Term-sheets and Sh*t-terms; Chapter 1: Valuations

I remember when I was building my startup, we got a term sheet from an investor. I was a first-time founder and had no idea what most of the terms meant, but all I knew was that we were getting an "x" amount of money for "y" amount of equity that we were giving to the investor - sounds simple, doesn't it?

PS: This was 2017, SAFE notes (Simple Agreement for Future Equity) and Convertible notes - they weren't widely used (at least in India) at that time - so we were dealing with a simple priced round.

For those of you, who don't know what a term sheet is - it's a document that lays out "basic" commercials of the proposed investment and is given by the investor to the company

Coming back, we were super excited as we finally had someone believe in the idea that we were going after.. and more than that, we had someone believe in us!

It's a fantastic feeling TBH! But once that feeling settles, and one starts getting involved in the paperwork, everything can get confusing (especially for a first-time founder).

So let me spin you a story about a founder who got a term sheet but with sh*t terms and how everything unfolded after - this is going to be a series and will have chapters :)

PS: this is completely fictional and everything shared here is to share what bad terms could look like and what to look out for!

So Rahul (I'm sure you've heard that name before) who was building a startup in AI (of course) and got a term sheet from Bad Capital for his pre-seed round - Rahul was really excited as after pitching to 100+ folks he finally had someone believe in him. But the terms he got were bad..really really bad..

Chapter 1: Valuation

Valuation is set between the founder and the investor and honestly, for early-stage companies, valuation is an art which draws itself from the science of demand and supply.

If a founder has lots of investors keen, they can ask for a higher valuation but at the same time if there are fewer folks keen on investing in their company the valuation can come down a bit.

Rahul wanted to raise $750k to get cracking and had his friends, family, and BFFs who were willing to invest about $250k - at this point, he was confused about how to price this round/value his company and felt that he should connect with a Micro-VC fund to come in and lead the round.

Through a friend, Rahul gets connected with Bad Capital. Bad Capital is really excited about what Rahul is building and is keen to lead the round. Finally, something that Rahul has been looking out for so bad is happening!

Bad Capital issues a term sheet to Rahul valuing the company at a pre-money valuation of $1M and investing an amount of $500k

Pre-money? Okay yeah, this can sound confusing - so, pre-money valuation means the value of the company minus the capital that is going to be invested by the investors

So now Rahul has to involve his friends, family, and BFFs in this round along with Bad Capital- so here is what the final structure of this round would look like:

Pre-money valuation: $1M

Bad Capital: $500k

Friends, Family and BFF: $250k

Post-money valuation: $1.75M

Investor holding: ~42%, of which

• Bad Capital: ~28%
• Friends, Family and BFF: ~14%

Founder holding: ~58%

Diluting ~42% in the first round of financing is nuts but Rahul accepted it because he felt he still retained a majority ownership share, and here is how things unfolded down the line:

Fast forward 2 years - Rahul and his team put their blood sweat and AI-generated tears into taking his AI company to the next level - all things on the company front looked great and it was time for the next round of funding!

When Rahul went to raise his next round of financing, he found a keen investor - Good Capital. Good Capital studied the company's performance and arrived at a pre-money valuation of $5M. They wanted to invest $1M for a holding of ~16% of the company, however, apprehension set in when looking at the company holding structure.

At the time that Good Capital was reviewing the possibility of investing in Rahul's company this is what the Cap Table (a document highlighting the shareholding of founders and investors) would have looked like after their investment:

Pre-money valuation: $5M

Good Capital: $1M

Post-money valuation: $6M

All investors' total holding (following dilution of investors from the first round): ~52%, of which

• Good Capital: 16%
• Bad Capital: 24%
• Friends, Family and BFF: 12%

Founder holding: ~48% (including the ESOP Pool)

Things became tricky for Rahul at this point - with just 2 rounds of financing, he will hold less than 50% of the company! This will become a potential red flag for future investors because it signals that there is very little upside for the founder remaining!

Okay so now I think we've figured out how a very high dilution very early in your startup journey can impact the company in the long run!

Btw, it's not like there is no or low risk with raising capital at a high valuation - a friend of Rahul's raised $5M at a $40M valuation from Best Capital, because he was a 2x founder and had some solid startup street cred - but he eventually had to shut down his company and return the capital to the investors because he could never scale the company to that level where he could justify that valuation to the future investors.

BFF Banter Tip on valuation and dilution during the first round of capital:

Your first round of capital (usually a pre-seed round) should be raised keeping the following things in mind - these points can help you negotiate the valuation terms with your investors;

1. How much capital do you need?
2. Where will that capital take you - quantify this - let's say metrics
3. What valuation do you expect to get for those metrics when you achieve them - say in both bull and bear markets?
4. How many founders are you? If you're a single founder, do you want to carve space for another founder down the line? ESOP Pool?
5. How much holding can you back-calculate from say 2 rounds of financing?
6. What's a fair price for your early believers and angels to come in at so that even they have a significant upside
7. Standard benchmarks that we've seen;

Angel round Dilution anywhere between 5-15%

Micro-VC + Angels Dilution anywhere between 10-20%

Institutional fund + others (this is usually a seed round and the quantum of capital is a lot more) Dilution anywhere between 15-25%

I'd love to hear your story and how you navigated the first round of financing - so feel free to write back 😉

By the way, we've drafted the entire Term sheet Playbook right here! It's way more comprehensive than what I've shared here and is a solid resource for early-stage founders - it even includes a sample term sheet!!

Other BFF Banter;

Why we invested in Stupa

Why we invested in All is Well

Hiring;

Marketing managers - Assemble!!

A couple of our portfolio founders are looking out for some really kickass marketing folks - I can vouch for the founders that you'd work for!!

"I will make you an offer that you can't refuse" - Godfather