Term sheet talks #1: Valuation
This is a blog post I wrote for 212 Venture Capital’s blog on Medium. You may view the original post here.
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It is not very often that we come to the term sheet stage with a company. We may feel like critical perspectives in our objectives and main incentives can go amiss when we do. To put things into perspective, both from the VC and the entrepreneur point of view, we have started this blog series to underline some key terms and discussions that emerge, particularly during the term sheet stage of a VC to start-up relationship. Every investor has a different set of theses as well as other possible quantitative models accompanying these theses. Our intention is not to detail any specific way 212 handles these; instead, we want to start a general discussion on all the concepts that matter. Irrelevant of the fund size, theses, or any other subjective constraint, we want to share perspectives on universally essential concepts. Let’s start with the basics: The term sheet is a document that will vary in length depending on how your VC chooses to operate things. Many great resources online, such as Ycombinator, will provide examples of term sheets. Also, this long-standing compilation of essential terms by Brad Feld and Jason Mendelson might prove helpful. If you believe you might want to refresh the basics on cap table calculations, Investopedia might be a good source. Without understanding the crucial terms and the most fundamental objectives, it is easy to fall into some common pitfalls. One of the most common places for misinterpretation is when valuing a company. Let us first identify some important questions about value. Later, we will specifically address company value.
- How does one value something? Is value an inherent quality of every object? Or, as in beauty, is it in the eye of the beholder?
- How does one triangulate the value? Whose opinion is needed to make sure the value attained is lawful?
- What makes the value change? Is it rarity or functionality that ultimately dictates what’s more valuable?
- When valuing something as abstract as a company, how does value get derived from moral goods and natural (physical) goods?
- How do external parameters, like the company’s location, current micro and macro market demand, politics, global ecological balance, or many others, play into this?
Examining each of the above questions would exceed the scope of this blog post. However, these questions help remind us that valuation, as one of the key terms in the term sheet, is a multi-faceted and complicated topic.
Before we go into some of the interesting insights that we have found concerning valuation, let us briefly illustrate some essential viewpoints from a VC’s point of view.
Venture Capital funds aim to generate positive returns for their investors. Their day-to-day responsibilities consist mainly of analyzing opportunities, markets, and designing the appropriate quantitative models that would numerically work. In other words, VCs try to build scenarios on how an opportunity could or could not skyrocket to generate big returns.
Analyzing an opportunity never merely focuses on the tangible: healthy communication and partnerships are just as crucial to making a successful company. While some VCs have different views on what the partnership should look like, we at 212 believe that the founders know best. We try to position ourselves in a way that is in the know, yet never too intrusive, and accessible when we are needed.
While VCs’ views on this partnership can fluctuate, it is fair to say that the general inclination differs dramatically between developed and emerging markets. This dynamic is affected in multiple ways: Developed markets have abundant capital these days, whereas emerging markets still struggle in many aspects. Rules and regulations governing the tech & start-up ecosystem are at very different maturity levels, leading to many investors in emerging markets needing to “over-protect” themselves from certain loopholes. Start-ups in developed markets tend to approach fundraising more like a continuous process than a sporadic, cut-down-all-operations kind of intensive endeavor. They raise funds through successful marketing and communications throughout the whole year. All the above parameters and many more left unmentioned contribute to making valuation an even more complicated topic. All in all, it is safe to say that start-ups from the emerging world should not start comparing themselves with their developed competitors from day one. It might be a big blocker for all parties involved and might not reflect reality.
Regarding reality, inflated, unreal growth is another critical issue: To keep on telling the story of a unicorn-to-be, or a decacorn-to-be, founders and investors, and everyone on board, agree to dim some facts and polish others. For a grand example, please take a look at the case of WeWork in this perspective by the New York Times.
So what is the right way to value a company? As we explained earlier, several factors could inform the number you were hoping for being different from the VC’s final number. Since start-ups are very new companies without a steady cash flow or other financial histories that would allow regular valuations using DCF or other methods, we have to look to other tools to do accurate valuations. The most common way that VCs value any start-up is by using market multiples. They will observe recent exits and the current landscape of your given industry to extrapolate a fair valuation. However, your given industry is not the only basis of this valuation method. Factors also include which country you are in, the economic variables of your region, and many other variables. That is part of the reason why many American start-ups often receive higher valuations than those of their European counterparts. However, over the last few years, a massive trend has seen American VCs look for investments elsewhere in the world like Europe or MENA, which has significantly boosted valuations in these regions.
So how should start-ups and investors go about discussing valuation? As upfront as possible. Scarbrough and colleagues’ 2013 exploration of the role of trust in deal-making for early-stage technology ventures are only one of many good examples of this rule of thumb. The article investigated a sample size of over 100 start-ups and discovered that communication and competence efficiently help build trust. In conclusion, VCs love founders who have shared responsibility and are fully upfront about everything going on in their business, whether positive or negative.
Thank you: Kaan Kermen for co-writing this piece with me Emre Hacıyunus Şimal Gezer