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Thursday, August 13, 2009

Venture Capital 101 for Startups - Valuation

from Samuel Wu





Understanding the valuation language: Pre-money vs. Post-money valuation

Before we can start any meaningful discussion regarding venture capital for startups, it is very important that every startup understand the language of valuation. What does the VC mean when he says that he is ready to make an investment based on a “pre-money valuation of $8 million” or a “post-money valuation of $10 million.” Or if the VC tells you that he will put in “$2 million based on a $8 million valuation, giving a $10 million post-money.”

Let’s define some of the terms:

    • Pre-money valuation is the valuation of the company prior to the investment.
    • Post-money valuation is the valuation of the company after the investment.

We will use the following example to demonstrate the principles discussed in this article:

COMPANY TechStartup, Inc., a Delaware corporation
VC Imagine Ventures
INVESTMENT AMOUNT $3 million to purchase 2 million shares of Series A Preferred Stock
PRE-MONEY VALUATION $4.5 million
CAPITALIZATION The company has a total of 3 million shares of Common Stock issued and outstanding held by the three founders (each founder owning 1 million shares).
OPTION PLAN The company has granted to its employees options to purchase a total of 1,500,000 shares of Common Stock. None of the options have been exercised by the employees. The total option pool is 3,000,000 shares.

In this example, the pre-money valuation is $4.5 million and the post-money valuation is $7.5 million (i.e. $4.5 million PLUS the investment amount of $3 million).

Per Share Price

The price per share of the Series A Preferred Stock that the venture capital investor is willing to pay is equal to the pre-money valuation of the company divided by the total number of shares outstanding.

Per share price of Series A Preferred Stock = pre-money valuation / total number of shares outstanding

For example, if TechStartup, Inc. has a pre-money valuation of $4.5 million and 3 million shares of common stock outstanding, the price per share of Series A will be $1.50 (i.e. $4.5 million divided by 3 million shares outstanding). However, in most deals, the total number of shares outstanding is said to be on a fully-diluted basis. Most of the time, this means that the total number of shares will include all outstanding common stock PLUS all outstanding options, warrants and other convertible securities (including any previously issued convertible preferred stock) as if fully exercised or converted into common stock. Therefore, if TechStartup, Inc. had issued options to its employees to purchase an aggregate of 1,500,000 shares of common stock, the total number of shares outstanding on a fully-diluted basis will be 3,000,000 plus 1,500,000, or 4,500,000 shares . Now, the per share price of the Series A is only $1.00.

By basing the per share price on the fully-diluted basis, the investors are making the existing common stockholders assume the diluting effect of the unexercised options. Sometimes, investors will also negotiate for the fully-diluted number to include unissued options and any increase in the size of the option pool in connection with the financing. Occasionally, venture capital investors will request that an option pool be increased to make sure there are enough shares to provide adequate incentives to the startup’s employees and management. This will dilute the existing common stockholder even more.

Dilution by Definition of Fully-Diluted Basis

As mentioned above, most venture capital financing deals will calculate the per share price on a fully-diluted basis. The definition of this basis must be set forth clearly from the outset. Does it only include issued and outstanding options, warrants and other convertible securities? Or, does it also include all unissued options? If the venture capital investors are requesting an increase in the option pool in connection with the financing, does the fully-diluted basis also include these shares?

The general rule is that the larger the basis (i.e. the number that is decided as the total outstanding shares), the less the investors will have to pay per share of Series A Preferred Stock and the greater the dilution to the existing stockholders. This is simply a function of the formula: per share price = pre-money valuation / total outstanding shares.

The principle behind the negotiation of the definition of what is the “fully-diluted basis” is deciding who will assume the effect of dilution. If the number of the securities in question are included in the fully-diluted number, the existing common stockholders will assume all of the diluting effect of those securities. If those securities are not included in the fully-diluted number, the existing common stockholders and the new investors will assume on a pro rata basis the diluting effect of those securities. The investors will argue for a larger fully-diluted basis (i.e. including the unissued options) so that the existing common stockholders will assume the diluting effect when those options are issued and exercised. The company will argue for a sharing of the diluting effect of the unissued options equally between the existing common stockholders and the new investors.

Below is a spreadsheet that I hope will make extra clear the impact of the definition of the fully-diluted basis on the dilution of post-money percentage ownership of the existing common stockholders. From Scenario 1 to Scenario 3, I want to highlight the fact that the nothing changes except for the definition of the fully-diluted basis – the valuation never changes – and the investors still go from owning 25% of TechStartup, Inc. to owning 40%.

I would be more than happy to send anyone the spreadsheet in Excel so that you can play with your own number if that would be helpful to you. Just send me an email at swu@innovationcaplaw.com

Sam Wu is a business, corporate and securities attorney and partner of Innovation Capital Law Group located in Irvine, California. Sam is also the founder and author of Technology Startup Law Blog (http://techstartuplawyer.com/) -- a down-to-earth legal resource for startups, emerging growth companies and venture capital firms covering issues relating to incorporation, venture capital financings, convertible bridge note financings, angel investors, mergers and acquisitions and other corporate and securities legal matters. To find out more about Innovation Capital Law Group please visit www.innovationcaplaw.com. You can reach Sam directly at swu@innovationcaplaw.com.


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