Basic Terms

This section presents the basic terms with which companies raising capital need to be familiar. A more detailed discussion of the valuation of startup companies and various calculations in connection with these terms is given in Chapter 9.

Sale of Shares by Shareholders Versus Investments

The main difference between the sale of shares by shareholders (a "secondary offering") a transaction to which the company is not a party and raising capital for the company (i.e., importing money into the company) is that in the latter case the company allots new shares to investors (i.e., adds shares to the company's allotted share capital), against which it receives an investment, usually in cash which it can use for its business.

For example: Speed Ltd. has 3,000,000 shares that are equally divided between its two entrepreneurs. In other words, each entrepreneur holds 50% of the company's equity. If a certain entity were to buy 1,500,000 shares from one entrepreneur, the other entrepreneur would still hold 1,500,000 shares out of the 3,000,000 (50% of the company) and will not have been diluted at all. Ostensibly, the company's financial condition has not changed at all either, since no new funds were infused into the company. If, on the other hand, an investor invests money in the company, in consideration for which the company allots to him or her 1,500,000 shares, then, although each entrepreneur still retains 1,500,000 shares, these shares now constitute only one third of the company's equity. In other words, they were diluted by approximately 17%, or one third of their holdings (for an accurate calculation of the number of shares allotted in investments and the rate of dilution, see Chapter 9). However, in this case the company receives funds or other resources which it can use for its activities. This type of issuance is the most prevalent in early-stage equity private placements, since the main reason for raising capital is the need to infuse money into the company and not the entrepreneurs' desire to realize their investment.

Terms for Describing the Value of a Company

• Share price The price of the share is the basic parameter for calculating the value of a company. Shares are the subject of the investment transaction and they are what changes hands from the seller to the buyer or from the company to the investor. Therefore, the price per share, multiplied by the number of shares purchased, is the gauge by which the value of the transaction is measured.

• Fully diluted An investment in a company is usually made on a fully diluted basis. This means that the calculation of the investor's holdings is made based on the assumption that all the options and other rights to buy shares will be exercised. The dilution also often includes the equity (options) which the company intends to allot to employees. Obviously, when full dilution is assumed, the number of shares from which the investor is entitled to receive a certain percentage according to the valuation of the company is higher, and hence the number of shares the investor actually receives is also higher (for a calculation of the number of shares allotted on a fully diluted basis, see Chapter 9 on issuing stocks to investors).

• Pre-money value This refers to the product of the number of allotted shares before the investment multiplied by the price of the share. Alternatively, in preliminary investments this parameter serves as the standard for the degree of dilution, which is determined according to the amount of money invested.

• Post-money value The post-money value of the company is its pre-money value, plus the amount of money invested. For example, if Speed Ltd.'s pre-money value is $3 million and it raises $1 million from new investors, then its post-money value is $4 million.

It should be noted that the price of the share just before and after the investment remains unchanged. Speed Ltd., for example, has 3,000,000 shares before the investment. Since its pre-money value was estimated at $3 million, the price of each share was $1. The company has now received an investment of $1 million in consideration for shares. Since the share price is $1, one million additional shares were bought and allotted. The total amount of allotted shares is now 4,000,000, i.e., the new investor holds 25% of the shares: 1,000,000 out of a total of 4,000,000, with the price of each share remaining $1.