This post is the second in a series giving practical advice to startups on understanding and negotiating a venture capital term sheet.
Previously, we provided a general overview of venture capital terms sheets and some of the pitfalls a startup may encounter when it comes to “binding” vs. “non-binding” provisions. In this post, we will discuss the issue that is usually at the forefront of most founders’ minds: the valuation of the company.
Valuation in the context of a venture capital transaction can be expressed in terms of pre-money valuation or post-money valuation. Pre-money valuation refers to the valuation of the company prior to the investment whereas post-money valuation refers to the value after an investment has been made. Most founders, when they think of the concept of valuation are referring to pre-money valuation. Calculating pre-money valuation is not intuitive or straightforward. When most people talk about a venture capital investment, usually the investor will say “I’ll give you $1.2 million for 10% of the company.” What is the implied pre-money valuation in this example? You might think the answer is $12 million, but that is actually the post-money valuation, not the pre-money valuation. To get the pre-money valuation, you need to first calculate post-money valuation and then back into the pre-money valuation.
The post-money valuation of a company is pretty straightforward to calculate. You take the dollar amount of the investment and divide it by the percent that the investor is getting. In our example above $1.2 million is divided by 10% yielding a post-money valuation of $12 million. But prior to the $1.2 million investment, the company is not worth $12 million. This is because once you add $1.2 million worth of cash to the company’s balance sheet the company has just increased in value by $1.2 million. Therefore to calculate pre-money valuation you need to take a second step which is to subtract the amount of investment from the post-money valuation. In the example above, the company is being valued at $10.8 million. This is calculated by taking the $12 million post-money valuation and subtracting the amount of the investment ($1.2 million).
Once we calculate the valuation, we need to figure out how many shares the investor gets for its investment and this is determined using a capitalization table. This also is not always as straightforward as you might think, because there may be holders of options or warrants in the company and there may be an employee stock pool as well. So if the founders have 4.5 million shares of the company they might think that giving the investor 10% in the company involves selling the investor 500,000 shares. But venture capital firms often consider more than just the shares issued to founders and previous investors. They will often also include, in the capitalization table, the employee stock pool and any outstanding warrants. This is what is referred to as the fully-diluted post-money capitalization. In our sample capitalization table below, you can see that the company must issue more than 500,000 shares to give our potential venture capital investor 10% of the Company.
Pre and Post-Financing Capitalization
|
Pre-Financing |
Post-Financing | |||
| Security |
# of Shares |
% |
# of Shares |
% |
| Common – Founders |
4,500,000 |
83.33% |
4,500,000 |
75% |
| Common – Employee Stock Pool | ||||
| Issued |
0 |
0% |
0 |
0% |
| Unissued |
900,000 |
16.66% |
900,000 |
15% |
| Common – Warrants |
0 |
0% |
0 |
0% |
| Series A Preferred |
0 |
0% |
600,000 |
10% |
| Total |
5,400,000 |
100% |
6,000,000 |
100% |
Because even the unissued employee stock is considered in the fully diluted post-money capitalization, in order to give the investor 10% of the company, 600,000 shares must be issued.
The final issue we’ll tackle in this post is the per-share price. Calculating this is relatively straightforward. Once you know how many shares the company will be issuing to the investor, just divide the amount of the investment by the number of shares issued. In the example above, the share price would be $2 per share calculated by dividing the investment amount ($1.2 million) by the number of shares issued (600,000).
While valuation and share price may be the most basic and fundamental items on the term sheet, they are not always as straightforward as you might think. Aspects such as outstanding warrants and employee stock pools affect the pricing of the deal when the valuation is calculated on a fully diluted basis. Having a full understanding of how these concepts work together will help you understand the economics of the deal being proposed.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
