Course overview
Financing
Investment process

III.Investment process

Valuation

The valuation of an early stage venture is an art, not a science. To better understand where your company should be valued at, it’s a good idea to study companies in the same market, at the same stage and in a similar industry.

When discussing valuation, it can be confusing because valuation can be calculated in two different ways. The valuation can either be based on what the company is valued at before the investment (“pre-money”) or after the investment (“post-money”). The fact is that when investors talk about valuation, they usually talk about pre-money valuation.

However, in practice it's quite simple. Pre-money valuation is what a company is valued at right now. Post-money valuation is the pre-money valuation plus the amount of capital raised in the funding round. So if your company has a pre-money valuation of €4 million and raises €1 million in capital in the investment round, the firm's post-money valuation is €5 million.

While getting investment money is difficult, it’s also possible to do too well in your investment round – raising so much money that it starts to be unnecessary and might even make it difficult to reach the milestones for an even higher round. That's why it's always good to be extremely honest with yourself about whether you really need the funding you’re raising.

Term sheet

When working with venture capital investors, the first key document in the investment round is called the term sheet. It defines the main terms of the investment round, including the size of the investment, the different series of shares and their privileges and other details. In practice, signing a term sheet means that the investor is willing to invest in your company. The term sheet does not legally bind anyone to the investment, and the investment round is only legally binding when the final name has been added to the shareholder agreement and the actual investment agreement.

Signing a term sheet means that the investor is willing to lead your investment round. Institutional investors rarely invest alone, but the industry works so that different funds also validate their investment portfolio by how many others are willing to invest in it. No matter how enthusiastic your investor may be about your company, it is unlikely that they would go along if every other potential investor says "no thanks". If your company is in a strong position, you should find several term sheets and try to pick the one that you feel can bring most value for you, which is most probably not the same as the highest bidder.

Remember that investors almost always says "maybe". Only if your company has something obviously wrong with it or its business area is quite impossible for the investor in question will you be likely to get a “no” immediately. Therefore, in the investment round, it’s worth trying to get the final "yes" or "no" from each investor as soon as possible.

Each “no” reduces the amount of work you need to do as you can focus on the investors who have the potential to get involved. Ultimately, it’s enough to get a positive response from even one investor. This often requires meeting dozens of investors and keeping in touch. You should also keep in mind that the whole process takes time (and in practice, it usually takes more time than you initially think).

Due diligence

Investors rarely withdraw from an investment when the terms have been agreed. Usually at this point, the process moves into the due diligence phase of an investment round, where the investor goes through the details of the company to make sure everything is as it should be. This is often a formality, but if the firm has bigger problems, the investment round may also fail at this stage.

The second step, which can stretch painfully long, is drafting a shareholder agreement. A shareholder agreement is the key document in the investment round and can radically change the way your business operates. Never neglect to use a good lawyer who is familiar with early stage VC deals to check a shareholder agreement. But keep in mind that when the details are refined by your own lawyer and, in the worst case, by the lawyers of many different investors, it can take months.

The investment round requires nerves of steel. After months of uncertainty, your company may end up with a million in the account. Or it could be that all the trouble is for nothing when the deal stumbles over some technical detail, or your investor gets a better investment and, after months of waiting, your investment is exactly zero euros.

The nerve-racking feature of investment rounds is that before the last investors and founders’ names are on the paper, anything can still happen. Only after all the investors in the investment round and founders have signed a shareholder agreement and investment agreement is the agreement legally binding. Then you can open the champagne.

The shareholder agreement

The shareholder agreement is the most important document for a startup. It defines the founding shareholders, investors and minority shareholders. At its simplest, a shareholder agreement contains information on who owns all of the company's shares and what is required of them. Often shareholder agreements are documents of several dozen pages, especially when large foreign institutional investors are involved.

A startup entrepreneur should know the main points of what is defined in a shareholder agreement. However, we do not recommend that you check the legal text itself. It's always a good idea to get a good lawyer who understands the startup world to check the fine print – and help you to avoid any unpleasant surprises. This area is so complex and detailed that even if you read all the literature on the subject, some important detail may still be lost.

The shareholder agreement may include, but is not limited to, the following: classes of shares, shareholder guarantees, shareholder commitments for future funding rounds, shareholder commitment, shareholder rights in future funding rounds, administrative practices and prerogatives, informational rights, transfer rights, vesting conditions, investor protection clauses and a ban on recruitment.

Often, professional investors seek to protect their investments through various contractual mechanisms. Typically, a company is divided into common stock and preferred stock. Investors usually buy the latter for the amount of money they invest. It is then possible for the holders of the preferred stock to define different hedging rights.

The most commonly seen hedging rights in startup shareholder agreements are clauses called tag-along, drag-along, anti-dilution, and liquidation preference:

1) Tag-along

Tag-along means that if a majority of shareholders decide to sell a business, the minority is entitled to participate in the transaction for the same amount. For example, if the original founders own 51% of the firm and decide to sell their stake, other shareholders may participate in the transaction with their own shares.

2) Drag-along

Drag-along means that if a majority of shareholders decide to sell their shares, minority shareholders must sell their shares. The purpose of these clauses is for protection a situation in which a majority believe it’s possible to make a “good enough” exit, but where some minority shareholders disagree.

3) Anti-dilution

Anti-dilution is a hedging mechanism designed to protect investors' equity holdings in a situation where the company has to raise its share capital with lower valuation. If, for example, a company has raised €10 million with a €50 million post-money valuation, a total of 20% of the company's shares have been transferred to investors: an investment of €10 million corresponds to 20% of the valuation determined for the company. If the company runs into trouble and now has to raise, for example, €5 million at a valuation of €25 million, the value of the previous investors' equity stake will be halved to €5 million. In this situation, the anti-dilution clause protects investors so that they receive the same amount of new shares at the same amount as the company decreases. In this case, investors' ownership would then rise to 40% after the new round without additional capital being invested.

This mechanism can be seen as disadvantageous for the startup entrepreneur. On the other hand, it only matters when things start to go wrong, and then there are usually bigger worries to contemplate than getting a big slice away from an exit. After all, 51% of €0 is as much as 10% of €0 – but if the startup eventually takes off, the monetary value of a 10% stake may eventually be astronomical (for example, at the time of Rovio's IPO, a 10% holding would ultimately have brought in a capital gain of nearly €100 million).

4) Liquidation preference

This means that upon exit, an investor has a greater preference for the proceeds from the sale of shares than for a normal shareholding. By doing so, the investor seeks to protect themselves in a situation where the selling price of the company is significantly lower than expected in the investment round. Depending on the agreed odds, the terms of the preference for the sale of shares may even lead to a situation where the founders receive nothing from the sale of the business themselves.

A “1x non-participating liquidation preference” is usually a fair option for all parties involved and is generally thought of as a way for an investor to protect their investment in a risky early-stage company. A 1x non-participating liquidation preference gives the rights to the 1x returns (the money that was initially invested) before other shareholders get anything if the sales price is less than the valuation with which the investor invested. If the sale price is higher, everyone gets their share stated in the cap table. Sometimes a participating liquidation preference is used and a 1x participating liquidation preference means that the investor is entitled to their 1x returns and then to a share of the rest of the liquidation proceeds.

seriesseed.fi (Finland), nvca.org/resources/model-legal-documents/ (Nordics) and startuptools.org (USA) have the relevant documents free to download on their websites.

A very important thing to remember is that the terms in the Shareholders’ Agreement don’t just affect the founders. If you’re an employee at a startup and a part of the employee stock option plan, it’s a good idea to familiarize yourself with the different terms in these agreements and what they mean in practice for you.

Vesting

The key parameter of the shareholder agreement is the gradual earning of shares, known as vesting. This means that the shareholding is typically staggered. It’s normal practice for the shares held by the founders of the company to vest over a period of four years, with for example the first 25% transferring to the entrepreneur’s control when they have worked for the company for one year and the remainder transferring on a quarterly basis.

Vesting may also take place on a monthly or annual basis, depending on what is agreed with the investors. The purpose of vesting is to commit the founders to the company, and if you leave the company before the end of the vesting period, you will lose the stake in the company that had not yet been transferred. For example, if after an investment round you own 30% of the firm you set up, but you decide to leave the firm after two years of employment, you will only have a 15% stake in the firm.

As discussed in Chapter 7, employees with stock option plans are also subject to vesting.

Startup millionaires

Startups often deal with quite significant amounts of money. It’s true that, especially when it comes to investing in startups with an institutional hedge fund, the amount can quickly add up to millions. And even if the invested capital is a few hundred thousand euros, the value of the firm can still be a seven-digit number. These millions can easily get to an entrepreneur’s head. Similarly, huge numbers occasionally lead to misleading headlines in the media.

Sometimes people imagine that by the time a startup completes a million-dollar financial round, startup entrepreneurs automatically become millionaires. However, this is not the case at all. The money invested in the startup will go entirely into the company's account and will be used for the company's operations: salary payments, outsourcing, office rent, marketing, overheads and the like. It’s quite typical for a startup entrepreneur who has finished a million-euro financing round to get a monthly salary of a few thousand euros from their company and live off of canned tuna in the hope that their product will one day become a big hit.

Another way in which the startup world gives birth to virtual millionaires is to value an entrepreneur's stake in the company. If an investor owns one percent of the shares of a €100 million listed company, the value of the assets is exactly one million. This is because an investor can sell his shares on the stock exchange at any time and set off their value for pure cash.

Determining the ownership of a private company is more complicated. In practice, selling a private business is done with a negotiated purchase price between the buyer and seller, which can be anything depending on how much the buyer is willing to pay and at what price the seller is willing to sell. Thus, shares in a private company do not have the same fixed and unambiguous value as a listed company. For a normal company, valuation is based on the firm's turnover, earnings, and other key figures.

A startups’ valuation, on the other hand, is quite arbitrary. Especially the earlier the stage the firm is in, the investor's opinion of the firm, the reputation of the team, and other factors for which it is virtually impossible to calculate monetary values for become more important. At a later stage, the investment may be based on fairly advanced financial calculations, but even so, startup valuations are very subjective due to their steep risk profile.

For example, while in theory an entrepreneur who owns 20% of a startup valued at €10 million has a €2 million stake, the value of the shares are virtually non-existent. Before a startup makes an exit, it is extremely unlikely that an entrepreneur will be able to dispose of any of their shares. Usually, the rights to sell startup shares are protected by various shareholder agreement mechanisms. Even if such hedging mechanisms had not been negotiated for the investment round, it is unlikely that there would be a buyer for the startup shares who would be willing to pay the price set by the investment round.

In fact, a startup entrepreneur's job rarely translates into financial success unless the company succeeds so well that it is sold to a larger company or listed on the stock market. In the startup world, there are few true startup millionaires.

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Kiuas is one of the leading startup accelerators in the Nordics, bringing early-stage startups together and providing them with the best support and tools to take their progress to the next level.

Maki.vc is an early stage venture capital firm dedicated to partnering with founders who never conform to category standards.

AVP is the entrepreneurship education program at Aalto University. Students in multidisciplinary teams do hands-on exercises and gain tools, ready to be used to construct a startup or to renovate an existing company. We teach students to build like an entrepreneur.

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