Chapter 16 – Finding A Valuation And Term Sheet That Fits

Your company is going to need financing next year. Are there any tips that can help you accelerate the process of getting the right financing?

Things are brutal at Unicorno. The founders have realized that they cannot fund operations without additional financing. Forced to fight for their economic lives, they will need help to prepare themselves for the rigorous scrutiny that always accompanies cash provided by new investors. How much is Unicorno worth today? How much could it be worth in the future? How much money will it take to finance operations and working capital needs until the company generates positive cash flows? What is the likelihood of successfully generating positive cash flows, and what control will current stockholders give up in exchange for obtaining cash from new investors? Not being prepared for these questions can result in lower valuations, reduced ownership, and even failure to obtain funding.

Estimating the current value of Unicorno is important because it is the basis for determining the “cost” of any new equity financing. Simply calculated, if Unicorno is currently valued at $10 million, has no debt, and is seeking another $10 million in capital, it would be worth $20 million after the investment. Current owners would hold 50% of the new $20 million company, while the new investors would also own 50% interest for their contribution of $10 million cash.

Much like the real estate market, potential investors will arrive at a valuation for Unicorno by obtaining valuations of comparable deals. What are the valuations of recently funded deals in the same market segment, the same stage, and in the same region? Knowledge of these transactions is critical. It is also important to understand what methods investors will use to validate your value within this range of comparable deals. Recognize that valuations will be affected by competition (greater capital amounts funding similar deals will increase valuations) as well as the business cycle (ventures are less likely to be funded during a downturn in the economy, decreasing valuations).

On the surface, investors will each use different methods to value your company. However, each of these methods will share some common goals: to evaluate Unicorno’s internal capabilities, market dynamics, critical risks, and funding needs. Every potential investor will assess your internal capabilities by rigorously reviewing the quality of the company’s operations (i.e., management, product, technology, manufacturing, sales, marketing, channels, and partnerships). Each will try to understand your market dynamics by measuring the potential size of the total opportunity, what piece of the market you can win against other companies competing in the space, and what profit can be realized with respect to your competitors, suppliers and customers. Exposure to legal, regulatory, and political risks will be explored (Uber is the poster child for companies that face these risks). In the end, they will examine every aspect of the logic and assumptions behind how much cash you request, assess each as positive or negative, and attach value to the direction.

Sophisticated investors conduct this examination by boring into your business plan’s financial model. They will probe into the model to find strengths, weaknesses, holes or unrealistic assumptions. Any veteran of this process will tell you that investors are essentially assessing how well management obtains information about its business opportunity, how this information is oriented to learning, and how effectively specific milestones are set to act on this learning. The better each team executes this dynamic planning-to-feedback loop, especially the tempo at which information is effectively oriented to action, the less uncertain Unicorno becomes for potential investors.

Therefore, there are two keys for the back office when you hit the funding trail. The first is to have worked with every functional team to build financial and compensation models that synthesize and harmonize each internal teams’ goals, tactics and capabilities. These models should be molded into an overall strategy that can exploit opportunities within your particular market as they arise. The financial model should highlight significant variables or uncertainties, and it’s critical that it supports the most recent numbers you pick with clear-cut, well reasoned assumptions. The second is to demonstrate that back office operations produce the least amount of friction possible to the company’s development, manufacturing, marketing and sales efforts. A company is never funded because of its back office prowess, but back office blunders (such as making errors in the capitalization table, excluding working capital needs in your financial model, or not being able report accurate results) can be the reason your company is not funded.

If an investor finds something attractive about Unicorno they will send a term sheet, a non-binding outline of a potential transaction. If the company’s opportunity is not attractive, a term sheet might be sent directly to a key engineer or executive, offering terms of employment at another venture. However, if the term sheet is presented to the company, management should immediately consult with an lawyer that has experience negotiating financing transactions. A term sheet will offer funding and summarize all important legal and financial terms. Your founders need to understand that each of these terms require expert attention. They should consider how each of the terms interact with each other and what economic assumptions are implicit within the terms.

Unicorno management should examine the terms and decide if the economics are close to what they expected and how the terms will negatively affect the company if something goes wrong. If the terms or economics are not desirable, they may want to seek other investors. Assuming there is no exclusivity clause in the term sheet, they can shop the deal to several potential investors simultaneously. Do not bad mouth any of the investors or shop specific terms from one offer to another investor. It is common for deals to have multiple investors, and you never know which investors may eventually come together to fund an opportunity.

What can go wrong with a financing? From Unicorno’s perspective, nearly everything. The deal can be underfinanced, forcing the company to raise capital that will probably dilute current investor’s ownership interest. Investor conflict could block a partnership or acquisition. The company can underperform against its plan, potentially triggering a liquidation preference or dilution clause that may render employee stock worthless in an acquisition. If a liquidity event does not occur by a certain date, the company could be obligated to redeem an investor’s interest in a specific time frame. The founders or management could lose control over hiring, compensation or operational decisions. An attorney with an understanding of your market and current deals is a critical resource. From Unicorno’s standpoint, the critical part of negotiating a term sheet that works for both parties is a clear understanding of the terms, the economic assumptions behind the terms, and how those terms compare with other deals in similar circumstances.

Takeaway Questions:

• Does your management team understand the terms and conditions of your company’s financing? What are the liquidation preferences for each investor, employee and advisor?
• What are the valuations of recently funded deals in the same market segment, the same stage, and in the same region as your company?
• What are the key metrics used to evaluate your industry (e.g., ARR, MRR, Cost per Core, Cost per Click, CPM, SEO traffic, Processor speeds, etc)? Does your management team use these measures to set goals and review results?

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