Editor’s Note: This article was co-authored by Mackey Craven and Sean Fanning.
A great deal has been written about venture investments, ranging from up-to-date reporting on round sizes and valuations (just read the most recent Crunchbase, Pitchbook or CBinsights blog) to breaking down the complexity of a venture deal into consumable components (Brad Feld’s and Jason Mendelson’s Venture Deals is hands down the best resource on the topic).
Let’s say for a moment that you’ve read all that, executed like hell, and find yourself in the enviable position of choosing between multiple term sheets – how do you choose which one to take?
While the answer is sometimes easy because your favorite firm gave you the best terms, it’s rarely so straightforward. Through supporting CEOs in OV’s portfolio, we developed a simple, yet powerful, framework for picking a term sheet. Our five steps will help you compare the qualitative and quantitative aspects of various term sheets to more easily make the best decision for your business.
Partnership and Terms: The Two Elements of Taking a Venture Investment
Only two things matter when you receive a term sheet: who wrote it and what it says. While it can be straightforward to compare either investors or economics, the challenge is that they come as an indivisible pair. In other words, you should be able to rank the investors issuing term sheets in preference order after spending time with them, referencing CEOs who they work with and getting to know their firm as a whole. In addition, the job of ranking term sheet economics is a straightforward mathematical exercise if each investor is using standard market terms – look at valuation, round size, post-money option pool and other economic factors. The simplest criterion to determine “economic superiority” is your post-money ownership percentage as it takes into account all these relevant factors.
So how do we merge these two elements?
Step One: Make Two Lists
First, rank the term sheets by what you receive (a partner and capital to scale). Then rank the term sheets by what you give (ownership and other rights). Assuming the VCs you are considering offer market terms, the second list will be ranked by post-money ownership.
The challenge emerges when evaluating your qualitative judgements of partners and what you can do with the capital they provide alongside the quantitative economic rankings. While it’s an easy decision if the preferred partner also has the most attractive offer, this is often not the case.
What makes choosing between multiple term sheets challenging is not identifying which deal is better for the company or which partner you prefer, but that they come as a set and often don’t perfectly align.
Step Two: Use Your Judgement
Not all investors are created equal. We find ourselves discussing this topic with CEOs regularly when their preferred partner does not offer the best economic terms. “Gut ” is an important part of the process, but there is a data-driven way to make a decision. Translate your qualitative judgements on each partner into quantitative rankings based on the marginal value working with them will bring over your other options. This is Step 2:
Next to each investor on the first list, write down the percent more value per year (P) that you think your business will gain by working with your preferred partner over working with the investor ranked last on that list. Maybe it’s 1% more valuable, maybe it’s 5%, maybe it’s 50% – that’s something only you can decide. If it’s 0%, then you may want to question whether your preferred partner is truly better for the business.
The reality is not all venture firms or venture dollars are created equal – venture capital is not a commodity. Whether your objective is to maximize the impact of your company’s mission or to maximize value for your shareholders (including you!), you are probably looking to build a large, enduring enterprise. So, the question boils down to, how much more valuable of a company can I build by working with my preferred partner and the capital they provide?
Step Three: Calculate the Value Factor
You can calculate the Value Factor for each term sheet using the equation (1+P)^Y, where Y is the number of years you expect to be working together. Once you have calculated the Value Factor, you can incorporate what was previously a qualitative judgement on an investor into a purely quantitative output.
Step Four: Rank the Term Sheets by Value Adjusted Ownership
Putting It All Together
While the idea that getting a smaller piece of a bigger pie is a truism, it’s also likely to be the reason you’re considering raising venture capital in the first place – to trade off some ownership in your company for partnership and capital to achieve its potential.
Create a third (and final) list rank ordering the term sheets by Value Adjusted Ownership. To calculate this, multiply the Value Factor by your post-money ownership. The term sheet with the highest Value Adjusted Ownership is the best one for the business.
Value Adjusted Ownership incorporates your qualitative judgement on the marginal value your business will gain by choosing a specific partner with the quantitative tradeoff of taking an investment with that partners’ proposed terms. The term sheet with the largest resulting Value Adjusted Ownership is the one you should sign, and the best part is that it’s based completely on your own judgement.
The Power of 5%
Calculating some Value Factors makes the impact of this more tangible. The table below shows the Value Factor for varying marginal enterprise values per year, P, after Y years of partnership.
For example, if working with a given firm over another would add 5% more enterprise value per year to your business for three years, that translates into a Value Factor of 1.16x. As an example, a Value Factor of 1.16x means that raising a $10M Series A at a $20M pre-money valuation from the preferred partner would be more valuable than raising a $10M Series A at $30M pre-money valuation from the other after just three years of partnership. But how?
In Step 1, you would calculate that your post-money ownership after raising $10M at a $20M pre-money valuation is 66.6% of your pre-money ownership, holding all else equal. You would also calculate that your post-money ownership after raising $10M at a $30M pre-money valuation is 75.0% of your pre-money ownership, holding all else equal. The second is clearly worth more on paper today.
In Step 4 you would multiply the Value Factor of 1.16x (based on a P determined in Step 2 and calculated in Step 3 or referencing the table above) by 66.6% to get a Value Adjusted Ownership of 77.3%. The Value Adjusted Ownership of the non-preferred partner would remain the same at 75.0% since it is the baseline from which the percent more value per year (P) is determined.
As 77.3% is larger than 75.0%, you (and all other existing shareholders) would be financially better off by raising $10M at $20M from the preferred partner because you will make more money when you exit – the one valuation that really matters.
While a 50% valuation difference may seem insurmountable at first glance, the Value Factor puts it into perspective. That is the power of 5%.
Step Five: Sign the Term Sheet
Armed with the previous four steps and an understanding of the Value Factor and Value Adjusted Ownership, you have all the tools to confidently make the right decision for your business. Sign the term sheet and get back to what you want to be doing, building the company!
OV’s 5 Step Framework
To recap, here is the condensed version of OV’s 5 step framework to picking a term sheet:
- Make two lists. First, rank the term sheets by what you receive (a partner and capital to scale). Second, rank the term sheets in order by what you give (ownership and other rights). Assuming the VCs you are considering offer market terms, the second list will be ranked by post-money ownership. If your favorite investor issued the most favorable term sheet – you’re done! You can skip directly to step 5.
- Use your judgement. Next to each investor on the first list, write down the percent more value per year (P) you think the business will gain by working with them over working with the investor ranked last on the list. If you think the value you’ll get from each investor and their capital is equal, or P = 0 for all terms sheets – you’re done! Choose the term sheet at the top of your second list and skip to step 5.
- Calculate the Value Factor. Use the equation (1+P)^Y to calculate the Value Factor, where Y is the number of years you expect to be working together.
- Rank term sheets by Value Adjusted Ownership. You should rank order the term sheets by Value Adjusted Ownership. To do this, multiply the Value Factor by your post-money ownership. The term sheet with the highest Value Adjusted Ownership is the best one for the business, based exclusively on your judgement.
- Sign the term sheet! Then get back to what you want to be doing, building the company!
We hope you find this framework as valuable as we do at OpenView, and would love to hear if you end up using it to help pick a term sheet!