Demystifying Term Sheets: Part 1 - The Foundation & Valuation

Demystifying Term Sheets: Part 1 - The Foundation & Valuation

Negotiating a term sheet can feel like walking a tightrope, a delicate balance between ambition and protection for both entrepreneurs and investors. Every line of a term sheet carries weight, telling a story about the future of a business. Drawing from years of experience in the VC play, we are pulling back the curtain to highlight what really matters in a term sheet, how both sides should approach it, and the lessons we have learned (sometimes the hard way) to avoid common pitfalls.

In the spirit of transparency, we are sharing a copy of our full term sheet template here.

This article is meant to serve as a guide to navigating term sheet negotiations, highlighting the most critical clauses, and sharing tips for both entrepreneurs and investors. Our term sheet reflects how we do things differently. When our founders Gonzalo Martínez de Azagra and Igor de la Sota set up the fund, they did not just replicate existing VC practices, they built something that truly represents Cardumen Capital’s values.

That said, this guide is not set in stone; it is a living document that evolves as the market changes. But before diving into the details, here is an important starting point: a term sheet is not a promise to invest, in other words, it is not a legally binding document. Even when signed, it is not a guarantee of funding. Instead, it should be seen more as an agreement to keep negotiations private and, in some cases, to pause the company from exploring other offers for a certain period of time.

Now, let us get down to business. While every term sheet is unique, just like every investment offer, there are certain key terms that almost always come up in negotiations. Keep reading to learn what these are and why they matter.

Valuation and Price:

The valuation agreed upon by founders and VC investors directly impacts how much of the company a founder will sell; thereby determining the level of dilution incurred during the financing round. The valuation will also set the price per share (PPS) at which a company’s stock is offered.

How Valuation is Determined

Pre-money valuation: The value investors assign to a company before any new capital is invested during a funding round. The way this value is determined varies depending on the company’s stage. For early-stage startups, the pre-money valuation is typically the result of negotiations between the founder(s) and the lead investor. This process considers factors such as market benchmarks for comparable companies, the company’s growth trajectory, the strength of the founding team, any signs of early traction, among others. In contrast, for more mature companies, the valuation is often derived from financial models that estimate a range of values, with a specific figure chosen based on strategic considerations and market conditions. Widely speaking, this valuation is pretty speculative.

Price per Share (PPS): A company’s agreed-upon pre-money valuation is a key factor in determining the price per share an investor pays. Essentially, a company is divided into shares, and when an investor acquires a portion, they purchase these shares at a defined price.

The PPS is calculated using two key inputs: the pre-money valuation and the fully diluted capitalization table, which includes all outstanding stock and any authorised shares that could be issued in the future, such as those in an employee option pool (discussed below). This ensures a comprehensive view of the company’s share structure.

Pre-money valuation / fully diluted capitalization table = PPS

Post-money valuation: Accounts for the capital raised in the current round and it is simply calculated by adding the pre-money valuation to the invested capital. The post-money valuation gives investors a view of their ownership percentage in the company, based on their investment.

Pre-money valuation + Round size = Post-money valuation

Invested amount (Investor ticket) / Post-money valuation = Investor % ownership

Industry Best Practices

Pre-money valuations tend to be more common, as they provide investors clarity on the PPS at the time of investment and exact round sizes often fluctuate due to investors adjusting their final allocations.

Key Takeaways

Cardumen Insight:

Regarding valuations, especially at early stages, we would encourage entrepreneurs to remain flexible and engage in open discussions with potential investors to find a mutually beneficial approach. At Cardumen, we invest in people as much as businesses. The founding team’s experience, expertise, and track record are critical factors for us. We place significant emphasis on assessing the team’s ability to execute their business plan, and tackle challenges effectively. Additionally, and not exclusively, we would also evaluate the market opportunity, the stage of product development, and the distinctiveness of the product offering.