Chapter 5: Milestones, Term sheet and Valuation

Author: Alessio Tonacchera

Estimated reading time: 7 min

Introduction

Before the start of a funding round, founders will need to carefully evaluate the milestones that will be realized over the next years, understand the Term Sheet structure along with its most common terms and, finally, the valuation of their company.

1. Milestones

When looking to plan for your company’s growth strategy or to go fundraising it’s important to break down what you need to do in terms of projected milestones.

From a founder’s perspective, milestones are effectively points in time along the company’s timeline before a future event or goal. Rather than the goal itself, milestones are a subset of ‘the goal’.

Founders need a better understanding of which milestones are important for investors from a fundraising point of view. Investors seek to minimize risk while not losing an opportunity to invest in a hot company so that they are constantly trying to find the least risky point to fund a startup.

The most strategic timing for a company to raise funds is either right before or right after the completion of a key milestone. Raising capital when the company is fairly distant from the next milestone might cause the startup to be seen as less attractive.

Now let’s look at the psychology of investing post a key milestone being completed:

If an investor decides to purposely delay the capital commitment for a company to witness the completion of a specific milestone, then he is trying to effectively de-risk the investment before issuing capital.

However, he knows that by playing the cards this way, other players will also be on the table quite quickly because the company is not only attractive to him, but also to many others that were standing by the sidelines waiting to see what the company would do. Therefore, the investor in question wants to get in before the company is too valuable for them to invest in.

Accordingly, the art of picking milestones is trying to determine which ones are the key ones to focus on. As a rule of thumb, these subgoals are the main landmarks in different departments of the company that the founders need to put extra thoughts on:

  • Human Resources – Hiring key people that will make a huge impact on your organization
  • Product – Product launches, version releases, demos and beta are all in case of indicating the product development phase
  • Market – Market validation. As in, first customers, first paying customers, 10k-1m users, proof of the market potential and proof of your scalability
  • Funding – The precedent funding rounds and grants, investors that lead and participated, and future requirements for investment need.

You can break these down into smaller ones if you would like, but that is where you start having to make judgement calls as to what is meaningful and what is not.

2. Term Sheet

A term sheet is a non-binding agreement with the basic terms and conditions of an investment. Serves as a basis for future negotiations and more detailed, legally binding documents.

The Term Sheet is not a binding agreement to invest in the company. The real funding action is subject to actual documents, due diligence, other closing conditions (e.g. legal opinion). However, it’s very unusual for the actual deal to vary significantly from the term sheet. Although not binding some provisions in the contract have legal effects, for example, confidentiality (company can’t disclose terms or even existence of term sheet) and exclusivity (company can’t shop deal – usually 30 to 60 days) conditions.

We’re now ready to analyze the key sections of the typical VC Term Sheet.

1) Offering Terms

The offering terms section includes the closing date, investor names, amount raised, the price per share and pre-money valuation.

  • Pre-Money vs. Post-Money Valuation
    Pre-money valuation simply refers to the imputed value given to the company before the new money is invested. On the other hand, the post-money valuation will account for the new investment(s) after the financing round. The post-money valuation will be calculated as the pre-money valuation plus the newly raised financing amount.

2) Charter

The charter shows the dividend policy, liquidation preference, protective provisions, and pay to play provisions.

  • Dividend Policy: clarifies the amount, timing and cumulative nature of dividends
  • Liquidation Preference: represents the amount the company must pay in case of corporate liquidations or similar events (after secured debt, trade creditors, or other company obligations). The liquidation preference is perhaps one of the most important clauses found in a term sheet. While most entrepreneurs focus on the valuation, the VC focuses on the structure of the liquidation preference
  • Anti-Dilution Protection: protection for VCs in case of a down round, so that their equity percentage (and investment value)remains stable at the pre-round level.
  • Pay to Play Provision: preferred shareholders lose anti-dilution protection unless they invest in the next round at a lower price (“down round”); normally preferred will automatically convert to common in such a case.

3) Share Purchase Agreement (“SPA”)

A Share Purchase Agreement is a legal document that describes and determines the details around a transfer of shares of a legal entity from the seller to the buyer. The SPA includes initial clauses on reps & warranties, foreign investment regulatory stipulations and legal counsel designation for the eventual Share Purchase Agreement.

4) Investor Rights

The investor rights section highlights registration rights, lock-up provisions, information rights, the right to participate in future rounds, and employee stock option specifics:

  • Registration Rights: right to register shares with ESMA so that investors can sell on the public market
  • Lock-up Provision: it establishes the timing limitations for sale in case of an Initial Public Offerings (IPO)
  • Information Rights: right for preferred shareholders to get a copy of quarterly and annual financials
  • Right to Participate: existing investors have the right to buy shares offered in subsequent financing rounds
  • Employee Option Pool: the percentage of stock reserved for key employees (existing and new hires) and timing of vesting of the options.

5) Right of First Refusal / Co-Sale Agreement

The right of first refusal (ROFR) provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other 3rd party. A co-sale agreement provides a group of shareholders the right to sell their shares when another group does so (and under the same conditions).

6) Voting Agreement

It establishes the future Voting Agreement, with callouts of Board composition and drag-along rights.

  • Composition of Board of Directors: usually a mix of founders, VCs, and outside advisors (~4 to 6 people on average).
  • Drag Along Rights: all shareholders must sell if the board and/or majority shareholders approve.

7) Other

Other terms could include a no shop/confidentiality clause, the term sheet’s expiration date, and a copy of the Pro-forma cap table.

The above explained are the main components of a Venture Capital term sheet. We will take a deeper dive into this topic in our next article dedicated to Term Sheets and Cap Tables, where we will explore the respective negotiating positions of VCs and entrepreneurs as well as dive into the more sophisticated math associated with the world of venture-backed start-ups.

3. Valuation

According to Investopedia, “Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.” The price is at the core of the negotiation as it defines the number of shares an investor will get while the price also represents the company’s intrinsic/market value.

Venture capital firms and individual investors have dozens of models to value a startup, ranging from the easiest ones that are only based on assets to the most complex ones that involve several qualitative variables and statistical analysis. Some of the most common startup valuation models include:

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) – the most widely used model to price expected returns is indeed based on the concept of the marginal investor having a diversified market portfolio but this requirement rarely occurs. We can therefore adjust for this lack of diversification via the Beta and therefore adapt the traditional CAPM to ensure we capture the risk of the startup as a stand-alone asset or in other words encompass both systematic and unsystematic risk.

Comparables

Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which startups compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method.

The “comps” valuation method provides an observable value for the business, based on what other comparable companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current. We use comparable listed companies to find the EV/Sales Multiple.

Precedent Transactions

Precedent transactions analysis is another form of relative valuation where startups compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired. There Analysing how the market behaved in a comparable type of investment is fundamental.

The values represent the en bloc value of a business. They are useful for M&A transactions, but can easily become stale-dated and no longer reflective of the current market as time passes. They are less commonly used than Comps or market trading multiples.

DCF & rNPV

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where the business’ unlevered free cash flow is forecasted into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis. It is the most detailed of the three approaches and requires the most estimates and assumptions. However, the effort required for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios.

In addition, rNPV (“risk-adjusted net present value”) or eNPV (“expected NPV”) is a method to value risky future cash flows. rNPV is the standard valuation method in the drug development industry, where sufficient data exists to estimate success rates for R&D phases.

VC Method

Considering the expected IRR and the length of the investment, we define the target shares value.

Reverse Engineering

With reverse engineering, we can calculate the valuation based on financing need and the percentage of equity that the founders are willing to give away for it. By dividing the investment needed by the percentage, we could get an implied valuation. This way, it’s very clear for both parties what they’ll give and receive. Please note that the valuation will largely depend on the cash burn of a startup. The more costs a startup sustains, the higher its valuation. For (pre-)seed VCs, reverse engineering is often the go-to method as it barely needs any financial information. But also VCs that invest in later stages, will often use this method to double-check.

Startup valuation models rely on estimation and assumption. There’s no perfect way to value a business that has next to no specific comparison in the market. Nevertheless, the methods presented in this article can give you a clear idea of what you could expect and what you should be asking for your startup. Still, what is most important is to see how Startup Valuation is actually performed in a VC context and which are the most valuable data taken into consideration when doing it.

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