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When fundraising, the main topic of negotiation is often the pre-money valuation used to calculate the price of stock issued to investors. Pre-money valuation refers to the valuation of the startup prior to the fundraising. The pre-money valuation matters because it determines the percentage of the corporation an investor will receive in exchange for their investment.
Startup investors typically calculate their percentage ownership based on the fully-diluted capitalization of the corporation. Capitalization, in this context, refers to the capital structure of a corporation — i.e. the structure of the equity and debt of a corporation. The term diluted refers to the fact that the ownership percentage represented by each share of stock is diluted each time new shares are issued. The term fully-diluted means that the capitalization is calculated assuming that all plans and obligations (whether outstanding or potential) to issue shares have been fulfilled.
Thus, a startup's fully-diluted capitalization commonly assumes:
- any shares reserved for issuance under a stock plan have been issued.
There is no single definition of fully-diluted capitalization. For example, un-issued shares reserved for issuance under a stock plan can be excluded from a fully-diluted capitalization. This is commonly done when the fully-diluted capitalization is being calculated in connection with the acquisition of a startup, since startups typically do not issue equity following an acquisition. By contrast, these shares are almost always included in a fully-diluted capitalization in the context of equity compensation. Another possible difference is with securities that convert into stock in connection with a preferred stock financing, such as convertible notes and safes. Some definitions of fully-diluted capitalization assume the conversion of these securities, while others do not.
- 8,000,000 shares issued and outstanding;1
- 1,000,000 shares reserved for issuance under a stock plan2 for employees and consultants, of which:
- 500,000 shares are subject to outstanding options and
- 500,000 shares remain available for issuance; and
- 1,000,000 shares informally set aside for accelerators or additional co-founders
Corporations can buy stock back from stockholders. Stock that has been issued and not been bought back is considered to be issued and outstanding. If stock is repurchased by the company, it is no longer considered to be outstanding.
One traditional way for startups to raise seed financing is to sell convertible notes (also referred to as convertible promissory notes). These seed financings are known as convertible note financings.
Although convertible notes have traditionally been popular for seed financings, the trend in Silicon Valley and other major startup ecosystems is toward safes. See Safes.
Notes (also referred to as promissory notes) are promises made by someone to pay a specified amount to the holder of the note (also known as the noteholder) at some time in the future, known as the maturity date. Convertible notes are notes issued by a corporation that convert into shares of the corporation's stock upon certain events. When startups sell convertible notes, the notes typically obligate the company to repay the purchase price plus interest in the event that the note has not converted by its maturity date.3
Although they are notes, both the startup and the investor (i.e. the noteholder) usually intend for the note to convert into stock, rather than for the corporation to repay the note. Typically, convertible notes convert into shares of the series of preferred stock issued in the corporation's next equity financing, as part of that equity financing. Convertible notes often also convert into shares of the corporation's stock if the company is acquired or does an IPO. Most convertible notes have features known as valuation caps or discounts which affect the number of shares the note will convert into. Valuation caps and discounts are explained in our article about safes.
Despite their popularity, many people consider convertible notes awkward to use. Even though investors and startups do not typically think of convertible notes as an obligation of payment, they must agree on an interest rate4 in order to issue a convertible note. If a note has not converted by its maturity date, the investor and company must spend time and energy deciding what to do (usually, they extend the maturity date).
These problems exist because convertible notes were not originally designed for seed financings. They were originally designed for bridge loans — loans made by VCs to companies they invested in, to help those companies survive until their next round of venture capital financing. Startups began using convertible notes for seed financings because the paperwork and negotiation was considerably simpler than for an equity financing.
Recently, various organizations have created alternative forms of investment designed for seed financings from the ground up, in order to address the problems with convertible notes. In Silicon Valley and other major startup ecosystems, these alternatives are gaining popularity over convertible notes.
Often, the terms of the note specify that the corporation does not have to repay the note unless investors specifically request it. In some states, there may be lending regulations that limit how far out the maturity date can be set.
The interest rate cannot be below the applicable federal rates (AFRs) published by the IRS. The applicable federal rate is used by the IRS to determine whether an investment is a loan for tax purposes. Not setting an interest rate or setting an interest rate below the AFR creates tax issues for both the investor and the startup. The accrued interest typically also converts into shares, along with the principal balance (i.e. the amount invested).
There are three major types of safes — safes with a valuation cap, safes with a discount, and safes with both. These correspond to the three major flavors of convertible notes.
The number of shares of preferred stock a safe will convert into is determined by dividing the amount of the safe investment by a price (per share) for the preferred stock. The lower this price is, the more shares a safe will convert into. The higher this price is, the fewer shares a safe will convert into.
If the investment amount for a safe with a valuation cap is $1 million, and the price per share used for conversion is $2.00, the safe will convert into 500,000 shares by default.
When a safe has a valuation cap and the safe is converting into preferred stock as a result of a preferred stock financing, there are two ways of determining the per share price of preferred stock to use for the safe conversion. The first is to use the per share price of preferred stock from the preferred stock financing. The second is to calculate a price by dividing the valuation cap by the fully-diluted capitalization (referred to as company capitalization in safes). Safes convert using the lower of these two possible prices, making the valuation cap a limit on the valuation that is used for the conversion.
If the valuation cap for a safe is $20 million, the fully-diluted capitalization of the company is 10 million shares, and the price per share of preferred stock in the preferred stock financing is $3, then the price per share used for converting the safe will be $2. However, if the price per share of preferred stock in the preferred stock financing is $1, then the price per share used for converting the safe will be $1.
The fully-diluted capitalization can be calculated differently depending on the type of valuation cap on the safe. Traditionally, the fully-diluted capitalization is calculated excluding safes and convertible notes. If the valuation cap is a post-money valuation cap though, then the fully-diluted capitalization is calculated including them. The term post-money in post-money valuation cap refers to the fact that it functions as a cap on the valuation after (post) the safe financing (money) is taken into account.
Assume the valuation cap for a $1 million safe is $20 million and the fully-diluted capitalization of the company, excluding conversion of safes, is 10 million shares. Also, assume that this safe is the only investment the company has received.
If the valuation cap is a regular valuation cap, then the fully-diluted capitalization used for the safe conversion will be 10 million shares. If the valuation cap is a post-money valuation cap, then it will be 10,526,316 shares. This is because the $1 million is 5% of $20 million, and 5% of 10,526,316 is 526,316.
In this scenario, the price per share used for the conversion will be $2 in the case of a regular valuation cap, but $1.90 in the case of a post-money valuation cap (assuming the price per share of preferred stock in the preferred stock financing is higher).
By limiting the valuation used for conversion, valuation caps ensure that safes will convert into a minimum percentage of the company, as calculated prior to the preferred stock financing. For safes with regular valuation caps, this minimum will be lowered when the company issues additional safes. By contrast, for safes with post-money valuation caps, this minimum percentage remains the same no matter what other safes the company has issued.
Assume a company has never received any investment and has a fully-diluted capitalization of 10 million shares, excluding conversion of safes. If someone invests $1 million through a safe with a regular $20 million valuation cap, the safe will never convert into less than 500,000 shares. Immediately prior to the preferred stock financing, this would represent ~4.8% of the fully-diluted capitalization after the safe conversion (500,000 divided by 10,500,000).
Now suppose someone else invests another $1 million through an identical safe. That safe will also never convert into less than 500,000 shares. Immediately prior to the preferred stock financing, each safe would represent ~4.5% of the fully-diluted capitalization after the safe conversion (500,000 divided by 11,000,000). The first safe converts into a lower percentage as a result of the second safe (and vice versa).
If these safes had post-money valuation caps instead, each safe would be unaffected by the other. If the second safe were never issued, the first safe would convert into 526,316 shares (as calculated in the prior example). This would represent 5% of the fully-diluted capitalization after the safe conversion (526,316 divided by 10,526,316). If the second safe was issued, then each safe would instead convert into 555,556 shares, which would still represent 5% of the fully-diluted capitalization after the safe conversion (555,556 divided by 11,111,112).
Valuation caps are also referred to as conversion caps or target valuations.
The conversion price can also be set to have a fixed discount from the price per share of the preferred stock. This ensures that the safeholders will get a better deal than subsequent preferred stock purchasers.
If someone invests $1 million through a safe with a 10% discount, the safe will always convert into shares that are worth 90% of what someone would have to pay for the same number of shares in the preferred stock financing.
Valuation Cap & Discount
Some safes have both a valuation cap and a discount. When safes with both a valuation cap and discount convert, the more investor-favorable method is used — i.e. the method that results in the safe converting into more shares.
By default, if a safe has not already converted by the time the company is acquired, the investor has the choice of (1) receiving their investment back5 or (2) having the safe convert into common stock using the same valuation cap or discount as for a preferred stock conversion.
When investors have significant negotiating power, they may negotiate to have the safe specify an option to receive a multiple of their investment back (typically 2×). This has the effect of increasing the minimum acquisition price at which founders and employees will receive proceeds from an acquisition.
If the proceeds from the acquisition are insufficient to return the investment back for all safes, the proceeds are typically distributed pro-rata to the investors. This means that investors will receive proceeds in relative proportion to the size of their investment.
While most startups issue convertible notes or safes in seed financings, some issue preferred stock (which is standard for post-seed financings). Financings where the startup sells preferred stock are known as equity financings, since preferred stock is a form of equity.
Typically, startups create a new series of preferred stock for each equity financing. Startups issuing preferred stock in a seed financings will usually call the new series Series Seed or Series AA. These financings often use forms based on those used in post-seed financings, but that are specifically adapted for seed financings.
By convention, for post-seed investments, the series are designated by letters in alphabetical order. For example, the series created for the first post-seed financing is typically called Series A Preferred Stock. The series created for the next financing is usually called Series B Preferred Stock, and so on.