Most investors in start-up companies rely on post-money value for purposes of determining the impact of a new round of financing or a grant of stock options.  This is misguided. Why?

A company’s post-money value is typically based on a very simplified version of its cap table.  It ignores differences in share classes, including the liquidation preferences and participation rights of preferred shares.  As a result, the post- money value of a company calculated this way does not reflect the true economic value of the shares.
Let’s Look at an Example:

A private company is currently raising $3 million in a Series B round.

Step 1: The parties negotiate the percentage to be given to the new investors in exchange for $3 million invested in the company. For this example, we will assume that they agree on a 25% stake. A term sheet is being negotiated.

Step 2: The new cap table is created based on: $3 million divided by a 25% equity stake in the company on fully diluted basis, resulting in a post-money value of $12 million ($3 million/25%). This reflects the ownership structure, but does not consider actual economic returns.

What’s the Problem? This overly simplistic calculation of the post-money value of the company assumes that all share classes have the same financial terms. It ignores the economic impact of the liquidation preferences of the preferred share classes.

What then is the true economic post-money value of the company, based on the Series B round?

Let’s take a look at the cap table and liquidation preferences:

Table

The true economic post-money value of the company is much lower than $12 million due to the economic rights associated with the preferred shares.

Furthermore, if there would be a $12 million exit tomorrow, based on the above cap table provided by the company’s advisor, the common shareholders (founders) would expect to receive a payout of $6 million (50% of $12 million). In reality, they will receive a payout of only $3.5 million ($12 million, less $5 million of liquidation preferences invested in Series A and B, multiplied by 50%).  This equates to a difference of almost 50%!

Over time, the difference between the overly simplistic calculation and the true calculation of company value will grow. The gap between the expected future payouts for the founders and each share class vs. the reality will be significantly larger.  By the time an exit or other liquidity event takes place, the cap table may have become even more complex….making the likelihood of unpleasant financial surprises a near certainty.

Welcome to the “Start-Up Ecosystem”, a place where stakeholders are not sufficiently aware of and frequently not well-advised about the nuances of valuation-related issues.

Conclusion:

  • In a majority of cases, founders, investors and shareholders sign terms sheets with economic rights that they do not fully understand.
  • Valuation decisions are made by either guessing or using simple Excel methodologies. They are often times wrong.
  • Decision makers frequently work with stale and inaccurate data which are not shared in real time. This causes major gaps between expectations and future payouts for founders and shareholders: in a next round financing, in a liquidity event, when selling securities on secondary market platforms.

Unfortunate Result: loss of time and money for the founders, shareholders and employees who have been granted stock options.