Definitions
Pre-money: Valuation of a company prior to an investment from VC or Angel calculated on a fully diluted basis.
Post-money: Valuation of a company after an investment from VC or Angel.
Option pool: Shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a start-up company
Fully diluted: Include issued and outstanding options, warrants and other convertible securities. May include unissued options.In-the-money: Strike price < market price
Calculations
Pre-money = Founders' share + option pool
Post-money = Pre-money +investment amount
Example 1 (wikipedia)
Round A
Initial shares in company = 100 (100% owned by founders)
Investors buy 20 newly issued stock at $10 million.
Post-money = $10million/20shares * 120shares = $60 million
Pre-money= $60m - $10m = $50m
Founders ownership = 100shares/120shares = 83.33%
Round B
Initial shares in company = 120 (100 owned by founders and 20 owned by Round A investors)
Investors buy 30 newly issued stock at $20 million.
Post-money = $20m/30shares*150shares= $100m
Pre-money= $100m - $20m = $80m
Founders ownership = 100shares/150shares = 66.67%
Upround/Downround
Pre-money valuation of round B > Post-money valuation of round A = Upround
Pre-money valuation of round B < Post-money valuation of round B = Downround
Successful companies receive series of uprounds until they are acquired or go public.
Example 2 (wiki)
Initial shares = 1,000,000
Convertible loan note = $1,000,000 at 75% of the next round price
Warrants for 200,000 shares at $10 price
ESOP of 200,000 shares at $4 price
Investment of $8,000,000 at $8 price
Post money = $8 * Total number of shares after transaction
Total number of shares = Initial 1,000,000 + 1,000,000 from new investment ($8,000,000 / $8) + 166,667 from loan conversion ($1,000,000 / (75% * $8) ) + 200,000 from ESOP in-the-money options = 2,366,667 shares
Warrants cannot be exercised because they are not in-the-money (the price of $10 per share is higher than investment price of $8 a share)
Post money = $18,933,336
Pre money = $18,933,336 (Post money) - $8,000,000 (Investment) - $1,000,000 (Loan conversion) - $800,000 (ESOP) = $9,133,333
Example 3 (socaltech)
Pre-money valuation = $4.5m
Capitalization: 3 founders own 3m talks (1m each)
Option plan: Employees granted options to purchase 1,500,000 shares of Common stock. None exercised yet and option pool is 3,000,000 shares
Pre-money = $4.5m
Post-money = $7.5m ($3m + $4.5m)
Price per share of Series A = Pre-money valuation / total number of shares outstanding fully diluted = $4.5m/(3m+1.5m from option plan) = $1.00 per share
By basing the share price on a fully diluted basis, the investors are making existing common stockholders assume the diluting effect of the un-exercised 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.
Impact of fully diluted basis: Nothing changes except for 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%.
Example 4 (fast ignite)
Deal: 2 on 3 with 20% option pool ($2m investment with $3m pre money and 20% on post)
Means company is worth $2m (true pre money), investors put in $2m and $1m is reserved for option pool for a post money valuation of $5m. Investors and founders both own 40% of the company. If no option pool, they both own 50% and the post money will be $4m.
Why increase option pool?
Example 5 (simenov)
Pre-money is not what the founders should look at because it includes the option pool. Instead, founders should look at "the promote" which is founder ownership * post money
A: 6 on 7 offer with 20% pool ($6m investment on $7m pre money with 20% options on post)
B: 6 on 9 offer with 30% pool ($6m investment on $9m pre money with 30% options on post)
A = $4.4m promote
B = $4.5m promote
Pre-money: Valuation of a company prior to an investment from VC or Angel calculated on a fully diluted basis.
Post-money: Valuation of a company after an investment from VC or Angel.
Option pool: Shares of stock reserved for employees of a private company. The option pool is a way of attracting talented employees to a start-up company
Fully diluted: Include issued and outstanding options, warrants and other convertible securities. May include unissued options.In-the-money: Strike price < market price
Calculations
Pre-money = Founders' share + option pool
Post-money = Pre-money +investment amount
Example 1 (wikipedia)
Round A
Initial shares in company = 100 (100% owned by founders)
Investors buy 20 newly issued stock at $10 million.
Post-money = $10million/20shares * 120shares = $60 million
Pre-money= $60m - $10m = $50m
Founders ownership = 100shares/120shares = 83.33%
Round B
Initial shares in company = 120 (100 owned by founders and 20 owned by Round A investors)
Investors buy 30 newly issued stock at $20 million.
Post-money = $20m/30shares*150shares= $100m
Pre-money= $100m - $20m = $80m
Founders ownership = 100shares/150shares = 66.67%
Upround/Downround
Pre-money valuation of round B > Post-money valuation of round A = Upround
Pre-money valuation of round B < Post-money valuation of round B = Downround
Successful companies receive series of uprounds until they are acquired or go public.
Example 2 (wiki)
Initial shares = 1,000,000
Convertible loan note = $1,000,000 at 75% of the next round price
Warrants for 200,000 shares at $10 price
ESOP of 200,000 shares at $4 price
Investment of $8,000,000 at $8 price
Post money = $8 * Total number of shares after transaction
Total number of shares = Initial 1,000,000 + 1,000,000 from new investment ($8,000,000 / $8) + 166,667 from loan conversion ($1,000,000 / (75% * $8) ) + 200,000 from ESOP in-the-money options = 2,366,667 shares
Warrants cannot be exercised because they are not in-the-money (the price of $10 per share is higher than investment price of $8 a share)
Post money = $18,933,336
Pre money = $18,933,336 (Post money) - $8,000,000 (Investment) - $1,000,000 (Loan conversion) - $800,000 (ESOP) = $9,133,333
Example 3 (socaltech)
Pre-money valuation = $4.5m
Capitalization: 3 founders own 3m talks (1m each)
Option plan: Employees granted options to purchase 1,500,000 shares of Common stock. None exercised yet and option pool is 3,000,000 shares
Pre-money = $4.5m
Post-money = $7.5m ($3m + $4.5m)
Price per share of Series A = Pre-money valuation / total number of shares outstanding fully diluted = $4.5m/(3m+1.5m from option plan) = $1.00 per share
By basing the share price on a fully diluted basis, the investors are making existing common stockholders assume the diluting effect of the un-exercised 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.
Impact of fully diluted basis: Nothing changes except for 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%.
Example 4 (fast ignite)
Deal: 2 on 3 with 20% option pool ($2m investment with $3m pre money and 20% on post)
Means company is worth $2m (true pre money), investors put in $2m and $1m is reserved for option pool for a post money valuation of $5m. Investors and founders both own 40% of the company. If no option pool, they both own 50% and the post money will be $4m.
Why increase option pool?
- Deal engineering. It’s true, some investors pad the pre-money with a large option pool and try to sell this to entrepreneurs as their company having a higher value. That’s bull and won’t fly in the end. Even if an entrepreneur doesn’t understand what’s going on, the company’s lawyers will be able to point it out. If they didn’t, fire them.
- Pushing more capital. Sometimes, a large option pool allows an investor to deploy more capital. This works in the case when the investor wants to (a) invest relatively more money into the company and (b) positions that they absolutely must own at least X% of the company. Say, the investor wants 20%. If the company is valued at $10M then the investor would put in $2.5M for a post money of $12.5M ($2.5M / $12.5M = 20%). However, if a 30% option pool is added then the post money will be $20M (the pool will be $6M) and the investor will put in $4M ($1.5M or 60% more than before!). The pre-money would have jumped to $16M. As an entrepreneur, I’d love this. I get more money ($4M as opposed to $2.5M) and I don’t get diluted any further. Well, technically, the true pre-money valuation is a smaller percentage of the total but as long as I don’t waste the option pool, the unused portion will come back.
- Convenience. It is easier for investors to start owning X% and, with a well-padded option pool, know that their ownership percentage is more likely to go up on exit, when unissued options are canceled, as opposed to down, as the option pool is increased. Also, from a board perspective, it is simply easier to not have to grow the pool every few months.
- Board dynamics. Increasing the option pool requires board approval and in some cases, depending on the rights of the preferred investors, various shareholder votes. When there are multiple investors and/or classes of preferred shareholders, it may be difficult to grow the option pool even for very legitimate reasons. Investors who want companies to be able to appropriately reward employees and others through equity may want to ensure that the option pool is sufficiently large at the point when they have maximum leverage–during a financing. I experienced this situation with a European investment I made. The partner representing the largest existing European VC had a rather limited notion of how much equity it took to motivate management and employees. I negotiated hard to get the maximum increase in the option pool possible (on top of a valuation we had already agreed upon) because I doubted the company’s ability to increase its pool post financing.
- Protect from dilution. They protect everyone from dilution. If you take a term sheet with an artificially small option pool, it will have to be increased in the future and your ownership will be diluted. To take Jeff’s specific example, the second deal 6 on 9 with 30% pool is noticeably better than the 6 on 7 deal with the 20% pool even though the promotes are nearly identical because the extra 10% in the pool are insurance against another 10% dilution. In short, don’t get into deals because you feel you’ll own more of the company only to find out that you get further diluted in the future through option pool increases.
Example 5 (simenov)
Pre-money is not what the founders should look at because it includes the option pool. Instead, founders should look at "the promote" which is founder ownership * post money
A: 6 on 7 offer with 20% pool ($6m investment on $7m pre money with 20% options on post)
B: 6 on 9 offer with 30% pool ($6m investment on $9m pre money with 30% options on post)
A = $4.4m promote
B = $4.5m promote