October 19, 2023
By Luciana Jhon Urrunaga, Esq. and Anibal Manzano, Esq.
This is post #2 in our Term Sheet Series. Find our previous post here.
Your company’s valuation is at the top of the term sheet and, understandably, the term that gets the most attention. It determines the price your investor is going to pay for the piece of your company they are purchasing. Valuation can be expressed as pre-money valuation or post-money valuation. Pre-money valuation is the implied value of your company prior to the new investment coming in. Post-money valuation is the company’s pre-money valuation plus the total amount of new money coming in.
To illustrate, let’s say your investor is investing $1 million in exchange for 10% of your company. To figure out your post-money valuation, simply divide $1 million by 10%.
$1,000,000 / 10% = $10,000,000 Post-Money Valuation
To find your pre-money valuation you would take the post-money valuation and subtract the new money your investor is contributing to the company.
$10,000,000 - $1,000,000 = $9,000,000 Pre-Money Valuation
The next step is to figure out how many shares you will be issuing to your investor in exchange for their investment. To determine this, you will need to draft a capitalization table (“cap table”). It is imperative to maintain an up-to-date and orderly cap table since the company’s incorporation to keep track of ownership of the company’s stock as well as other securities. You may think determining how many shares to issue is as simple as multiplying the ownership interest you want to award —in this example, 10%‚—by the total number of shares your company has issued (let’s assume the company has issued 10 million shares to its founders so far). This assumes you would issue the investor 1 million shares. However, this is not typically the case.
When issuing stock to investors, they will ask you to take into account shares that have already been issued (i.e., shares typically issued to founders at the company’s incorporation) and any promised shares. However, sophisticated investors will typically also want to account for shares (i) covered by options issued to employees, (ii) issuable upon conversion of Simple Agreements for Future Equity (“Safes”) or convertible notes issued to previous investors during bridge rounds, (iii) to be reserved in connection with a stock option plan increase that occurs as of immediately prior to the equity financing, and (iv) issuable upon conversion of any other convertible security. This is what the startup world refers to as the fully diluted shares. Fully diluted shares are the total number of shares that would exist if all parties exercised their stock acquisition rights, and this is the number that you will typically use to determine how many shares your investor should receive. The diagram below will help illustrate the concept of fully diluted shares.
For our example, let’s assume the company has not only issued 10 million shares to investors, but has also set aside 1 million shares to issue to employees and consultants in the future via an equity stock option plan (“ESOP”).
10,000,000 (Issued and Outstanding Stock) + 1,000,000 (ESOP Reserve) = 11,000,000 Fully Diluted Shares
If your investor were to want to purchase 10% of the company following the ESOP Reserve increase, it would need to purchase 1,222,222 shares (11,000,000 / 90% = 12,222,222 Shares * 10% = 1,222,222). As illustrated above, it is imperative to consider any ESOPs, pending ESOP increases, and convertible instruments when calculating shares to be issued to an investor.
Of the three calculations, this is the most intuitive. Once you have determined the amount of shares that you will be issuing to your investor, simply divide the amount of the investment by the number of shares they are being issued.
$1,000,000 (Investment) / 1,222,222 (Preferred Shares to be Issued) = $0.818181
In our example, the investor would be purchasing the stock for $0.818181 per share.
Anibal Manzano is a corporate lawyer who specializes in venture capital and startup law, mergers and acquisitions, and cross-border transactions connected to the United States and Latin America. He is based in Boca Raton, Florida and regularly represents startups and investors in connection with venture capital financing transactions and related corporate and securities matters.