Big Red Car here. Lazy slow Sunday afternoon.
The Boss has been getting a lot of questions about a subject which has been hammered pretty flat — or so I thought, sayeth the Big Red Car.
So, once more into the fray, Old Sport.
Valuations
In the money raising game, an entrepreneur must establish some valuation of the enterprise BEFORE the new money comes into the company.
Just a word of caution — these “valuation” discussions have next to nothing to do with liquidation value, enterprise value or any other similar “real world” valuation parameter.
This term “pre-money valuation” has only to do with re-shuffling the equity after the injection of fresh capital.
Pre-money valuation is the agreed value of the company before the injection of new money. It is likely to be a negotiated fiction but one that follows some qualitative rules.
Pre-money valuation
For the sake of discussion let’s work with the following assumptions:
Jill and Jack have been bootstrapping their new startup and are now ready to approach some angel investors or other “professional” investors.
They have arbitrarily settled on a “pre-money” valuation of $4,000,000. They are comfortable with this valuation having taken a look at comparable market comps, researched some incubator and accelerator alumni valuations and visited informally with a couple of venture capitalists. So, $4,000,000 it is.
Initial cap table
Jill and Jack own 55% and 45% respectively. Jill owns 55%. Jack owns 45%. [Big Red Car is purposely making their relative ownership percentages different so you can see how that works.]
They also have decided to reserve an option pool of 10% for future key employees. This is a percentage of the entire company’s ownership reserved for future employees. Jill and Jack own the balance — 90% — in accordance with their respective ownership percentages. [Stay sharp, the Big Red Car is trying to trick you here. The option pool dilutes the absolute ownership of both Jill and Jack. Hell, you figured that out already, right?]
The Articles of Incorporation and the ByLaws provide for the issuance of 1,000,000 shares of common stock.
If the pre-money valuation is $4,000,000 and the number of shares is 1,000,000 then each share is worth $4/share ($4,000,000/1,000,000 = $4/share).
The initial fully diluted — “fully diluted” is a fancy term meaning the options are assumed to be in the money and exercisable, the worst case scenario for Jill and Jack — cap table looks like this. [It is always easier if you work the problem using the number of shares rather than the relative percentages. Use both to ensure that you have checked and footed your work. Either approach arrives at the same conclusion and each is a check on the other.]
You can check your work by comparing the following: the option pool is 10% of the total shares, Jill owns 55% of the remaining shares, Jack owns 45% of the remaining shares. All is in balance.
New money
An investor contemplates investing $1,000,000 in the company. They have agreed to a $4,000,000 pre-money valuation. Therefore they are looking for an ownership interest equal to 20%. Let’s see how that is derived.
That 20% is derived as follows:
1. Pre-money valuation is $4,000,000.
2. New money is $1,000,000.
3. Post-money valuation is $5,000,000 ($4,000,000 + $1,000,000 = $5,000,000). [This is just the pre-money valuation with $1,000,000 cash on hand, right?]
4. $1,000,000/$5,000,000 = 20%
This is pretty straightforward, right, Grasshopper?
Another way to look at it is the following:
1. Pre-money valuation is $4,000,000.
2. Value per share is $4/share ($4,000,000/1,000,000 shares = $4/share).
3. New money is $1,000,000.
4. New money is $1,000,000 at $4/share equals 250,000 shares.
5. Total shares outstanding is now 1,250,000 shares. [Pro tip: Modify the Articles of Incorporation and ByLaws to provide for total shares of 1,250,000.]
6. Post money valuation is $5,000,000 (1,250,000 shares x $4/share = $5,000,000).
You notice we have not discussed the option pool at all. The option pool has a fixed number of shares. That is why it useful to focus on the shares as the basis for the arithmetic.
Pragmatically, what you will actually be issuing is share certificates, so the focus on the shares makes sense, no?
The entire transaction
The entire transaction looks like this:
In this manner, the issue of the option pool has flowed smoothly through the calculations because you have focused it on a finite number of shares. It started out and ended with 100,000 shares. What changed was the total number of shares outstanding — started with 1,000,000 and ended up with 1,250,000. The filly diluted ownership percentage for the option pool decreased from 10% to 8% — a 20% dilution exactly the amount of ownership received by the new money investor.
Details
First, remember that what you are ultimately issuing to the investors is shares. So the focus on shares makes a lot of sense and makes it all very easy.
Second, if the option pool is not awarded in its entirety, then it typically reverts to the founders. Make damn sure that is what your investment or shareholder’s agreement says. Don’t leave it to chance.
Third, if in the future you should want to increase the size of the option pool it is perfectly fair to expect the new investors to share in that dilution. Again, something that should be reflected in the shareholder’s agreement. This is negotiable and don’t expect the investors to be thrilled about it but it is not an unfair expectation and will likely require their approval as Boardmembers.
In viewing the transaction with this dual approach of both percentage and shares, it is easy to understand and make the math work.
If you have any question, contact The Boss.
But, hey, what the Hell do I really know anyway? I’m just a Big Red Car.
