VALUATION

409a valuationA formal report that tells you the fair market value of your company’s common stock prepared in compliance to recommended guidelines issued by regulatory bodies.FURTHER READING

409a valuationA formal report that tells you the fair market value of your company’s common stock prepared in compliance to recommended guidelines issued by regulatory bodies.


83(b) electionA form that tells the IRS that you will be taxed on the value of granted shares today rather than recognizing income on their value as of the date that they vest.


acceleratorA type of business incubator that typically accepts startup teams into a three-month program and may provide capital, basic living expenses, office space and mentorship, often in exchange for equity in the startup.


accountingThe process of contextualizing each transaction in order to present an accurate picture of the company’s financial performance. Accountants go beyond recording a transaction; they interpret how each transaction impacts the financial status of the business.


acqui-hireOne company’s acquisition of another for the primary purpose of hiring its employees, rather than for the intrinsic value of the business itself.


acquisitionA process where a company acquires the controlling interest (more than 50%) of another company.


advisorAn individual providing guidance, connections, advice and support to the entrepreneur, often in return for a small equity stake.


Amazon Web Services (AWS)A service that allows startups to cheaply rent server space and development tools in the cloud and scale up as needed rather than purchasing their own expensive servers.


angel groupA formal or information organization of individual accredited investors who pool their deal flow, resources, expertise and capital in order to make angel investments.


angel investorAn accredited investor who invests his or her personal capital in early stage, potentially high-growth companies.


angel roundA round of investment into a startup company from angel investors not previously affiliated with the founder. Typically the first money invested in a company after the founder’s own money and the founder’s friends and family.


annual recurring revenue (ARR)The subscription-based revenue which software-as-a-service or platform-as-a-service (SaaS/PaaS)-based companies receive each year; also known as the run rate.


Articles of Incorporation (or Certificate of Incorporation)Documents filed with the state’s Secretary of State or Registrar which acts as a charter to document the establishment and existence of a corporation—typically including the business’s name, address, a statement of business purpose, and details related to the types of stock the corporation is entitled to issue.


authorized sharesThe maximum number of shares that a company can issue, as decided by its Board of Directors. For a Delaware C-Corporation, any increases or decreases to this number require amending and restating the Certificate of Incorporation in Delaware. Gust Launch starts each company with 10 million authorized shares—a very common number to begin with.


balance sheetA condensed financial statement showing the nature and total value of a company’s assets, liabilities, and capital on a given date.


BHAGBig Hairy Audacious Goal, the giant sweeping vision of a startup founder to change the world.


Board of DirectorsA group of people elected by a company’s shareholders (often according to the terms of a negotiated shareholders’ agreement) that makes decisions on major company issues, including hiring/firing the CEO.


bookkeepingThe process of recording all of the company’s transactions in a set of books, also known as a ledger. Entries are recorded in accounting software, which will compile reports based on how bookkeepers tag such entries.


bootstrappingFunding a company without external help or capital and reinvesting initial profits.


bridge loanA temporary investment instrument used to cover a company’s operating expenses until a future financing.


business-to-business (B2B)When one business engages in commercial interactions with other businesses (one business is the supplier and the other businesses are the customers).


business-to-consumer (B2C)When a business engages in commercial interactions directly with consumers (the consumer is the end-use customer of the product or services provided).


burn rateThe monthly negative cash flow from a startup.


business model canvasA strategic management template for developing or documenting business models through a visual chart with elements describing a firm’s value proposition, infrastructure, customers and finances.


business plan competitionA program to encourage entrepreneurs to develop plans for new businesses, and sometimes a showcase competition for existing startups seeking financing.


buyoutThe purchase of a company or a controlling interest of a corporation’s shares, product line or business. A leveraged buyout is an acquisition accomplished with borrowed money or by issuing more stock.


cap (on a convertible note)The maximum company valuation at which a convertible note will convert into a company’s stock.


cap table (capitalization table)A record of all securities and their shareholders commonly displayed in a fully diluted view.


cash flow statementReconciles the beginning cash balance to the ending cash balance by illustrating the sources and uses of cash from operations, investing, and financing activities.


common stockA US term for a form of equity ownership of a company, equivalent to the terms “voting share” or “ordinary share” used in other parts of the world. In a liquidity event or a bankruptcy, common stockholders receive all of the net value of a company after paying the fixed amounts due to bondholders, creditors and preferred stockholders. Common stock usually carries with it the right to vote on certain matters, such as electing the board of directors.


convertible noteA type of loan (also known as convertible debt) which provides that the amount of money loaned may (or must, under certain conditions) be converted by the investor into shares of stock in the company at a particular price.


convertible preferred stockPreferred stock in a company that is convertible at the option of the holder into common stock at a predetermined valuation. This provides the priority and security of holding preferred stock, as well as the potential value appreciation of common stock.


corporate ventureAn investment from one corporation in another, typically at an early stage for strategic reasons.


crowdfundingA joint effort by many individuals to support a cause, project or company. Donation-based crowdfunding bears no expectation of returns. In reward-based crowdfunding, contributors are promised rewards (such as the ability to purchase a product) in exchange for their contributions. Equity-based crowdfunding gives funders the ability to purchase equity interests in a company.


customer lifetime value (CLTV or LTV)A forecast of the total net profit related to the entire lifetime of a specific customer relationship.


DBA RegistrationAllows you to conduct business in a name other than your own (or your company’s) legal name, and allows others to identify the person or entity behind the business name you’ve registered.


deal leadThe investor or investment organization taking primary responsibility for organizing an investment round in a company. The deal lead typically finds the company, negotiates the terms of the investment, invests the largest amount and serves as the primary liaison between the company and the other investors.


debtBorrowed money that needs to be paid back. The entrepreneur rents the money for a specific period of time and promises to pay interest on the money for as long as the loan is outstanding.


demo dayA public pitch event or “graduation” day for a group of startups in an accelerator or other program at which each company has 5–15 minutes to present its investment opportunity to potential investors in attendance.


dilutionWhen a company sells additional shares of stock, thereby decreasing the percentage ownership of existing shareholders. Note that if the valuation of the new sale is at a high enough level, the value of stock held by existing investors may increase, even though the percentage ownership may decrease.


discounted convertible noteA loan that converts into the same equity security being purchased in a future investment round, but at a discounted price representing a risk premium for the early investment.


due diligenceThe process of investigation whereby both an investor and an entrepreneur have the opportunity to analyze and assess each other for the potential of an investment opportunity and partnership.


duty of careA fiduciary duty of a board of directors that obligates board members to reasonably avail themselves of all material information before making a business decision.


duty of loyaltyA fiduciary duty of a board of directors that requires a director to put the interests of the stockholders ahead of their own individual interests.


EBITDA“Earnings Before Interest, Taxes, Depreciation, and Amortization.” By not including interest, taxes, depreciation, and amortization, you can clearly see the company’s cash flow.


Employer Identification Number (EIN)A unique, 9-digit identification number utilized by the Internal Revenue Service, (IRS) and assigned to business entities to identify employers as part of the tax reporting process. In order to obtain an EIN, business entities must file or apply to the IRS.

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entrepreneurA person who organizes and operates a business or businesses, taking on greater than normal financial risks to do so. Entrepreneurs are the founders of startups, and are the people angel investors support.


equityA corporation is divided into shares, which represent a slice of both the company itself and the value the company creates. These shares, once distributed, represent the company ownership (a word commonly interchanged with equity).

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equity seed roundWhen an entrepreneur first sells a part of his or her business— and therefore a proportional part of the good things (like profits) and the not-so-good things (like losses)—to an investor. Equity investments, unlike loans, do not need to be paid back.


exitWhen a company is either acquired for cash, sold during a public offering, or abandoned as a failed venture.


founders stock (or founder’s equity)The common stock owned by one or more of a company’s founders, typically received when the company was incorporated.

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franchise taxA yearly tax for conducting business as a separate legal “person” from its owners.


friends & family roundAn investment in a company that often follows the founder’s own investment, from people who are investing primarily because of their relationship with the founder rather than their knowledge of the business.


fully diluted sharesAll stock (common and preferred) and issued options (or warrants) as if converted to common stock. This is less relevant in the early days, but it’s a representation that investors care about as it most accurately reflects preferences, rights, and decisions made during a liquidity event (e.g. an acquisition or IPO).


funding platformAny online website used to facilitate investments in private companies. As a defined term, a specific type of platform defined by the JOBS Act of 2012 that will allow non-accredited investors to invest in private offerings.


grantMoney provided by a government agency or other organization that does not need to be repaid and does not purchase equity.


GustThe global SaaS platform for founding, operating, and investing in scalable, high growth companies. Gust’s online tools support corporate legal and financial formation and operation for entrepreneurs, as well as deal flow and relationship management for investors, from startup through exit.

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incubatorA program or shared office center designed to support the successful development of companies by offering cost effective resources and support.


independent contractorA specific classification of worker that is not an employee of the company. Usually distinguished by 1) whether the business has a right to direct and control how the worker does the task for which the worker is hired, 2) whether the company has a right to control the business aspects of the worker’s job, and 3) what kind of relationship the worker has to the business.


intellectual property (IP)An intangible asset of value. The protections of IP—trademarks, copyrights and patents—determine if you can prevent other people from copying these creations, and whether or not you yourself can use them freely.


initial public offering (IPO)The first public sale of the stock of a formerly privately held company. After a lockup period, investors are typically able to sell their shares on the public stock market, as they are no longer illiquid.


investment roundA set of one or more investments made in a particular company, by one or more investors on essentially similar terms at essentially the same time.


issued sharesThe total number of shares that have been granted by the company and purchased by a shareholder. These are also commonly referred to as issued and outstanding shares.

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Form K-1A tax document that explains to the IRS the attributed income received by partners in a partnership. As hybrid of a partnership and a C-Corp, LLCs demand that all “partners” file K-1s annually.


lead investorSee deal lead.


liquidation waterfallThe sequence in which all parties, including investors, employees, creditors and others, receive payouts in the event of a company’s liquidation through acquisition or bankruptcy.


liquidity eventWhen investors have the ability to convert some or all of their equity interest in a company into cash. Typically as the consequence of an acquisition, this can also happen if a company is very successful and new investors are willing to buy out the interest of early investors.


lock upA period of time (typically after an IPO or an acquisition of a startup by a public company) during which certain shareholders are not allowed to sell their stock. Often 90 or 180 days, but could be a year.


Main Street businessA colloquial term used to describe traditional small, local retail and service companies. They typically serve local markets, provide jobs and benefit the local economy, but are usually not high-growth industries or eventual targets for investment or acquisition by larger companies.


major investorAs used in investment term sheets, any investor who puts in more than a defined amount into a given round, and is therefore entitled to specific information and/or voting rights.


micro-VCThe correct term for organizations often referred to as “super angels.” Structured similarly to a traditional venture fund, a Micro-VC is typically much smaller in size, with fewer partners, and invests less money but at an earlier stage.


non-disclosure agreement (NDA)A legally binding arrangement between two parties where one or both parties will classify confidential information and prohibit the other party from disclosing shared information.


optionsA different way of distributing ownership-options are the right to buy shares based on a set of conditions. When an option is “exercised,” the option to buy stock is used and the result is issued shares. They’re typically used as part of a compensation package in the form of an incentive to employees, directors, advisors, and other people key to the company’s success.


option poolAn allocation of shares reserved to be granted as options via a company’s equity incentive plan (or stock option plan). You can also issue other derivatives from this reserved pool (e.g. warrants, RSAs, RSUs, etc).


patentAn exclusive right, granted by the federal government, conferring the rights to exclude others from making, using, or selling an invention, design, or process for a fixed amount of time.


pay-to-playA term in VC financings that requires investors to participate in future down-valuation financings of the company, or else suffer punitive consequences (such as getting their preferred stock converted into common stock). One reason why investors keep some dry powder on hand.


peer-to-peer lending (P2P lending)A type of online financing solution through which individuals lend money to other individuals or small businesses.


pitchA presentation, typically supported by slides, in which a startup company’s founder describes his or her company and seeks an investment from angels or venture capitalists.


portfolioA collection of companies invested in by an angel or VC.


post-money valuationThe value of a company immediately after it has received an equity investment, including both the company’s pre-money valuation and the amount it received from the investment.


pre-money valuationThe value of a company immediately prior to receiving an investment, used to determine what percentage of a company’s ownership will be purchased in exchange for a specified investment amount.


preferred stockA type of equity ownership of a company that has both a fixed value and priority in liquidation sequence.


private companiesCompanies that are not publicly traded on the stock market.


public companiesCompanies that are freely traded on the public stock exchanges such as NASDAQ and the New York Stock Exchange.


QSBS exemptionThe Qualified Small Business Stock exemption allows a C-Corp’s stockholders to—under specific circumstances—write off 100% of personal taxes up to $10,000,000 after five years of ownership.


QuoraA leading question-and-answer website where questions are answered by industry experts in entrepreneurship, investing, and other fields.


representations and warrantiesA list of material statements or facts included in the investment documentation to which the entrepreneur unequivocally commits.


return on investment (ROI)The amount of money or net benefit generated by an investment or spend.


runwayHow long a startup can survive before it goes broke; that is, the amount of cash in the bank divided by the burn rate.


SAFESimple Agreement for Future Equity, a new form of funding for early-stage companies developed by Y Combinator to solve a number of issues with traditional convertible note funding.


SBIRSmall Business Innovation Research grant program from the US government.


SECThe United States Securities and Exchange Commission, charged with regulating all sales of corporate securities.


seed fundA venture capital fund specializing in very early-stage startups.


seed roundWhen a number of investors provide capital to a new company with anywhere from $500,000 to $3 million. Investors are typically rewarded with convertible notes, equity, or a preferred stock option in exchange for their investment.


SendGridA customer communication platform for sending transactional and marketing email.

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serial entrepreneurAn entrepreneur who has previously founded and run one or more ventures.


Series AWhen a number of angel investors or VCs contribute typically $2-10 million in exchange for equity. The fund is named after the type of equity investors hope to receive: Series A preferred shares. This implies they will be the first group of investors to receive preferred shares.


Series A crunchA putative problem that occurs if more companies get early-stage funding from angels and seed funds than are eventually able to obtain later-stage funding from venture capital funds.


Series B, C, D…Investment rounds from venture capital funds subsequent to the first Series A round.


series seedUsed generically to refer to a company’s first equity round from serious seed or angel investors following its friends & family round but prior to a Series A.


shareholders’ agreementAn agreement signed during a financing transaction by all of a company’s shareholders in which they agree in advance to various provisions. These will typically include indicating which parties are entitled to designate members of the board of directors and thus control the company.


SimplexityA bookkeeping service with a long history of working alongside startups. The Gust Launch Financials package includes a subscription to Simplexity.


social proofAn investment approach leaning heavily on the identity of other well-known people who are supporting the company.


social ventureA company established to create societal benefit through entrepreneurial methods.


soft landingA face-saving acquisition of an unsuccessful startup, usually for little or no compensation.


strategic investorA corporate investor funding an early-stage company primarily for reasons related to the investing company’s interest.


success feeA percentage commission paid to an intermediary or other individual as an incentive on the closing of a large financing transaction.


sweat equityThe equity or ownership interest created in a startup by its founders as a result of their contributions in the form of hard work and toil.


term sheetA summary of the major terms of an investment round that is agreed upon by all parties prior to beginning extensive legal documentation for the round.


trademarkGrants a business the exclusive right to use the mark, words, symbols, or title in commerce.


unissued sharesThe total number of shares that are authorized to issue, but have not yet been issued to shareholders. Mathematically, this is the difference between authorized shares and issued shares.


Valley of DeathThe period between a startup’s initial funding and the end of its runway. If you get through here, you should be OK.


value propositionA statement a company uses to express why customers should purchase their product or service, including the ways it adds more value than that of alternative offerings.


venture capital fundAn investment fund that puts money behind high-growth companies.


venture debtA type of debt financing provided to venture-backed companies from specialized banks or non-bank lenders.


vestingA concept applicable to both stock and options, which prevents the recipient from owning all stock or options outright and instead earn them over time. For stock, vesting typically refers to stock that’s earned over time and, therefore, not re-purchasable by the company. For options, vesting indicates the number of options that become exercisable.


vulture capitalistA VC whose operating method is to deliberately take advantage of an entrepreneur’s troubles.


waterfallThe order in which investors (and everyone else) get their money out on an exit. Almost always this is “last in, first out.”

Valuations 101: The Venture Capital Method

We recently started a series of posts on establishing the pre-money valuation of pre-revenue startup companies for purposes of investment by seed and startup investors.

The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The concept is simply…since:

Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation

(in the case of one investment round, no subsequent investment and therefore no dilution)

Then: Post-money Valuation = Terminal Value ÷ Anticipated ROI

So, let’s address each of these:

Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; let’s assume 5–8 years after investment. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and, based on those revenues, estimating earnings in the year of the sale from industry-specific statistics. For example, a software company with revenues of $20 million in the harvest year might be expected to have after-tax earnings of 15%, or $3 million. Using available industry-specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of $45 million). It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of $40 million. OK…let’s split the difference. In this example, our Terminal Value is $42.5 million.

Anticipated ROI:

Assuming our software entrepreneurs needs $500,000 to achieve positive cash flow and will grow organically thereafter, here’s how we calculate the Pre-money Valuation of this transaction:

From above: Post-money Valuation = Terminal Value ÷ Anticipated ROI = $42.5 million ÷ 20X

Post-money Valuation = $ 2.125 million

Pre-money Valuation = Post-money Valuation – Investment = $2.125 – $0.5 million

Pre-money Valuation = $1.625 million

OK, but what if the investors anticipate the need for subsequent investment? I have seen some complex methods for accommodating anticipated dilution, but here is an easy way to adjust the pre-money valuation of the current round. Reduce the pre-money valuation (above) by the estimated level of dilution from later investors. If investors in this round anticipate eventually being diluted by half, the pre-money valuation for the current round would be about $800,000. If only 30% dilution is anticipated, reduce the pre-money valuation of this round by 30% to about $1.1 million.

Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies. The Venture Capital Method is often used as one such method