Venture Capital & Term Sheets
The textbook math behind how venture capitalists value startups, size ownership, and structure preferred stock.
The big idea
Metrick and Yasuda's textbook explains venture capital as a finance discipline. VCs value a startup by estimating what it could be worth at exit and discounting that back at a high target return, then adjust for the dilution later rounds will cause. They invest through preferred stock whose features, such as liquidation preferences and participation, change who receives what at different exit values. The book also covers how venture funds themselves are structured and paid, so founders can see the incentives on the other side of the table.
Key takeaways
The VC method starts with a plausible exit value and a holding period, then discounts at the investor's target return, often far above public-market returns because many startups fail. The result is the post-money valuation that makes the deal worth doing for that investor. Every input is a guess, so test a range.
Post-money valuation is the pre-money valuation plus new cash. The investor's ownership is the investment divided by the post-money. Confusing the two is a common source of misunderstanding in negotiations, so always state which one you mean. A single sentence of clarity can prevent a costly misunderstanding later.
Later rounds shrink everyone's stake. The book uses a retention ratio, the share of today's ownership expected to survive to exit, to work out how much an investor must own now to hit its target at exit. Founders should run the same calculation for their own stake.
Venture investors buy preferred stock. A liquidation preference returns their money before common holders are paid; participating preferred also shares in the remainder. Two offers at the same valuation can pay founders very differently in a modest exit. Model several exit values before you compare offers.
A distinctive tool in the book is mapping how much each class of stock receives at every possible exit value. These exit diagrams make preferred stock look like a combination of options, and the authors use option-pricing ideas to value it. Founders do not need the formulas, but drawing the diagram reveals hidden costs.
VCs invest in rounds tied to milestones, which works like an option to abandon a company if progress stalls. It limits their losses and forces founders to show value before receiving more money. Founders should raise enough to reach the next value-raising milestone with a buffer.
The framework
Project a plausible company value at exit and the years to get there.
Divide exit value by (1 + target return) raised to the number of years.
Divide the investment by that discounted value to get ownership at exit.
Divide by the expected retention ratio to get ownership needed today.
Draw the payout at several exit values, including preferences and participation.
Apply it this week
Read next
An investor's-eye view of how venture funds work, so you can read a term sheet and pick partners with open eyes.
A compact, line-by-line guide to venture term sheet clauses and the valuation math behind them.
How venture funds raise money, pick deals, get paid and exit, so founders can understand what drives an investor's yes or no.
This page is an original summary and commentary prepared by XRAYCLOUD.AI with AI assistance. It is not affiliated with or endorsed by the author or publisher, and it is no substitute for the book — read it for the full argument.