In Part I, I discussed the different methods of investment and the order in which this investment is made to explain how this creates the startup’s capital structure. This second article discusses how valuation impacts the investments made and ties the two concepts together.
1 Understanding Dilution and Valuation
When a company is first formed but before any angels or venture capitalists have invested, all of the shares are typically common shares tightly held between a small group of people. As new equity investment comes into the company, the total number of shares grows, and the relative share of the company held by the existing shareholders decreases, or in other words, they get diluted.
For example, assume one founder initially holds 100 common shares, which represents all the shares that have been issued. Then, assume he successfully raises an investment from a VC firm, which is issued 200 shares of Series A Preferred stock. There are now a total of 300 shares outstanding—the original founder owns 33 percent of the company and the VC firm owns 67 percent. Later, on another round of financing, both the founder and the Series A Preferred stockholders would get further diluted.
Why would someone be willing to get diluted? The answer is that even though each investor’s share of the pie is getting smaller, ideally the entire pie is getting bigger with each round of investment faster than the rate of dilution. At the beginning, a founder might start out with 100 percent of a company worth $100,000, but by the time the Series A round is invested, it might be worth $1 million. This refers to the valuation of the company. Pre-money valuation refers to the valuation of the company before a new round of investment is made, while post-money valuation is simply what the company is worth after the new investment is completed. The difference between the pre-money and post-money valuation for a particular round is equal to the amount of investment raised by that round.
To go back to our example, remember the original founder started with 100 shares of a company that was originally worth $100,000, meaning he owns 100 percent of $100,000; his price per share was $1,000 ($100,000 valuation divided by 100 shares). Let’s say the founder further develops his idea, files some patents, validates his business plan, and lines up some users who are willing to pay for his product, so that by the time he is ready to raise venture capital money to grow the business, his startup is worth $1 million pre-money.
Then, a venture capital firm decides to invest $2 million. The total value of the startup after the investment is the $1 million pre-money valuation plus the new money of $2 million, for a total post-money valuation of $3 million. This implies that the VC firm will hold 67 percent ownership, therefore they must hold 67 percent of the total shares. For this to hold true, the VC firm must be issued 200 new shares, so that there are 300 shares outstanding. The new price per share is the $2 million invested by the VC divided by his 200 shares, or $10,000 per share. This price per share also applies to the original founder’s shares, which is how his original 100 shares are now worth $1 million.
To show this visually, the chart below shows our example above, plus an additional Series B round that values the startup at a total of $10 million. You can see that even as the ownership percentage goes down, the total value of the Founders and Series A Preferred Stock goes up.
2 How Is Valuation Determined?
There is no single way of determining valuation, but some factors influencing valuation include the startup’s industry and its total market size, the company’s potential for growth, and what comparable companies are valued at. For companies driven by the number of users they have, their valuation may be based on metrics like a value per user. If a company already has revenue or earnings, its valuation may be based on a multiple of those.
All of the above figures provide a range of valuation for the company. The final valuation figure that is agreed upon is often the result of a negotiation between the startup and the VC firm.
3 What Does This Mean for a Company Looking to Raise Money from Venture Capital?
First, be realistic about how much dilution you will experience. Founders who expect to raise money while keeping control of the company with 51% or more ownership of the shares won’t be able to attract venture capital financing.
Although a first round of external financing may not cause dilution below 51%, subsequent rounds will. Remember, getting additional investment is about making the pie bigger! Dilution of the original owners or founders below 50% in a VC-backed company is essentially required based on how venture capital financing works.
Since several rounds of investment are required and the company’s valuation is hopefully continuing to increase, new investors in each round need to be able to take enough equity in exchange for their dollars to make the investment worthwhile for them. Artificially restricting the amount a VC firm can invest in order to keep the owners or founders at a high ownership percentage will only reduce the amount that can be raised, and hence the company’s chances for success.
Second, understand that valuation is not fixed but can change and is subject to interpretation, and for a startup a higher valuation results in less dilution for existing shareholders for a given amount of capital. Find the key drivers of your company’s valuation and build your company’s story and strategy around them. All else being equal, it’s in the company’s best interest to negotiate for a higher valuation to reduce the amount of dilution.
Third, be careful of any terms that grant excessive protection from dilution, whether they be granted to founders or employees, or to new investors. This spreads the burden of dilution onto those who don’t have such protection, and it can be a red flag for potential investors.
For instance, a key early hire may be granted 20% of the company when he’s hired, and he may ask for an anti-dilution provision in his contract. This means that no matter how many subsequent rounds of investment are raised, that hire will always have 20% of the company. This can be a drag on the ability to attract new investment, and it can also create future incentive and management issues for that particular employee as the company grows more mature, as he or she is guaranteed 20% regardless of their performance. In contrast, CEOs often hold 10% or less of the equity of the company when it comes time to exit in most successful VC-backed investments.
4 Understanding Valuation Caps
Remember that some investments are made in the form of convertible notes or SAFEs. If the valuation of a company runs up significantly before these convert into equity, then these investors may get less equity than they intended. For this reason, sometimes a valuation cap is specified in these contracts.
To use a simple example, suppose an investor invests $1 million via a convertible note, on an expectation that the next round values the startup at a total of $10 million post-money. This means that their ownership interest would be 10 percent. Instead, the startup finds itself in a rapidly growing space and does very well, and the next round values the startup at a total of $20 million post-money. The original $1 million invested via the convertible note now only garners a 5 percent ownership interest.
To prevent a scenario like the above from happening, a valuation cap sets a limit on the price of conversion and how much dilution might occur on a convertible note or SAFE. To continue our example, if there was a valuation cap of $12 million on the investment, then this means that even if the post-money valuation was $20 million, the investment would convert as if the valuation was $12 million. In this way, the valuation cap helps reward the convertible note or SAFE investor for the risk that they took being an earlier investor.
For a startup, a valuation cap will result in more dilution for existing shareholders compared to an uncapped convertible note or SAFE, and it is in the existing shareholders’ interest to avoid a cap or to set such a cap higher. However, investors are motivated by trying to set the cap lower so that they can obtain more ownership for their investment and avoid excessive dilution. Because of these diverging interests, the valuation cap usually gets heavily scrutinized and negotiated when convertible note and SAFE agreements are drafted.
5 Raising Money from Friends and Family
Raising money from friends and family is a completely acceptable way of raising money for your company, especially if you don’t plan on having to rely on angel or seed investment or having to raise anything at all from VC firms. However, if you do, it’s important to set the right expectations.
Friends and family typically invest in common stock alongside the founders. If seed or VC investment later does happen, friends and family need to realize their share holdings will be diluted (but again, in exchange for a piece of a bigger pie). It’s also important to communicate that their investments are not liquid, meaning that if they want their investment back, it may be difficult to do so as there is no public market for the company’s shares until the company goes IPO, unless you are willing and able to buy them out if they want to exit.
