In investing circles, there’s an old saying: you set the valuation, I’ll set the terms. Meaning, the valuation can be any price but the terms actually have a greater impact on who makes what money. When investors model potential investments, they attach a value to the different financial terms thereby lowering the effective valuation (e.g. the term sheet says one pre-money valuation but the reality is that the investor actually views it as a lower pre-money valuation).
Here are three common term sheet terms that lower the effective valuation:
- Cumulative Dividends – Much like an interest payment, this amount accrues until the company is sold (e.g. a $1 million investment with a 7% dividend would be a $70,000 increase in ownership in year one, a $74,900 increase in year two, etc. for the investors)
- Participating Preferred – Many term sheets require that the investors get paid back before other shareholders get any money (non-participating preferred) but if the exit is greater than the investment valuation, everyone splits up the proceeds based on ownership. Some go further and require participating preferred where the investors get their money back (or a multiple of their money) and then split the remaining proceeds based on percent ownership, thereby double dipping.
- Option Pool Shuffle – Investors typically require that entrepreneurs create a new option pool representing 10-15% of the company as part of the financing event. If the new option pool is created before the investment, as opposed to after it, and the investor buys in at the agreed-upon pre-money valuation, the company is effectively less valuable to the current shareholders since their ownership stake has been reduced (e.g if the entrepreneurs each own 30% and then add a 10% option pool, their ownership stake is 27% at time of investment when the new investors dilute them further).
These three common term sheet examples aren’t meant to make investors look bad. Rather, the goal is for entrepreneurs to better understand the most common terms that effectively lower the pre-money valuation so that it can be incorporated into the decision making process.
What else? What are some more term sheet terms that lower the effective valuation?