Nivi · April 11th, 2007
Summary: Focus on your share price and the number of shares you own — metrics like valuation and percent ownership can fool you.
If valuation is your only pespective on a company’s capital structure, you can get fooled by games like the option pool shuffle which make your valuation seem large but actually depress your share price.
Focus on share value, not share quantity or valuation.
The most naive shareholders focus on the quantity of shares they own. That’s a mistake. The company can double your share quantity with a simple stock split. Do you feel rich now? We know companies that have 200M shares outstanding after the Series A just to fool their employees!
Merely uneducated shareholders focus on the percentage of the company they own. News flash: owning 99% of a company that is worth $10 is not going to make you rich.
Experienced shareholders (and Venture Hacks readers) focus on the current value of their shares and the company’s prospects. Investors in public companies with wacky capital structures don’t fancy that they own 0.0003% of a company that is worth $1B. Instead, they multiply today’s share price by the quantity of their shares to determine their share value. They track percentage ownership and valuation, but they focus on share price.
You should do the same:
Understand how any proposed change to the company’s capital structure affects the share price.
Employees should track share price too.
The number of options that new hires receive drops quickly as the value of the company increases and risk decreases. But the value of these options declines much more slowly because the increase in share price partially compensates for the reduction in share quantity.
On the other hand, if the share price is going down, the CEO and other “key” members of the management team often receive more shares to boost their share value — particularly after a new financing with inside investors.
The employees and founders who are left out of this little party should crash it.
Appendix: How to derive the share price.
These terms are negotiated in a simple Series A:
p = pre-money ($)
c = cash invested ($)
o = option pool size post-money (%)
and we hope you already know this:
x = existing shares outstanding (shares).
With these known values, it is easy to calculate all the unknowns:
value symbol equation post-money ($) t t = p + c new options (shares) n n = (x · o · t) ÷ (p − o · t) share price ($/share) s s = p ÷ (x + n) investor shares (shares) i i = c ÷ s effective valuation ($) e e = s · x
Topics Option Pool · Valuation
HipMojo.com - Main Street Meets Madison Avenue, Wall Street and Silicon Valley » The Evolving VC Landscape: VCs Being Attacked, by VCs? // Apr 12, 2007 at 10:53 am
[…] post is interesting, mainly because it’s akin to my advice to stock investors about not looking […]
Thank you for another great “math of wisdom.”
BTW, not that I am carried away with math, but for the sake of “the rest of us” non-MIT geniuses, it would be easier (and laymanly more digestible), if you first calculated the effective share price as simply as:
s = (p – t.0)/x (1)
Thus, it follows that
n = t.o/s (2)
Of course, if in equation (2) we plug in the value of s in equation (1), we get to your equation
n = (t.o.x)/(p – t.o)
In a negotiation, you can also try to change the rules of the game (change the formulas). For example, I know a few CEOs that have successfully negotiated that any option pool be created after the investment by institutional money, not before. So, the investors took the pool dilution along with the founders. This represents a significant increase in valuation without asking for an increase in valuation. It’s a hard chip to win in bargaining, but it’s worth taking a shot considering the high reward.
Question for the group:
I’m a co-founder at OnCard Marketing. We did a convertible note to raise our seed round and will probably begin the Series A process over the next 4 months. I have recently come into some new-found wealth that I would like to invest in the Series A along with existing and new investors to minimize dilution to my founders common equity. I understand I will then own two classes of stock and have similar rights on my preferred stock as my investors.
Question: Will Series A investors want/allow me to do this?
Thanks!
JTreiber,
Any rational investor would love it if you did this – it’s “putting your money where your mouth is,” and validates the price that they are paying as not being too high. From a game theoretic perspective, it also gives you the same information rights as your investors if you ever leave the company (although information rights often have a minimum ownership threshold, so see what that is), and it might give you tie-breaking power in certain situations (say, if the rest of your Series A is divided across two investors).
However, it does put you in a bit of a conflicted situation on the valuation, so have one of your other founders negotiate the valuation with the Series A, and you just tag along.
Also, make sure that you only signal your readiness to do this once you are *sure.* If you say you’re going to do it and don’t follow through, you’ll be sending a very negative signal on the valuation.
Finally, as a matter of diversification, I would advise against doing this unless the amount is not very consequential to you or unless you believe that the company is being undervalued in this round. You probably already have enough stock in the company and should be diversifying / hedging.
Just wanted to add that share percentage is key – not just share price. If your ownership goes down to less than 25% of the voting shares, and you are pushed into a minority position, your power within the company weakens considerably – to the point that your value can be wiped out fairly easily unless you have suitable provisions in your investment agreement. Fighting a case based on the prejudice of minorities is expensive and incredibly difficult, particularly if you have been forced out and off the board. And even if you win you often don’t get your legal costs paid. Control or protections over share issues are absolutely vital.
Question:
Recently joined and early-stage startup which has been 100% self funded to date. I’m joining as an executive and recognizing that the core team is not yet built-out, I’m suggesting to the founders that they take their dilution up-front and set aside a share-option pool to be used to build-out the core team. This serves three purposes; 1) protects me and others from further (unknown) dilution as we bring on new team members, 2) it avoids the endless negotiations and re-calculation of the cap table for every new hire, 3) it provides a pool of shares which can be used as compensation for project-based consultants.
Does this make sense?
Valuing Startup Options @ Hyperextended Metaphor // Jan 3, 2010 at 7:52 pm
[…] a contrarian perspective, you can read Venture Hacks, which disagrees with me and says you should focus on share price. They also have a whole post on analyzing startup job offers. Further evidence there are many ways […]