Terminology
financial terms : 1
Stocks & Options:
A stock is a portion of ownership in a company. Founders, employees and general shareholders typically own Common Stock. All stock is not made equal! Professional investors like VCs, hold a special class of stock called Preferred Stock. Since early investors take on risk when investing in startups, preferred stock holders have special privilidges in comparison to common stock holders. Common examples would be preferrential treatment on assets and earnings, voting rights and liquidity events. At minimum all professional preferred stock holders sign terms that give them preference to recovering their investment before holders of common stock. The specifics of the preferrential rights are defined through termsheet for every investor/round of investment.
If you have ever worked for a startup, it is very likely that you have been wooed by promise of attractive Options. In simple terms, the bearer of options has the right to purchase a fixed number of shares of the startup at a discounted price. Typically, options issued to employees operate under specific schedule and expire after a finite period; such a schedule is referred to as Vesting Schedule. For example, an employee may be issued 50,000 options of which the first 10,000 are only available after the end of 1st year. The remaining 40,000 are proportionately made available to the employee at the end of every month for the next 3 years. The process of vesting, incentivizes the employee to stay with the company, help it grow and eventually, individually benefit from the growth. Ability to execute on options and the vesting schedule can be affected by new investments, M&A activity and so forth. I shall cover those in more details. A company will typically set aside a options, referred to as options pool, to be issued to employees, key management, board members and advisors. The size of the options pool may vary over the life of the company as the company generates more revenues/investments and adds employees. Unexercised options simply 'disappear' at liquidity event or at the end of the term of those options.
Investments & Valuations:
Let us delve into a few terms that you would hear of when discussing valuations.
Outstanding Shares: Outstanding shares refer to all the company shares that are currently being held by all its shareholders.
Fully Diluted Shares: This is a term that will often occur on a term sheet and needs your full attention when you build models for your deal. Fully diluted refers to the number of outstanding shares that would exist if all options, convertible debt, warrants, convertible bonds were to be executed. This number is larger than the true outstanding shares.
Pre-money valuation is the value of a company as agreed upon by the company and investors, prior to receiving an investment.
Post-money valuation is the value of a company immediately after an investment has been made in a company. Post-money valuation=pre-money valuation + value of new equity received from outside investors (typically, the investment amount).
Liquidity event is an event in which a company is sold and ceases to exist in the form prior to such an event. An IPO brings liquidity to privately held shares but it should not be considered to be a liquidity event. For the purpose of the next few examples, we shall assume that the liquidity events are pure cash buyouts.
As-converted basis defines the ratio by which a series of preferred stock is converted to common stock in case of a liquidity event or IPO. Very often the ratio starts at 1:1 for seed investment but changes during future financing round. This ratio is important for anti-dilution provisions and voting.
Capitalization Table is a spreadsheet that tells you who owns how much of a company before and after a financing round.
Some Investment Scenarios:
The ambiguity in basic valuation can start with a statement as simple as “VC is investing $5,000,000 at a $10,000,000 valuation”. Is the $10,000,000 a pre-money or post money valuation? As all things on a termsheet, the valuation and the way valuation is computed is up for discussion. Let me explain with a case and a few scenarios
A VC is making a $5,000,000 Series A investment in XYZ Inc with a pre-money valuation of $10,000,000. Prior to the investment, there are 10,000,000 outstanding shares of XYZ Inc held by the founders and 2,000,000 unexercised options in the options pool. Based on this information, the post money valuation of XYZ Inc is $15,000,000.
The founders typically assume that the valuation is computed purely on the 10,000,000 outstanding shares; thus their ownership post deal is 66.67% and the VCs own 33.33%. In reality, VCs compute valuation based on full dilution of stock at the time of investment; meaning the pre-money valuation of $10,000,000 is on 12,000,000 shares instead of the 10,000,000 as assumed by the founders. This alters the ownership distribution. Let’s compute some scenarios. In each case, the company is eventually being bought out for $15,000,000. Based on the the number of options exercised, the pay offs from the liquidity event will be between the outstanding only post money valuation and fully diluted post money valuation. For sake of simplicity, I have assumed Series A & common stock convert on a 1:1 ratio and there is no liquidation preference or participation by Series A.
Note: Tables and graphs not visible in mobile version
Scenario I: VC firm and XYZ Inc calculate pre-money valuation based based on full dilution without any changes to the size of the options pool. Fully diluted, the Founders own 55.56%, the VCs own 33.33% and the options pool is 11.11%.
Scenario II: VC firm asks XYZ Inc to add another 1,000,000 options to the existing options pool prior to Series A investment. This is common during investments as they lead to new hires and the options pool needs to reflect the company's future plans. Fully diluted, the founders own 51.28%, the VC owns 33.33% and the option pool contains15.39%. Do note that the addition to the options pool is reducing the % ownership of the founders while leaving the % ownership of the VCs unaffected.
Scenario III: The VC firm and XYZ Inc agree to add 1,000,000 new options post money. If there is a fully diluted liquidation event, the added options would add to the valuation of the company as each share is priced at about $0.83. The company would thus be worth a total of $15,833,000. Upon full dilution the founders would own 52.63%, the option pool would be 15.79% and the VC would have 31.58%. Do note that, the fully diluted, VC ownership is lowest of all three scenarios, but the pay off is same, $5,000,000. This is due to the increased valuation due to the new options added post-money.
The adjoining graph illustrates the three scenarios with two different payout options; a liquidity event with only outstanding shares (no options exercised) and another assuming full dilution. In reality, based on the number of exercised options, the actual cash payout would vary between these two numbers. Do note the increased valuation in scenario III when liquidity is accompanied by full dilution.
Convertible Debt & Warrants:
Convertible debt is a type of bridge loan: a small loan issued in anticipation of an equity financing round. As the name suggests the debt issued is converted into equity during the next round of financing. The conversion also occurs at a discount in comparison to the share price in comparison to the next round of financing. Typically, a startup and investor will opt for convertible debt financing early in its life, when there is a large spread in possible company valuation. The rationale is that, the milestones achieved by the company prior to future equity financing would help narrow the valuation. The investor thus takes up lower risk and gets to participate in the company’s upside.
Here’s an illustration: An angel investor wants to invest $1,000,000 in XYZ Inc., but, there is disagreement on the company valuation: angel currently does not value the company above $2,000,000, whereas the founders believe it is worth at least $5,000,000. Instead of executing an equity investment, the angel consummates a convertible debt deal of $1,000,000 with terms stating that the debt would convert into equity at a 20% discount during the next round of financing. Let’s assume there are 3,250,000 outstanding shares of XYZ Inc prior to the investments. In the series A financing round, a VC firm invests $2,000,000 at $1/share, thus receiving 2,000,000 Series A shares. The angel receives $1,000,000/($1x0.8) = 1,250,000 series A shares at a discounted price of $0.80 /share. The total series A share allocation would be 3,250,000 shares for a total of $3,000,000 in investment. With 3,250,000 outstanding shares prior to the investment, the pre-money valuation would be $3,250,000 at $1/share and the post money valuation after conversion of debt to equity, would be $6,500,000. The founders would own 50% of the company, the VC owns 30.77% and the angel owns 20.23%.
A convertible debt investor’s intentions is to not so much to collect interest on the loan but receive the discounted equity in the company they invest in and participate in the upside. This can be in jeopardy if the company merges or is acquired prior to a financing round. In this case, the convertible debt investor will only receive the loan principal, interest and some multiple of original principal (if negotiated).
Dilution due to high valuation during equity financing round is another risk that a convertible debt investor faces (imagine last scenario with $15,000,000 pre-money valuation). There is also the investor’s remorse, where had the angel invested in company equity instead of a convertible debt deal, there would have been a considerable upside during the VC led financing round. In order to protect themselves from such eventualities, the angel may add a valuation cap to the convertible deal terms which caps the maximum company valuation that may be used when converting debt to equity. The valuation cap defines the maximum effective stock price that can be used when converting debt to equity. For example, let’s assume the valuation cap were to be set at $5,000,000 and the VC equity financing deal is happening at $15,000,000 pre-money valuation. In this case the angel will receive 650,000 shares at about $1.53/share for the $1,000,000 convertible debt at a valuation cap of $5,000,000, whereas, the VC would receive 432,900 shares at $4.62/share for the $2,000,000 investment. The founders would thus own about 75% of the company, the VC would own 10%, the angel would own 15%.
Warrants are another flavor of convertible debt. Let me illustrate this with an example. An investor issues a $1,000,000 convertible debt with 20% warrant coverage over a term of 5 years. What this means is that, during the next round of equity financing, the $1,000,000 debt is converted into equity based on the stock price during that round of financing (discounts are typically not applied). The warrants give the holder of the warrant the option to purchase company stock at a predetermined price (typically price per share of the previous or next round of equity financing) over the term of the warrant. Let's assume, the warrant in this example is for the valuation at the next round of equity financing; which happens to be $1/share. In that case, the 20% warrant, gives the holder of the warrant, the option to by shares at $1/share for a maximum of 200,000 shares ($200,000 warrant) over the next 5 years. Since warrants typically have a long term, they can be a hinderance in case of M&A activities. Convertible debt deals with discounting and warrants can also be a challenge for accounting as IRS may associate value to a warrant. Other terms of interest in structuring convertible debt deals are super pro rata rights to create access to investing in future rounds and liquidation preference rights in order to assure that investors receive their money back before anyone else. Also note that convertible debt and warrants are used when computing fully diluted scenarios in an investment round. Unexercised 'warrants' vanish at the end of their term.