Doing an Equity Round - Negotiating Price

Doing an Equity Round – Negotiating Price

Jen Berrent

Inga Goldbard

October 22, 2013 Attorney Advertising

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Negotiating the Series A Price

Economic Terms of a Series A Investment: Pre-Money Valuation

Series A Investment (“New Money”)

Any outstanding Notes that may convert

Post-Money Option Pool – Expressed as a percent of post-money shares outstanding

– Change in option pool is implemented immediately prior to the financing (so included in pre-money fully diluted shares outstanding)

Post-Money Valuation

© 2014 Wilmer Cutler Pickering Hale and Dorr LLP

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What is Pre-Money Valuation?

Generally negotiated by the Company with the “lead” investor

As a rule, the investor wants a lower valuation, and Company wants a higher valuation – However, there can be drawbacks to setting the valuation TOO

HIGH in an early financing round (“valuation overhang”)

More an art than a science for early stage companies – Often determined based on the percentage of the company

investors and founders are willing to exchange for the amount of cash being put in (e.g. 20% for $1M = $5M pre-money valuation)


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Calculating Pre-Money Valuation

Company-Specific Factors investors may consider: – Market opportunity (size, growth potential, competition)

– Strength of management team (track record, vision, credentials)

– Strength of product

– Progress to date

Ask investors to explain their valuation analysis – This may not get you more money, but will at least give you more

information

Negotiable in tandem with other terms of the financing (liquidation preferences, dividends, anti-dilution, etc.)


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Price per share =

Pre-Money Valuation ($)

(Current Shares + Options Outstanding [+ Conv. Note Shares] + Unallocated Option Pool)

But this is circular!

What is the Series A per share price?


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Quick Note on Convertible Notes: If there are convertible notes outstanding that either

automatically convert into Series A shares, or may elect to convert into Series A shares, the value of the notes may be included as part of the pre-money or the post-money valuation – More favorable for the Company for Notes to be part of post-

money (higher price per share)

Can be negotiated in tandem with other financing terms


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Post-Money Option Pool

The circularity is: The price per share for the Series A stock is based on the fully

diluted number of shares prior to the financing including the option pool

The size of the option pool is based on the fully diluted number of shares after the financing

The fully diluted number of shares after the financing is based on the price per share for the Series A stock


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The Option Pool Shuffle

The following narrative is from a blog (venturehacks.com/articles/option-pool-shuffle) and it illustrates the option pool circularity The punch line is: Don’t let your investors determine the size

of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.

Our focus: The Series A per share price calculations (i.e., math).


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You have successfully negotiated a $2M investment on a $8M pre-

money valuation by pitting the famous Blue Shirt Capital against Herd

Mentality Management. Triumphant, you return to your company’s

tastefully decorated loft or bombed-out garage to tell the team that their

hard work has created $8M of value.


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Your teammates ask what their shares are worth. You explain that the

company currently has 6M shares outstanding so the investors must be

valuing the company’s stock at $1.33/share:

$8M pre-money ÷ 6M existing shares = $1.33/share.

Later that evening you review the term sheet from Blue Shirt. It states

that the share price is $1.00… this must be a mistake! Reading on, the

term sheet states, “The $8 million pre-money valuation includes an

option pool equal to 20% of the post-financing fully diluted capitalization.”

You call your lawyer: “What?!”


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As your lawyer explains that the so-called pre-money valuation always

includes a large unallocated option pool for new employees, your

stomach sinks. You feel duped and are left wondering, “How am I going

to explain this to the team?”

The option pool lowers your effective valuation.


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Your investors offered you a $8M pre-money valuation. What they really

meant was

“We think your company is worth $6M. But let’s create $2M worth of new options, add that to the value of your company, and call their sum your $8M ‘pre-money valuation’.”

For all of you MIT and IIT students out there:

$6M effective valuation + $2M new options + $2M cash = $10M post

or

60% effective valuation + 20% new options + 20% cash = 100% total.


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Slipping the option pool in the pre-money lowers your effective valuation

to $6M. The actual value of the company you have built is $6M, not $8M.

Likewise, the new options lower your company’s share price from

$1.33/share to $1.00/share:

$8M pre ÷ (6M existing shares + 2M new options) = $1/share.


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Post-Money Valuation

So what is the Company actually worth after the Series A financing?

$5M Pre-Money Valuation + $1M New Money + $500k [Value of Convertible Notes] _______________________________________ $6.5M Post-Money Valuation


Wilmer Cutler Pickering Hale and Dorr LLP is a Delaware limited liability partnership. WilmerHale principal law offices: 60 State Street, Boston, Massachusetts 02109, +1 617 526 6000; 1875 Pennsylvania Avenue, NW, Washington, DC 20006, +1 202 663 6000. Our United Kingdom offices are operated under a separate Delaware limited liability partnership of solicitors and registered foreign lawyers authorized and regulated by the Solicitors Regulation Authority (SRA No. 287488). Our professional rules can be found at www.sra.org.uk/solicitors/code-of-conduct.page. A list of partners and their professional qualifications is available for inspection at our UK offices. In Beijing, we are registered to operate as a Foreign Law Firm Representative Office. This material is for general informational purposes only and does not represent our advice as to any particular set of facts; nor does it represent any undertaking to keep recipients advised of all legal developments. Prior results do not guarantee a similar outcome. © 2014 Wilmer Cutler Pickering Hale and Dorr LLP

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Doing an Equity Round - Negotiating Price

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