Startup/VC Investment Math

My own personal primer.

THE BASIC CASE OF EQUITY FINANCING

Pre-money valuation: $5M
Founder owns: 5,500,000 shares
Total shares: 10,000,000 shares

  1. Simple equity investment, e.g.
    Investment of: $2M
    = “Post-money” valuation: $7,000,000
    = Investor purchasing 28.57% of the company ($2M/$7M).

  2. Price per share = pre-money valuation / number of fully diluted shares, e.g. Price per share = $5M / 10,000,000 shares = $0.50

    Sanity check: investor’s $2,000,000 will buy at $0.50 per share for a total of 4,000,000 shares. 4,000,000 shares/14,000,000 shares = 28.57%.

  3. Founder's resultant ownership:
    Number of shares he owns / by the total number of shares (5,500,000 / 14,000,000) OR the percent before * the decrease of ownership (55% x (100%-28.57%))

EMPLOYEE STOCK OPTIONS

Pre-money valuation: $15
Investment: $5M
Pre-pool and pre-money shares: 10M

Without employee pool:
Price per share = pre-money valuation / number of fully diluted shares
Price per share = $15,000,000 / 10,000,000
Price per share = $1.50

  1. With employee pool, e.g. 10%
    The pre-money valuation takes this into account.
    Price per share = pre-money valuation (which doesn’t change) / number of fully diluted shares + option pool shares (which does change)

    Note: when an investor demands that the option pool is a certain size, it almost always means that the option pool size is that certain size after the financing is complete.

    Post-money = founder's equity + 10% of rest (employee pool) + investor's equity = founder's equity + 10% of rest (employee pool) + ($5M/$20M) of rest
    = 65% (original) + 10% employee pool + 25% investor
    = 65% [$13M] [Founders] + 10% [$2M] [Option Pool] + 25% [$5M] [Investors] = 100% [$20M] [Total]

    = Price per share, pre money is $1.30.

THE BASIC CASE OF CONVERTIBLE DEBT

Convertible debt converts into equity at a qualified financing.
Founders own: 1,000,000 shares = 100% of the company

  1. 1st Investment: Investor CD comes along and invests in the company with a convertible debt deal done: $100,000, 4% interest, qualified financing of $1M, valuation cap of $3M. 20% discount.

    Convertible debt does not affect the cap table/company ownership if and until the debt converts. Nothing changes.

  2. 2nd Investment: Investor Y comes along and invests $200,000 at a valuation of $800,000 (not a convertible debt deal.) What does the cap table look like?

    The convertible debt did not get triggered because the qualified financing of $1M was not reached.

    Price per share = 800,000 / 1,000,000
    Price per share = $0.80
    Shares purchased by investor: $200,000 / $0.80 = 250,000

    Founders: 1,000,000 shares = 80% of the company
    Investor Y: 250,000 shares = 20% of the company

  3. 3rd Investment: Investor Z comes along and invests: $1M at a pre-money valuation of $2M. What happens in that case?

    Price per share = pre-money valuation / number of fully diluted capitalized shares.
    Price per share = 2,000,000 / 1,250,000 = $1.60
    Shares purchased: $1,000,000 / $1.60 = 625,000

    Investor CD's terms: $100,000, 4% interest, qualified financing of $1M, valuation cap of $3M. 20% discount.

    That convertible debt will convert into shares at the lesser of (a) 80% of the price per share paid by the purchasers in the qualified financing (remember the 20% discount); or (b) the valuation cap divided by the fully-diluted capitalization immediately prior to the closing.

    80% of the $1.60 is $1.28
    OR the valuation cap is $3M, so the price per share if the valuation is $3M is: Price per share = 3,000,000 / 1,250,000 = $2.40
    So the price per share will be $1.28 as it is lower.

    Number of shares purchased by Investor CD via conversion: $100,000 / $1.28 = 78,125

    ####Resulting cap table after Investor Z:
    Founders = 1,000,000 shares = 51.2%
    Investor Y = 250,000 shares = 12.8%
    Investor Z = 625,000 shares = 32%
    Investor CD: (conversion) = 78,125 shares = 4%

GETTING OUT - how about when investors exit the deal with a liquidation preference?

Liquidation preference gives preferred shares the right to be paid out first following a liquidation event. If a startup is liquidated for less than the investors invested, then their liquidation preference would allow them to get money while the common shareholders get nothing.

  1. The key to understanding liquidation preference is the liquidation preference multiple (bolded).
    Startup acquired for $15M Investor W invested $5M with 2x liquidation preference = investor gets $10M before any common shares paid out

What about the rest of the proceeds (the remaining $5M)?

  1. Full participation (fully participating Preferred Stock)
    E.g. the Series A Preferred (Investor W) participates with the Common share pro rata on an as-converted basis

    VC invests $10M of 1x fully participating Series A Preferred at a $10M pre-money valuation = VC would own 50% of the common stock.

    If the startup is acquired for $60M, the VC will take $10M (from liquidation preference) + $25M (from participation), for a total of $35M.

  2. Capped participation (partially participating preferred)
    This means that holders of Series A Preferred stock are paid their liquidation preference preferentially (meaning before common stockholders get a dime) and then they also get to share any of the proceeds that are left over, with the common stockholders until an aggregate of X times the original investment is reached.

    Even in capped participation, the VC still has the option to convert their shares to common and participate fully in the proceeds, but the entire class of shareholders must agree to forego their participation rules.

    VC invests $10M with 1x liquidation preference with a $30M (3x) cap, and that $10M represented a 50% ownership stake in the company.

    If the company sold for $60M:
    *the investor would get $10M (liquidation preference) plus $20M of the remaining proceeds to hit their cap of $30M (50% of the remaining proceeds, $22.5M, would put them above their cap).
    *If they converted all their shares to common and took 50% of the proceeds, they would also receive $30M.

    If the exit value were $65M:
    *the investor would get $10M (liquidation preference) plus $20M of the remaining proceeds to hit their cap of $30M (50% of the remaining proceeds, $22.5M, would put them above their cap).
    *the investors will get a better outcome by converting to common $32.5M, as no ceiling at $30M.

  3. Non-participation (straight preferred)
    With non-participation, “the balance of any proceeds shall be distributed pro rata to holders of Common share.”

    For example, let’s say a VC invests $10M on 1x non-participating Series A Preferred for a 50% ownership stake in the company.

    If the startup is acquired for $60M:
    the VC can either take $10M (from liquidation preference) + $0M (due to non-participation)
    OR take pro rata share of 50% for a payout of $30M

  4. The liquidation stack - seniority structures to determine which class of shares get paid out first:
    *Standard. Later stage investors receive their liquidation preference first (e.g. D, C, B, then A).
    *Pari passu. All investors receive their liquidation preference at the same time.
    *Tiered. Classes are grouped together (e.g. F and E, D and C, B and A).


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