Let’s say one investor A after long negotiation with you as a founder of a early stage startup, offer you a TERM SHEET, which they will give you US$ 2 million for 10% equity in your startup.

This will mean that the POSTMONEY valuation is:

US$2mio/10% = US$ 20 mio

And the PREMONEY valuation is

US$ 20 mio – US$ 2 mio = US$ 18mio

The next question is how many shares that need to be issued to that investor?

Answering this question, will necessitate the founder to look at his/her Capitalization Table, or called CAP TABLE.

Cap Table will be pretty much a table showing all securities (common share, preferred share for each Series, Warrants, etc.) that you have issued so far, plus the reserve for Employee or Talent Option Pool

As we have known the Premoney valuation, then we could :

(1) Calculate the current share price, and

(2) Then dividing the Investor’s investment against the current share price to come up with the total number of shares being issued to that investor.

Let’s put the above into the Cap Table, as demonstrated below.

So, we could see from the above Cap Table, that founders need to issue 666,667 shares to Series A investors.

Here we noted that the Cap Table should consider the shares that will be issued as well under Employee/Talent Option Pool that will be issued later.

Some notes from the above Cap Table:

First, though it is Preferred Shares that are issued to Series A Investors, and not Common Shares, however in the Cap Table, such Preferred Shares will always be assumed as “as-converted basis”, which means that when determining the right or benefit of preferred stock, it is assumed that the Preferred Share has been converted into some number of common shares.

Second, the Employee or Talent Pool Option that have not been issued yet, will be incorporated into the Cap Table as “fully diluted” basis. Here, the Series A investors, want to know all parties that will have a claim on the startup exit value.

Why in the Cap Table we need to use “fully diluted” assumption and “as-converted basis”, from the perspective of Investor, regardless whether the shares have been issued or not yet, or whether the options has been executed or not?

First, it must be related to risk of the deal.

Rob Johnson, in his paper under the title : Valuing Early-Stage Business: The Venture Capital Method, April 2020) said that such assumptions are necessary in view of the risk of the deal.

He said:

What is important to understand is that the use of such instruments does not actual change the risk of the deal – the capital invested is still at risk; rather these instruments are used to achieve other objectives. The investor will have invested in preferred shares or debt (a) first and foremost to secure simultaneously an equity position in the company (b) while putting most of his/her capital in a senior instrument that achieves the other objective described above (Note: that is to ensure that their investment is in a senior position). For this reason, one must always use the total amount invested – irrespective of what instruments the capital is invested in – to calculate the post-financing and pre-financing valuations.

Second, it must be related to the Exit scenario.

Though risk is definitely one element of this deal, yet, another equally important element to include all instruments (such as non-vested and all non-issued options and shares), I believe it is because all those investors focus on the valuation at a successful exit (otherwise, what is the point to sit there and do such exercise?), and when that times come, logically, all these shares will certainly be issued, vested and valuable. Here Venture Capital method assumes that all equity classes will effectively have the equal claims on the company’s value, although their respective interests might typically have different rights and privileges, which might again translate into differences in exit proceeds per share unit. One thing, which I read, quite common in practice, upon exit (for example, IPO), the terms might require “qualified IPO” meaning that all outstanding preferred stock will be automatically converted to common stock. From the perspective of the buyer at exit, they want to remove all those interests with special privileges and rights.

Third, it must be related to investor’s protection of their interest.

Investor will manage to anticipated dilution in the next rounds of financing. Any unanticipated dilution is shared among all shareholders, whereas anticipated dilution is borne by premoney investors. Thus the insertion of a hypothetical future round is an attempt by current-round investors to hedge future dilution and shift it to the current round’s premoney investors. The same intuition applies to refreshing the incentive stock plan pool in a way that shifts the dilution from shared to premoney investors.

Anticipated (claimed) additional funding necessary to reach a fixed exit value is also that the insertion of an additional future round is actually the insertion of additional costs not currently in the business plan. This indirect insertion is due to using a financing-flows valuation rather than an operating flows valuation like that most common in corporate finance.

Jakarta, 9 January 2021
Rainy day


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