Most investors and founders in start-up companies rely on post-money value for purposes to determine 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 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.
It's just an example of how AlgoValue, a comprehensive online valuation and cap table analysis platform, can help you better valuate your startup and track your cap table.
Let's Look at an Example:
A private company is currently raising $1 million in a Series A round.
Step 1: The parties negotiate the percentage to be given to the new investors in exchange for $1 million invested in the company. For this example, we will assume that they agree on a 33% stake. A term sheet is being negotiated.
Step 2: The new cap table is created based on: $1 million divided by a 33% equity stake in the company on a fully diluted basis, resulting in a post-money value of $3 million ($1 million/33%). 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 A round?
Let's take a look at the cap table and liquidation preferences:
The true economic post-money value of the company is much lower than $3 million due to the economic rights associated with the preferred shares.
Furthermore, if there were a $3 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 $2 million (66.67% of $3 million). In reality, they will receive a payout of only $1.33 million ($3 million, less $1 million of liquidation preferences invested in Series A, multiplied by 66.67%). This equates to a difference of almost $700,000!
Over time, the difference between the overly simplistic calculation and the true calculation of the company’s value will only grow. The gap between the expected future payouts for the founders and each share class vs. the reality will be significantly larger, and by the time an exit or other liquidity event takes place, the cap table may become even more complex.
Conclusion:
- In a majority of cases, founders, investors and shareholders sign terms sheets with economic rights that they do not always fully understand.
- Valuation decisions are made by either guessing or using simple Excel models. They are often times wrong.
Unfortunate Result: loss of money for the founders and shareholders.
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Written by Raphael Meyara, Co-Founder and CEO of AlgoValue.com
