Valuation is irrelevant, pay attention to the terms

One of my friends who happens to be way more plugged into the start up scene than I am, has been telling me for months to ignore valuation, but focus on term sheets.

A public company’s valuation is based on a simple formula  # of shares * share price. Any owner of shares can get a return on his investment if the company pays a dividend or if the share value appreciates. Pretty simple. The price of the share is decided every day in the market based on public data. Price goes up, you make money, price goes down you lose money.

A privately held company’s valuation is determined as a result of the negotiation between the investors and the owners of the company.

Part of the negotiation is what happens when the company gets sold or gets liquidated.

And this is the important bit. Something I have been ignoring.

Consider a company X that recently got 116 million dollars at a 2.76 billion dollar valuation. If the company gets sold to another company for a 116 million dollars a naive engineer like myself would do the following math:

.116 / 2.76 = % of company owned = approximately 4%

investors get back 116 *.04 = 4 million dollars

Investors lose 112 million dollars.

Except they didn’t. They lost 0 dollars.

Because the Term Sheet basically said that the first 116 million dollars goes to the investors. And after that 116 million do other people get money.

This makes the investment feel risk free because folks are assuming that in the worst case the company will not be worth less than 116 million dollars. The upside may be limited because the company has to be worth more than 2.76 billion but the downside feels manageable.

The risk free nature of these investments may explain why investors are willing to pile onto a firm like Company X. With downside limited, and a possible massive upside who wouldn’t want to get into the action?