• Basic Math Skills for a “Preferred Series A” - Financing Round
  • December 13, 2012 | Author: Kaiser Wahab
  • Law Firm: Wahab & Medenica LLC - New York Office
  • Founding a company and evaluating funding options seem like a mathematical challenge best left for the Einstein’s of our generation. This is definitely not so. Everyone interested in founding a company which is likely to seek venture capital should understand the basic math underlying the process.

    To understand the process, we can examine a basic hypothetical two founder software company (Micromedia). Knowing that an IPO is a possible goal, the founders, Mom and Pop, (the originators of a company and everything related to them are often referred to with “founders”) decide to incorporate to take advantage of issuing various classes of shares. Both founders decide to allocate the bulk of the outstanding common shares between them equally. Mom takes 1,500,000 shares and Dad takes 1,500,000 shares for a total of 3,000,000. Both Mom and Pop also fund their company with an investment of $10,000.

    With a flagship software suite and a niche market based on a growing customer base, Mom and Pop decide to take the plunge and seek financing. Mom and Pop also decide to reward their dedicated team of programmers, who’ve been “sweat equity” slaving over their keyboards, through a stock option plan. As part of that plan, the firm issues another 2,000,000 shares. Of those 2,000,000, only 750,000 were granted and of those only 10,000 were actually exercised by the programmers at the exercise price of $.01 per share.

      Shares % Micromedia Ownership
    Founders 3,000,000 60%
    Option Pool 2,000,000 40%
    Total 5,000,000 100%

    Based on their strong market performance, Mom and Pop score an investment commitment from both angel investors and a venture capital firm. (A critical distinction should be made between angel investment and venture capital investment. Generally speaking, angel investors are affluent and sophisticated individual private investors who are looking for viable high risk, high return startup investments. Venture Capital firms on the other hand are firms managing capital funds aimed at viable high risk, high return startup investments.)

    Another important distinction is the fact Mom and Pop’s investors are coming on board with “preferred shares,” not common shares. Like many other startups, these investors will participate in a “Preferred Series A Offering.” The venture firm provides 1.25 million dollars and an angel provides 250 thousand dollars, for a total investment of 1.5 million dollars.

    There are numerous features of preferred stock that are outside the scope of this article. It is sufficient to understand for now that “preferred” stock often means just that, the purchasers are preferred over the common stockholder in a number of critical ways. The other thing to understand is that there will be two distinct classes of shares held by two distinct classes of people, common shares for the founders and employees, and preferred shares for the investors.

    Now for some math and startup finance terms that will make this whole enterprise fairly transparent. There are two numbers to keep track of: the “pre-money” and “post-money” valuations. The “valuation” is simply what the company is valued at (which is one of the finer points of venture capital—a key component of any financing is the value of the company that is to be funded. Determining this number for an early stage company is part science, part art, part bluff). The pre-money valuation is the value of the company prior to financing, while the post money valuation is the value of the company after the financing. The parties agree that the pre-money valuation of Micromedia is $1,000,000. Hence, the post-money valuation will be 2.5 million dollars, or the original 1,000,000 plus the incoming 1.5 million.

    The reason valuations are critical is because they become the benchmark for determining how much each set of parties actually owns. Using the agreed upon Micromedia pre-money valuation, the price per share is $0.20 (this is the total pre-money valuation of $1,000,000 divided by the total number of outstanding common shares, or 5,000,000, including all vested/unvested founder shares and all granted/un-granted/exercised/unexercised options—or more simply ALL common shares). This is so even if the options have not been granted or exercised, or if the founders stock has not vested with the founder. (Founders often do not get all their stock up front, but rather must meet some milestone (time spent with the company is a common one) for it to “vest” with them. And often, in lieu of options, founders are offered “restricted” stock-stock that is simply set aside for the founder and held until vesting.)

    Based on this price per share, the Series A investors will receive a combined 7,500,000 shares (or the investment of $1,500,000 divided by the price per share of $0.20). At this point Micromedia has a total of 12,500,000 shares outstanding (Mom and Pop’s 3,000,000 common shares + the 2,000,000 options + the 7,500,000 preferred Series A).

      Shares % Micromedia Ownership
    Founders 3,000,000 24%
    Option Pool 2,000,000 16%
    Series A Preferred 7,500,000 60%
    Total 12,500,000 100%

    After a first round of financing, and hopefully after every financing, the founders should find themselves percentage diluted (meaning they own less of the company as a percentage than before), but not economically diluted (meaning the percentage they hold is still more valuable than what they had before.) Here, based on the post-money valuation of Micromedia, the founders’ shares have jumped from their original $10,000 investment to $600,000 (3,000,000 shares times $0.20/share). Hence the founders have not suffered any economic dilution, though their percentage ownership of the company was diluted.

    Financings and the pre and post effects are usually tracked on a simple table called a capitalization table. The table, among other things, tracks the various ownership stakes in the company before and after a financing.

    This same model is generally applied to various rounds of financing. However, the above is the most vanilla scenario, whereas other scenarios can involve other classes of shares and other complicating factors. In the final analysis, the process is not rocket science and follows a pragmatic and intuitive set of rules.