subjective elements (like investors’ confidence in you, product market fit, etc.) and the Venture Capitalist (VC) targets for investment size and percentage ownership.
Startup Valuation Basics
The startup’s valuation, along with the amount of money invested, determines the percentage of the company the new investors will own. This is one of the most crucial components of the term sheet, because it has the most direct impact on who owns what and how much cash each shareholder receives when the company sells.
Valuation is expressed in terms of pre-money and post-money values. By way of definition, the pre-money valuation is the company’s valuation before the new investment. The post-money is simply equal to the pre-money valuation plus the amount of the new investment. The new investors percentage of the company is equal to the amount of their investment divided by the post-money valuation. The founder’s basic objective with valuation is to maximize the amount of capital investment while minimizing dilution.
Face Value vs. Implied Value
When founders think about valuation, they often focus exclusively on the pre and post-money numbers and rely on them at face value. But this fails to account for many of the nuances and complexities of venture valuation and what it implies.
In the public markets, the simple equation of equity valuation = shares ⨉ value per share usually holds true. But it rarely applies to venture-backed companies.
This equation assumes that preferred stock and common stock are equal in value. However, preferred stock in venture-backed companies typically has significant economic advantages over common stock. These advantages can translate to very different outcomes between the two share classes, so they should not be valued the same.
Insights From 409a Valuations
If you look at a 409a valuation for the average startup, you’ll find that common shares are almost always valued quite a bit lower than preferred shares. This is because the standard 409A valuation methodologies are designed to incorporate preferred terms into the value calculation.
409A valuations don’t have any bearing on term sheet valuations, but the implied disparity in value between common and preferred is still real. Why is this the case? Because startups are risky ventures, and there is a high likelihood that the company fails or ends up getting acquired for less than expected. In these downside scenarios, preferred stock gives its shareholders special protections. Any given startup may very well end up in a situation where common shareholders only get 20% of the company’s value, even if they own more than 20% of the shares.
Again, your term sheet won’t reflect this reality. Common and preferred stock are assigned the same price per share in term sheet valuations.
Back-of-the-Envelope Implied Valuation
Let’s assume that a company with eight million shares of common stock has raised a $2 million Series A round at $1.00 per share. The post-money valuation of this deal is $10 million. But as you can see, if we use a more realistic share value for common of $0.40 per share, the “implied” valuation is barely more than half of the post-money “face-value.”
Now this is really just a thought exercise. The valuation that goes down on paper will be $10 million. The “implied” value of common will only come into play for 409A purposes. So, what’s the value of this framework to the entrepreneur?
The benefit lies in the understanding that your valuation may not be as favorable as your term sheet reflects. Investors can capture much more value than is implied by their percentage ownership. So always remember that, when it comes to venture capital, percentage ownership in the company is not always representative of actual economic ownership.
A High Valuation Does Not Make a Great Term Sheet
If you gain nothing else from this article, we encourage you to be aware that a high startup valuation does not always equal a great term sheet. In many ways, it can be just a vanity metric, because the term sheet can tell a very different story under the covers.
When you negotiate for a high valuation to take on more money, you often do so in exchange for onerous terms elsewhere on the term sheet. Even without punishing terms, higher valuations and larger rounds increase the hurdles you have to clear in order to satisfy your investors and produce value for founders and employees. In other words, big raises at high valuations essentially force you down the “go big, or go home” path. Depending on the situation, this might not always be the best approach.
So you should think carefully about how you want to approach valuation and fundraising. Not every business needs VC money to get off the ground, and you can potentially preserve a lot of value for yourself by taking it slow. Focusing on the fundamentals and raising as you go is a very viable strategy. It just depends on your goals, your capabilities, and your business.