When raising money from investors (angels or VC), it is critical to have a presentable and clean cap table. There are many reasons for this, but fundamentally, it is impossible to calculate a share price for the investment round unless you have complete agreement on how many shares are outstanding pre-money. The share price is calculated by taking the pre-money valuation and dividing it by the number of shares outstanding pre-money.
So Share Price (SP) = Pre-Money Valuation (PMV) / Shares Outstanding (SO). Example:
PMV = $3.5mm; SO = 2,456,758 shares; then SP for new round = $1.423 per share (and yes, often the share price is carried past 2 decimal places).
So having 100% accuracy on the 2,456,758 share number is critical (I used a wacky number purposely because usually the number is NOT nice and even).
So let’s talk about the components of the 2,456,758 share number. They are typically pretty simple: (i) shares owned by founders and (ii) shares authorized for issuance in a stock option pool, some of which may be issued to employees already and some of which will be available for future issuance. The option plan shares available for future issuance typically represent the number of additional options needed for hiring planned up to the point of the NEXT financing (as in we are doing a Series A round now, how many options do we need prior to doing a Series B round). Often times a plug is used around 10%. VCs in particular typically insist on a slug of available options counting in the pre-money share total as they do not want to be diluted later by the issuance of those options. I have posted on this previously.
Back to our basics. Let’s assume that Founder X owns 800,000 shares of common stock and Founder Y owns 1,300,000 shares of common stock and that the option pool in total has 356,758 shares allocated (to make the total stated above). On a fully diluted pre-money basis, that would mean the option pool represents 14.5% (356,758/2,456,758) of the cap table. That is normal for a pre-money % as it will drop down to about 10% post money depending on size of round and valuation.
For Founder X and Founder Y, this means that with respect to each other ONLY Founder X owns 38% (800,000/2,100,000) and Founder Y owns 62% (1,3000,000/2,100,000). This relative ownership is important to Founder X and Founder Y and should be on their minds from the beginning. If no additional equity is ever granted to Founder X and Founder Y, then Founder Y will ALWAYS own 1.63 times more equity than Founder X.
QUESTION #1: This leads to our cap table clean up question #1, namely is that the right allocation? Well, that is really up to Founder X and Founder Y. What drives smart investors nuts is when Founder X and Founder Y try to re-allocate their ownership after a deal is in due diligence. Reallocating is not impossible, but often not easy because of tax issues. Founder Y just cannot give shares to Founder X to reallocate after a pre-money valuation has been agreed on (or heavily discussed) because the reallocation would be a taxable transaction (Founder X is getting something of value in the shares and your lawyers and accountants will squawk loudly). LESSON: best to approach investors after you have your share allocation amongst the founders FULLY settled.
QUESTION #2: If you have not allocated the way you want from the beginning, then what can you do? The most common way to reallocate is to grant one of the founders a stock option with a “real” strike price based off the financing round price (typically a discount). This will obviously change their relative ownership. So, yes, you can fix, but I can safely say that the founder who ended up with options (to avoid tax issues) would have rather had actual stock instead (better tax treatment upon sale typically). And don’t forget that the options granted would come out of the available option pool.
QUESTION #3: What if Founder X and Founder Y issued themselves some sort of preferred stock instead of common stock? Well, that would be a hugely embarrassing mistake and a type of cap table clean that I really hate to see as it shows the complete naivety of the founders or the incompetence of their legal counsel or both. Exchange the preferred shares for common shares and start again.
QUESTION #4: What if the founders want to grant equity so some advisors that have been working with the company? That is fine, and should be in the form of option grants vesting over time. For the same reasons as expressed above, giving advisors actual stock (even if vesting restricted stock) will be taxable to the advisor if done when the company has a negotiated value. So, options with a strike price reflective of the negotiated value solves that problem (again, typically at a discount). Of course these options grants will also come out of the available option pool (remember that in our example the pool is 356,758 shares). If a whole bunch of that pool goes to advisors or to a founder under question #2 above, then MORE shares will have to added to the pool to assure that there are enough shares AVAILABLE for future grants after the financing closes. S0, being able to clearly state how many options you want to grant at the time of the financing is KEY. That will enable you to negotiate the number of options in the pool available for issuance post-money (i.e., after the financing closes). Again, that number is typically around 10%, as in 10% available on a fully diluted basis post-money. You might grants 25% pre-money to clean up your cap table issues, but the investors will still want a slug of available options post-money.
QUESTION #5: what if I have convertible debt outstanding that will convert into the Series A financing? No problem as this happens all the time. BUT, make sure you have a very clear listing of the debt, who owns it, when it was issued, interest rate and any applicable conversion discount. Typically, the debt plus accrued interest converts at a discount to the Series A price (10 – 30% typical). I like the call the dollar value of the debt plus interest factoring in the discount the “Purchase Power” of the convertible debt. For example if the debt holder has $223,000 of debt and accrued interest, with a 20% conversion discount, and the Series A price is $1.423 a share, then the debt holder would by Series A stock at $1.138 per share (.8*$1.423). That means the debt holder would buy 195,958 shares (rounded up) of Series A. So the debt holder Purchase Power is actually $278,848 (195,958*$1.423). This clearly illustrates the power of a conversion discount. Why is this important? Because most sophisticated investors will SUBTRACT the total Purchase Power from the negotiated pre-money valuation to avoid being diluted by the conversion of the debt. This will drive DOWN the Series A price (so no longer $1.423 a share (yes, this gets iterative but Excel can handle it). This make complete sense (at least to me). LESSON: make sure you understand your complete convertible debt picture and understand how it will impact your pre-money valuation. Too much convertible debt on your cap table is a pain in the butt to deal with as it will drive down your valuation.
QUESTION #6: What if the company has already issued some preferred stock to early angels (often Series Seed stock). No problem, this is also normal. But, the problem comes in when the Series Seed was issued at a share price above the new Series A share price (and with all the option clean up discussed above this is not unusual). The Series A investor in this situation will likely NOT want to give the Series Seed investors any anti-dilution protection. What we at CVF typically do is to pull the Series Seed stock into our Series A round on a one for one basis. So the Series Seed investors get Series A stock (which is typically better), but do not get price protection. They simply exchange EACH share of Series Seed (which for example they might have paid $1.75 a share for) for ONE share of Series A (which in this post’s hypo is valued at $1.423 a share). The problem is that IF the Series Seed had a liquidation preference equal to share price ($1.75) they end up with Series A stock with a liquidation preference of $1.423, so the Series Seed loses some liquidation preference protection (which might not make them too happy). This problem is another source of cap table clean up and one that the Series Seed investors have to eat usually. But it takes a good and long conversation between the founders and Series Seed holders.
I have covered a bunch of cap table clean up issues. This is probably the longest post I have written and the only one that I have written and posted from an airplane. So, I am going to stop, but will be happy to answer any questions in the comments or future posts.