Welcome to the first of a series of blog posts regarding the Key Economic Terms of a typical Funding Round Term Sheet as well as the Key Control Terms of a typical Funding Round Term Sheet.
From the point of view of both the investor and the start-up, three things are ultimately at stake: money, power and control.
In this blog series, we are explaining the most important economic terms of the Term Sheet, beginning with Valuation and Price more specifically the distinction between pre-money and post-money valuation. In summary, the terms differ as follows: The pre-money valuation is the value of a company before the potential investor has invested money. The post money valuation is equal to the pre-money valuation plus the amount that an investor invests (wants to invest). The distinction between these two terms is relevant to calculate how big of a share the investor receives for his investment.
Economic Terms of the Financing Round Term Sheet
After you have reached the first milestones with your start-up, there comes a time when you want to raise new capital through investors, so that your start-up can continue to grow. Before the investor invests in your company, a term sheet is typically negotiated as a basis for the later contracts and sets out a framework for negotiating the final agreements. Although a term sheet does not bind the investor to actually invest a certain amount of money, in practice it is more binding than commonly assumed with regard to the negotiated terms.
Valuation and Price
The valuation of your company and therefore the price per share ultimately decides how big of a stake an investor gets for his investment.
But how much is your company worth? Let me make a very simple example:
You set up your company in the form of a Swiss stock corporation (Aktiengesellschaft) with total share capital of CHF 100,000, divided into 100 shares with a nominal value of CHF 1,000.
Put simply, the valuation of your company immediately after its incorporation is CHF 100’000.
You develop a revolutionary app with which you can generate solid income over time. After two years your company account will have CHF 500’000 and you will have no outstanding liabilities and no other assets besides cash.
How much is your company worth now? Is it simply CHF 500,000? Is it much more because of the revolutionary app, which will continue to grow?
To answer this question there are various valuation methods (such as the discounted cashflow method which will not be discussed further here). Let’s say that you and the investor can agree on a valuation of CHF 1’000’000 for your company.
Now, there are two different ways to discuss valuation: pre-money and post-money.
The pre-money valuation is what the investor (and you) values the company at today, prior to the investment. In our simplified example, the pre-money valuation would be CHF 1’000’000.
The post-money valuation is simply the pre-money valuation plus the amount invested by the Investor.
To go back to our example, lets say the investor intends to invest CHF 250’000. This means that the post-money valuation of your company would be CHF 1’250’000.
How many Shares will the Investor get for his CHF 250’000?
The two different values of pre- and post-money in the end determine how big of a stake the investor gets for his investment.
The math is pretty straight forward: Stake of the Investor = Investment / post-money valuation
By investing CHF 250’000 in a company, that is post-money worth CHF 1’250’000, the investor buys a stake of 20% of your company (250’000/1’250’000).
With a share capital of CHF 100,000 before investment, this means that the share capital must be increased by CHF 25,000 (1,000 founder shares are 80% after investment; i.e. 20% = 250 shares of CHF 100 nominal value each).
Beware of the valuation trap!
When saying: “I’ll invest CHF 250’000 at a valuation of CHF 1’000’000”, Investors usually mean the post-money valuation. In our example this would mean that the pre-money valuation would only be CHF 750’000. In this scenario the stake of the investor would not only be 20% but 25% (250’000/1’000’000). Therefore, always make sure that you and the investor are clear on the valuation and weather you mean pre-money or post-money valuation. .
This simplified explanation of valuation and price does not include any employee options which must also be taken into account in the assessment (if any) and accounting for the agio (i.e. the difference between the nominal value of the shares and the actual investment, i.e. CHF 25’000 vs CHF 250’000).