8 million premoney valuation relative B u s i n e s s F i n a n c e

M3: PRACTICE QUIZ SOLUTION
Transcript
This video is to go over the practice quiz problems in order to get you well prepared for the graded quiz.
The first problem is a straightforward ownership valuation question, where a venture capitalist invests $1.5
million at a $4.25 million pre-money valuation. That gives a post-money valuation of $5.75 million. And that
means the VC is going to own just over 26%, one and a half the investment, divided by the post, and common
shareholders are going to retain just under 74%, the $4.25 million pre- divided by the $5.75 million post-. That
means that at exit, the split of the proceeds will be based on that ownership.
So, if the company sells for $100 million, The VC will get a little over 26% of that. And the common
shareholders will get a little less than 74 million of that. Because the VC owns a little over 26%, they’ll get a
little over 26% of the $100 million. And the common shareholders will get a little less than 74. Now, if there
were liquidation preferences, this could be different. But given one round and $100 million exit, it’s quite likely
that this would be precisely what the VC and the common shareholders would get. And then the common
shareholders would split $73.913 million.
Based on the ownership of the common shares. So if you as a founder own one half of the common
shares, you would get one half of the $73.91 million, or just a little bit less than $37 million. That’s of course
what you get gross, after taxes — well in California it would be more like $25 million, maybe even 20. The
second problem looks at a series of investments and asks you to construct the capitalization table and then to
dig into the common shares. So the capitalization table comes from the terms of each round, the investments
and the valuations. And if, with over the three rounds this company does well, we know it does well because it
gets additional rounds.
But it does well, we can see, as it raises more money at higher and higher valuations. Now the
capitalization table tracks the shares by class of shares. It has nothing to do with who owns the shares. Just
the class of shares. So what do the A-shares represent? What do the common shares represent? The Bshares, the C-shares etc. After the A round, there will only be A shares and common shares, and the A shares
will represent three elevenths of the total shares. Because the amount invested is three and the post-money
valuation is eleven. That common shareholders will retain 72.7% of the ownership based on the $8 million premoney valuation relative to the $11 million post.
B round is similar in that the B shares will represent $15 million, the amount invested, divided by $63
million, the post-money valuation. So if we add these up together. That 23.83% is the new shares, as a fraction
of the total number shares after the B route. And what those new shares will do, is they would dilute both the A
shares and the common shares. They’ll dilute all existing shares by 23.8%. So we calculate dilution by taking
the ownership going into the route and we could do this with the 72.7% as well. The dilu- ownership going into
the round times 1 minus the amount invested, divided by the post-money valuation. So the fraction of the
company that’s sold in that round.
So, this term is exactly the 0.238. And it gives you the dilution from the B round. So both the A shares
and the common shares fall as a fraction of the total shares, because there are now B shares as well. The
same thing happens to the C round, the C round represents 23.1% of the company post-C, that’s 60 divided by
260. And then the A-Shares, the B-Shares, and the common shares are all diluted by 23.1%. So each of these
is the ownership going into the round times 1 minus 60 over 260. That’s how you get the dilution. Now we’re
going to look more closely at the common shares. The common share column in the cap table represents all
the common shares owned by everyone.
Just like the A-shares, the B-shares and the C-shares represent that owned by different BCs. So at the
time of the A route, the A-shares investor, the VC coming in, and the founders, will negotiate some of the
common shares to go to what’s called the pool. And the Pool is a set of shares. It’s a pool of shares. That isn’t
owned by anyone right now, but it’s intended to be owned by future employees. So it’s stock that will be used
to recruit and retain new employees. The founders are going to keep a big chunk of stock, but they’re not going
to keep all of the common shares because some of the common shares are going to be needed to recruit and
retain great employees.
That’s an essential part of building a startup. So we’re going to imagine that the initial pool is 25%,
leaving 47.7% in the hands of the founders. Now the initial pool could be 20%, it could be 15%, it could be
30%, but it’s likely to be 20-25% at the time of an A round. Because a lot of stock is going to go out the door
very quickly. So after the A round, now the company’s funded, has $3 million. It’s going to go out and hire
some people. It can afford to do that. But it can’t afford to pay top salaries, because it only has $3 million in the
bank.
So that’s not going to allow the company with just cash to compete with Apple and Google and
Facebook. So they are going to offer a significant amount of stock to the new hires to get them to first join the
company, and then second, to incentivize them to work really hard to make the company a success. Now
exactly how much stock depends on how these hires negotiate, and what market is for the people who they
need to bring in but it will be a pretty big chunk in aggregate. So in this example, it’s 11.6% of the company
being granted to the A-hires. So one hire might get 1%. Another might get 3%. Another might get 2.5%, but it
adds up in this case to 11.6%. That comes straight out of the pool, so now the pool is down to 13.4%. 25%
prior to hiring people, giving away or, or granting 11.6% leaves 13.4%. Now these grants are going to have to
vest over time, and we’ll talk about that in the last problem.
Now, at the time of the B round, where the company sells B shares and there’s 23.8% dilution, the
dilution is going to apply to the A shares as we’ve seen, it’s going to apply to the founders and it is also going
to apply to the A hires and to the pool. So the dilution in the B round is going to cause the pool to drop from
13.4% to 10.2% of the total company. Now, that doesn’t make the company less attractive. It doesn’t make the
pool less useful because it’s now stocked in a company that has $15 million in the bank.
Has gotten a $63 million evaluation. It’s starting to get traction it’s got some buzz maybe. So this isn’t a
bad thing but it does reduce the stock as a percentage that’s available to recruit and retain new employees. So
while the number of shares didn’t change, the percentage of the total change because we sold a bunch of
shares in the B round. Now, after the B round we’re going to go out and hire more people. We may not have to
give them as much stock because the company has more momentum. But we’re going to give out a significant
amount of stock. In this example it’s 7.1% of the new expanded company.
And that reduces the pool down to 3.1%. And then after a C-round, where the pool is diluted further, the
pool is down to 2.4%, and we’re still going to be hiring people. So at this point, we will have to refresh the pool.
There isn’t enough stock to continue building the company. Everybody realizes this. The VCs know it, the
founders know it. So even though the founders have now been diluted down to 28%, the existing employees
have been diluted, everyone is going to support refreshing the stock pool. And how it’s refreshed is pretty
simple. The board of directors authorizes new common shares to be created, just like in the C round, they
authorize the C shares and the B round, they authorize the B shares.
And the A round, the A shares. They’re going to authorize new common shares to be created. And put
into the pool. Now, when those new shares are created, it’s going to dilute everyone, including the pool. So if
we do a 10% refresh, it won’t increase the pool to 12.4%. It’ll only increase the pool to 11.3% when we account
for the dilution that happens as part of that refresh. That 11.3% is probably sufficient for the refresh. But we
could make the pool bigger. If we did a 20% refresh, we’d get a pool of 18.7%, after the refresh. So if we
needed a bigger pool to be able to go out and recruit and train great employees, we could do a 20% refresh or
then we could do a 15% refresh. Any amount of refresh is plausible to support the growth and success of the
company. Now, the bigger the refresh, the more than the existing shareholders are going to get diluted by the
refresh. So at a 10% refresh, the A shares go down from 16% to 14.5%. It would follow to 13.3% with a larger
refresh. The same thing is going to be true for founders, they would get diluted more, A-hires would get diluted,
everyone would get diluted more by a bigger refresh. So nobody wants a bigger refresh except to the extent
that it supports the success of the company. Because everybody knows that having a big chunk of an
unsuccessful company is far less satisfying, it’s far less lucrative, than having a smaller chunk of a very
successful company. In the last two problems, we go back and we look at two things that will complicate what
happens in the first two problems.
First, we’re going to look at preferences and then we’ll look at vesting. Preferences impact the division
of a exit. Where it can be different than the straight ownership split. And then investing is applied to all those
shares that we were just talking about that get granted to new employees. And even shares that the founders
retain after the A round. So problem three is based on a $10 million Series-A investment, at a $15 million pre,
so a $25 million post. That means that VC owns 40% of the company, the $10 million divided by the $25 million
post. And the common shareholders retain 60% ownership. And that means that if the company were to sell,
say, for $30 million, that based solely on ownership common would get 60% and the VC would get 40%. So a
$30 million sale, common will get 18 and the VC would get 12.
That’s with no liquidation preference and that’s, that 60/40 split would apply even with a liquidation
preference or very close to that 60/40 split, if the company sold for 300 million or went public for 3 billion. But
had a small exit. 30 million is small compared to the amount that was raised, valuation. It’s not a loss, a
company is worth more than its initial valuation. It’s worth three times the capital that went in. But it is a small
exit. And liquidation preference may change how the $30 million is divided. It might not if there’s a basic
liquidation preference then the VC has a choice to take their 40% of the exit, or to take their original investment
back.
That’s a basic liquidation preference. And the VC would choose to take their 40% to get 12 million
because that’s more than the 10 million that the liquidation preference would give them. So because the VC is
taking 40% the common shareholders get their 60% and the $30 million is split 18-12, just like it would have
been if there was no liquidation preference. But if there’s a stronger liquidation preference, for example, if
there’s a multiple preference a 2x liquidation preference, then the division of the $30 million changes. Because
now, the VC, while they still have the option to take 40% of the total, because they own 40%, they will take
their two times the original investment, or $20 million over that 12.
So the VC will get $20 million, they’ll get 2x on their investment. That only leaves $10 million for
common shareholders. So instead of common getting 18 and the VC getting 12 with the 2x liquidation
preference, the VC gets 20 and common only gets 10. Another fairly common, per, preference is a participating
preference. When I say common, I mean you see it regularly. It has nothing to do with common shares. The
preference is always from the preferred shares. And the participating preference is often called, double dip
because it means that, that we see in addition to getting their investment back they also get their share of what
remains.
So it’s straight up participating. Your basic participating. The VC will get their $10 million back and they
will get their 40%, Of the remaining 20 million. It’s important to recognize that it’s not 40% of 30 that the
company sells for. Because after the VC takes their 10 there isn’t 30 left, there’s only 20 left. So it would be 10
plus 40% of the remaining 20. Or $18 million, which leaves only 12 for the common shareholders. So the
straight participating flips the payoff in this particular example. Instead of common getting 18 and the VC
getting 12, the VC gets 18 and common gets 12. So it’s a much stronger preference in this particular case. It
doesn’t quite give as much as the 2x preference, but it shifts the division of the $30 million heavily in the favor
of the VC. Now, because a participating preference can be quite strong, it’s sometimes capped. That is, there
is a limit set on how much the VC can get from their preference.
There’s never a limit on what the VC can get. Because the VC owns 40%, the VC can always get 40%
of the total. So if the company sells for a billion dollars, there’s no cap. They can get 40% of that or $400
million. So this 2x cap, which sets the cap at 2 times their investment or $20 million, is only going to cap what
the VC can get from the preference. Now, in this case, the cap turns out to be irrelevant. Because the cap is
$20 million, the VC’s payoff from participation, 10 plus another 8 in participation, is only $18 million. They’re
below the cap. The cap is not binding, so it doesn’t change anything. With a 2x cap, common gets a 12 and the
VC gets their 18.
Now, if the cap was set at 1.5, then the cap would be 15 and the cap would be binding. The VC couldn’t
get 18 with a 1.5x cap. It could only take 15 and they would take 15 because that’s better than their 40%,
which is only 12. But in this particular case, the 2x cap isn’t binding, and so the VC gets 18, common gets 12.
The last problem looks at vesting. And vesting is how common share ownership becomes unqualified or
uncontingent, non-contingent, so that a common shareholder can leave the company and take their shares
with them. This won’t be true when the common shareholder first starts out, whether it’s a founder or a new
employee.
The shares that are granted are compensation, they are to be earned over time. And vesting is going to
quantify how exactly that happens. So we have, in this example, a 96,000 share grant that vests quarterly over
four years, with a one-year cliff. Those are what define vesting, how many shares, how long it’ll take to get fully
vested. And then the step or the period over which vesting occurs during the interim, and then whether or not
there’s a cliff. What a cliff means is that the employee doesn’t get anything for the first year until the cliff, and
then at the cliff, they fully catch up. So the way this vesting would look is that for the first year, there would be
no vesting.
And then at one year, there would be a big step to 24,000 shares because that’s one year’s worth of
vesting. Four quarters vesting at 6,000 shares per quarter, which is what we’re vesting in this particular
example. 96,000 total over 16 quarters, 6,000 shares per quarter, 4 quarters in the year, we jump up to 24,000
shares vested. Now if the employee leaves, they would take 24,000 shares with them. They would leave the
other 72,000 shares with the company. And then after that, quarterly the vesting would grow 6,000 shares
each quarter, until after four years, because it’s four-year vesting, all 96,000 shares would be vested. So in this
particular case, there would be nothing vested in six months because we would be here in the middle of the
cliff period.
There would be 24,000 shares vested in one year, at the cliff, we jump up straight up to one year’s
worth of vesting, 48,000 in two years, 96,000 in four years. You could calculate over two and a half years, over
three and a quarter years, exactly how much would be vested. So it’s a well-defined, deterministic schedule
that gives the employee unbridled, unconstrained ownership of shares slowly over time, as they earn them by
working for the company for one, two, three, or four years.

Questions:

1.) Your company raises its A-round with a VC investing $1.5m at a $4.25m pre-$ valuation.

a. What is the A-round’s post-$ valuation?

b. How is ownership split after the A-round?

c. If your company subsequently sells for $100m, how much do you receive if you own one-half of the common shares?

2.) A new company launches with a $3m Series-A at an $8m pre-$ valuation, at the same time creating a 25% stock Pool. A year later the company raises a $15m Series-B at a $48m pre-$ valuation. Two years after that the company does its Series-C, $60m on $200m.

a. Create the company’s Cap Table through the Series C.

b. Suppose the company gave employees recruited between the A- and B-rounds 11.6% of the company, and employees recruited between the B- and C-rounds 7.1% of the company. How big is the Pool after the C-round?

3.) A start-up raises $10m in a Series A at a $15m pre-$ valuation. The company sells for $30m.

a. How much will common shareholders receive if the VC has a basic liquidation preference?

b. How much will common shareholders receive if the VC has a 2x liquidation preference?

c. How much will common shareholders receive if the VC has a participating liquidation preference?

4.) You join a start-up as the first employee, receiving 96,000 shares that vest quarterly over four years with a one-year cliff. How much of your stock has vested after:

a. 6 months?

b. 12 months?

c. 24 months?

d. 48 months?

5.) Given that 1) unvested shares and 2) shares that remain in the Pool are cancelled in an exit, if 20% of a firm’s shares end up being cancelled, what happens to the ownership of the remaining shareholders?