Venture Capital Deal Algebra
I’m intending this blog to be a mixture of my personal thoughts on being a venture capitalist (and my travels through the maze of the VC world); thoughts on life more generally; and what I’ll call VC 101 tips and pointers. One of the things I’ve noticed (and this is something that I’m happy to say the TypePad statistics really do a nice job of, my rant about them last week aside . . .) is that my VC 101 posts get a lot of traffic (and cross-posting/track-backs that drive this traffic). The impetus for my starting this blog was to capture my personal thoughts on being a VC, however I want to be sure I mix up my content to attract a broader array of readers. So, I’m going to keep up with the VC 101 posts, since it seems like there’s a segment of people who read my blog that sincerely appreciate an insiders view on the mechanics of venture capital. Today’s post is on deal algebra. Basically it’s a run-down of deal valuation terms. When you live in the VC world and use these concepts regularly, you sometimes forget that they are not necessarily obvious in their meaning (which can lead to confusion down the road; not good when you are embarking on a new venture with an entrepreneur). We noticed this a few years back, and as part of a larger effort to gather information that would be helpful to our portfolio companies Dave Jilk created this summary of key VC deal terminology that we sent around to a bunch of our CEOs and other people we work with (note: I’ve made some edits to Dave’s original work mostly for length). VC Deal Terms: In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that investors are able to calculate the relevant numbers in their heads. The concepts are actually not complicated, and with a few simple algebraic tips you will be able to do the math in your head as well. The essence of a venture capital transaction is that the investor puts cash in a company in return for newly-issued shares in the company. The state of affairs immediately prior to theinvestment is referred to as “pre-money,” and immediately after the transaction “post-money.” The value of the whole company before the transaction, called the “pre-money valuation” (and is similar to a market capitalization). This is just the share price times the number of shares outstanding before the transaction: Pre-money Valuation = Share Price * Pre-money Shares The total amount invested is just the share price times the number of shares purchased: Investment = Share Price * Shares Issued Unlike when you buy publicly traded shares, however, the shares purchased in a venture capital investment are new shares, leading to a change in the number of shares outstanding: Post-money Shares = Pre-money Shares + Shares Issued And because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the valuation after the transaction is just increased by the amount of that cash: Post-money Valuation = Pre-money Valuation + Investment The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by the total shares outstanding: Fraction Owned = Shares Issued /Post-money Shares Using some simple algebra (substitute from the earlier equations), we find out that there is another way to view this:Fraction Owned = Investment / Post-money Valuation= Investment / (Pre-money Valuation + Investment) So when an investor proposes an investment of $2 million at $3 million “pre” (short for pre-money valuation), this means that the investors will own 40% of the company after the transaction:
$2m / ($3m + $2m) = 2/5 = 40%
And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share: Share Price = Pre-money Valuation / Pre-money Shares = $3m / 1.5m = $2.00 As well as the number of shares issued: Shares Issued = Investment /Share Price = $2m / $2.00 = 1m calculate with post-money numbers; you switch back and forth by adding orThe key trick to remember is that share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to subtracting the amount of the investment. It is also important to note that the share price is the same before and after the deal, which can also be shown with some simple algebraic manipulations.
A few other points to note:
- Investors will almost always require that the company set aside additional shares for a stock option plan for employees. Investors will assume and require that these shares are set aside prior to the investment.
- If there are multiple investors, they must be treated as one in the calculations above. To determine an individual ownership fraction, divide the individual investment by the post-money valuation for the entire deal. For a subsequent financing, to keep the share price flat the pre-money valuation of the new investment must be the same as the post-money valuation of the prior investment.