The Interplay of Valuation, Ownership, and Dilution
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Pre-Money and Post-Money Valuation
Valuation is how much a company is worth; valuation and value may be used interchangeably, or valuation may refer to the process of determining a company’s value. A public company’s value is expressed by how much people are willing to pay for the shares on the stock market. For a private company, the company’s value is determined in negotiations between the founders raising money and the investors.
You may have heard of 409A valuations for startups.
The common stock in a private company can be valued through a formal process called a 409A valuation. 409A valuations are done for purposes of granting compensatory equity (typically stock options); they have little or no bearing on how much angels or VCs are going to pay for preferred stock in a company.
The pre-money valuation is the agreed upon value of the company immediately prior to the investment. The pre-money valuation is the single most important factor, but not the only factor, in determining how much of the company you will own when you invest a specific amount of money.
We will get into the mechanics of determining your ownership below. But first, how does this pre-money valuation get determined?
If a CEO is pitching their startup to accredited investors, they will have a slide near the end that describes their proposed financing, i.e. how much money they are planning to raise, and the pre-money valuation, in the case of a priced round. (In a convertible round, it would be the valuation cap and discount.) In a typical Series Seed preferred stock financing, a CEO may be looking to raise $1M with a pre-money valuation of $3M. That is the starting point for negotiation of the term sheet. If due diligence uncovers some issues, there will be pressure to bring the pre-money valuation down.
There are no hard and fast rules about how to calculate the pre-money valuation of a startup. A savvy CEO will understand how comparable startups have been valued. Seasoned investors will have an intuitive sense of a reasonable valuation based on other deals they have seen and the particulars of the company. Their assessment will depend on a range of factors, including:
Strength of the team. A CEO with prior successful startup exits can command a higher pre-money valuation.
Traction in the market. This can include number of customers, amount of revenue, and lead over the competition.
Assets. This can include intellectual property like granted patents and trademarks.
Stage of the product. Is it a beta product, a prototype, a fully functional product live in the marketplace with clear advantages?
Barriers to competition. Does the company have exclusive distribution relationships, key partnerships, or other assets that will make it hard for followers to compete?
Macro funding environment. Seasoned investors who have seen several cycles of pre-money valuations going up and then down across the board may be able to set appropriate valuations with more confidence.
Negotiating skill of the CEO and interest in the deal. If the CEO is a great salesperson and negotiator, they may be able to get a stronger pre-money valuation absent strength in many of the factors above.
The earlier the stage of the company, the harder it may be to come up with a pre-money valuation that entrepreneurs and investors can agree on. That is part of the appeal of non-priced investment vehicles like convertible notes and convertible equity—they essentially delay the need to determine a specific pre-money valuation.
founder The entrepreneur would like to see as high a valuation as possible, because it means they have to give up less of the company to raise a certain amount of money—as our fictional company story will make clear. Savvy entrepreneurs will understand that the higher the valuation, the harder it will be to generate investor interest, and they will do some benchmarking by looking at other deals of comparable companies. If the entrepreneur asks for too high a pre-money valuation in the opinion of investors, and is not willing to negotiate, investors will walk away.
In short, you will see a big range of valuations proposed by entrepreneurs, and after a while, you will start to get a sense of “fair” pre-money valuations.
The post-money valuation is the value of a company immediately following the investment. For example, if the pre-money was $3M, and the investment was $1M, then the post-money valuation would be $4M.
In this example, the investors and entrepreneurs came to an agreement that the company was worth $3M before the investment; immediately after the investment it is still worth $3M as a going concern, but now it has an additional $1M in the bank. Hence the post-money valuation of $4M.
In the simplest scenario, if the investors have paid $1M for the equity of a company that is now worth $4M, they should own 25% of the company, and that would be reflected in the capitalization table of the company in the relative share counts. We will discuss the divergence from the simplest scenario in detail below, including how the percentage of ownership for everyone immediately post financing is impacted by the topping up of the stock option pool.
Calculating Ownership and Dilution
founder It is useful for both entrepreneurs and investors to understand the mechanics of dilution, how dilution and ownership are calculated, and how the cap table will be impacted by investment.
Dilution is the decrease in ownership percentage of a company that occurs when the company issues additional stock, typically for one of the following reasons: to issue to a co-founder who came on after incorporation, to sell to investors, or to add to its stock option pool.
When a company is formed, the certificate or articles of incorporation states the total number of shares the company is authorized to issue, called authorized shares. If the company decides it needs more shares at some point, it will need to amend its certificate or articles of incorporation, and that typically requires approval of a majority of stockholders. Authorized shares can include common stock and preferred stock.
Issued and outstanding shares are the shares that have been issued to founders, employees, advisors, directors, or investors. Issued and outstanding shares do not include stock options that have been reserved in the option pool. Ownership percentage calculated on an issued and outstanding basis is determined by dividing the number of shares owned by an individual or entity by the total issued and outstanding securities.
Fully diluted shares take into account all issued and outstanding shares on an as-converted to common stock basis, assuming the conversion or exercise of all convertible securities, such as options, warrants, and convertible preferred stock. Sometimes fully diluted shares take into account not just issued options but the entire stock option pool share reserve. Investors prefer that the price per share be determined on a fully diluted basis because increasing the number of shares in the denominator in the formula above reduces the price per share.
Considering that a stock option pool can represent 15% or 20% of the shares of a company, the ownership difference resulting from the two definitions can be substantial.
If you are calculating dilution based on the number of issued and outstanding securities, then each time part of the stock option pool is allocated to an employee in the form of a stock option grant, your ownership percentage goes down slightly, since there are now more issued and outstanding securities (the additional stock options). If you are calculating dilution on a fully diluted ownership percentage (or simply put, a fully diluted basis), counting the entire option pool, then your ownership percentage doesn’t change, since all of the stock options, either allocated to employees or not, were already in the denominator.
When a company hires an employee and gives them stock options as part of their compensation, they usually issue the options out of the company’s stock option plan (not the company’s authorized but unissued shares).
In this section we will begin our example of a fictional company to explain some more key concepts, and illustrate how valuation and dilution effect ownership as represented in the cap table, starting with the initial company setup.
exampleJoe and Pete started a software company, Pext, Inc., which is developing an app to help pets send and receive texts. They retained a well-known startup lawyer who incorporated their company in Delaware and helped them assemble and execute all of the correct documents with respect to the formation and organization of the company. The corporation was initially authorized under its charter to issue a total of 30M shares, 25M shares of common stock and 5M shares of preferred stock. Thus, the company had a total of 30M authorized shares.
The Stock Option Pool
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