Venture capital investors valuate a company according to one or more of the models mentioned above, while using the discount rate required by the company's risk level. The result is the company's post-money value, based on the assumption that the company managed to raise the capital it needs to implement its plans. Post-money value makes it possible to calculate pre-money value, namely, the company's value after the investment minus the amount of the investment. The share which the investor will demand in the company's equity is also derived from the amount infused by investors into the company and from the company's post-money value.
Following is an example of an ordinary issuance (see the section on the number and price of the shares allotted to the investor), followed by an example of an investment made with the allocation of a pool of options and shares for employees (see the section on investment rounds with a pool of employee stock options). Investors usually require at the time of the share issuance that the calculation of the value and the number of issued shares be made on a fully diluted basis. Although the options are not allotted to the employees at the time of the issuance, a pool of options (15 25% in the early phases) is reserved, thus assuring investors that they will not be diluted in the future due to the allotment of options to employees. Since the entrepreneurs bear the cost of the pool, such an allotment may be seen as a "discount" of sorts on the price given to the investors. This is because they receive more shares for the same investment so that their share after the investment round and the allocation of the pool is identical to the share they would have received had they been promised that no diluting issuances would be performed in the future.
The section on the effect of pre-emptive rights presents a scenario in which a new investor enters a company in which the investor from the previous round has a pre-emptive right, i.e., the right to preserve his share. In this scenario, we will calculate the number of shares which the existing investor is entitled to purchase when required to invest according to the price given to the investor in the current round.
The Number and Price of the Shares Allotted to the Investor
The number of shares which are allotted to an investor is a function of the share to which he is entitled according to his investment and the valuation:
The number of shares allotted is determined in accordance with the existing number of shares:
The price per share is, of course, a direct function of the variables calculated above:
Let us assume, for instance, that investor X is interested in investing $15 million in Speed, Inc., a company with a pre-money value of $100 million. We shall assume that the company has 20 million shares, i.e., the value of each share is $5. The investor will therefore be allotted 3 million shares, constituting 15/(100+15) of the company's shares, i.e., approximately 13% (see Table 9-2).
Investment Rounds with a Pool of Employee Stock Options
The basic formula for deriving the share to be received by investors in consideration for their investment assumes that such share will be preserved until they exit the investment. In other words, the formula does not account for future investment rounds which will require an additional investment by the investors or will dilute them, nor does it account for an allotment of shares to employees or the management team. Any future allotment not incorporated into the valuation translates into a dilution of the investor's ownership percentage, and it is therefore essential that it be addressed at the time of the investment. Consequently, investors require a higher rate of initial ownership in order to secure the ultimate ownership percentage they desire.
In order to calculate the share to be received by each investor in the current round, the company's value is usually examined based on the assumption that it will raise all the outside capital it will require (i.e., the value incorporates the amounts to be raised in the future, discounted to present values). Thereafter, it is necessary to assess the stages in the company's development at which it will raise outside capital, and the company's value in each one of these stages. It is also necessary to estimate the ownership percentage which the entrepreneurs and the company's employees will hold. It is then possible to calculate the number of shares which will need to be allotted in each of the next investment rounds, and to estimate the allotment of shares required in the current round according to the expected dilutions.
Many investment rounds take into account the allotment of a pool of options and stocks for employees, with an exercise price lower than their price in the investment round. In practice, the cost of the pool is usually borne by the entrepreneurs, and in some cases by investors from previous rounds.
Since the options are usually long-term and are given either for no consideration or at a substantial discount off the market price, they are counted as shares for the purpose of calculating the value and the number of shares, but the proceeds anticipated from their exercise are usually disregarded.
For the sake of illustration, we shall continue with the previous example, but shall assume that investor X requires that a pool of options be set aside for future employee recruitments at the scope of 20% after the investment. We shall further assume that until now all of the shares were held by the entrepreneurs.
At the end of the allotment process, on a fully diluted basis, the investor will have after the round the same share in Speed's equity, i.e., 15/115 = 13.04%. This figure reveals the entrepreneurs' holdings on a fully diluted basis as part of the equity after the investment: 100% 13.04% 20% = 66.96%. It is now possible to calculate the total number of shares after the investment (including the pool for future allotments): 20/66.96% = 29.87M. From here, it is easy to calculate the number of shares which will be set aside for the employees' option pool: 20%*29.87 = 5.97M, and the number of shares which will be issued to the investor: 29.87-20-5.97=3.9M.
Since the pool is not issued at the time of the investment, the investor's initial share in the equity is obviously higher than in a scenario without an employee option pool and is initially 3.9 / (20 + 3.9) = 16.3%. The amended required ownership percentage may be described by the following formula:
In the above example, the investor's share in the equity will be 13.04%/(1 20%) = 16.30%.
The price per share is an immediate result of the number of shares: 15M/3.9M = 3.85. The results are summarized in Table 9-3.
The Effect of Preemptive Rights
Let us assume that the only financial investment in the company was made in the past by investor Y, who has a stake of 25% in the company, i.e., 5 million shares, in consideration for his investment. Based on his or her investment agreement, the investor is entitled to preserve his or her share in the company, and he or she wants to exercise this right. The company's pre-money value is, as before, $100 million, i.e., the allotment price is $5 per share, and we shall assume that no future dilutions are expected (in other words, this is the first scenario). Also, assume there is no requirement for an employee option pool.
The calculation of the number of additional shares to which investor Y is entitled is based on the fact that his total number of shares must constitute the same percentage (25%) of the company's total number of shares after the investment, which includes the shares of investor X (to whom shares are allotted at $5 per share), the founders' shares (who usually do not enjoy a preemptive right), and the new and existing shares of investor Y himself for which he would pay $5 per share. In other words:
Simplifying the equation enables us to find the number of new shares which investor Y will be entitled to buy in order to preserve his share:
Investor X is allotted 3 million shares, and investor Y will invest $5 million in order to preserve his share, in consideration for which he will be allotted 1 million new shares. At the end of the process, investor Y will hold 6 million out of 24 million shares, i.e., exactly 25% (see Table 9-4).