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2013 10 15

Venture Capital Math 101: Pre-money, Post-money, Seed, Series A, B, C, D, up rounds and down rounds

Have you ever heard someone say “We raised 4mil A round at 20 pre”?

Like all trades, tech financing has its own vernacular. There is nothing you can’t figure out with basic math in the above quote. Soon, you as well can decode the crazy moon language spouted by entrepreneurs, investors & tech media.

Raising money from investors (VCs, angels, even friends & family) is always about two things:

  1. Price
  2. Control

This post will focus on the price of ownership bit. Also caveat lector: like snowflakes, the process of raising funds is unique, fragile and sometimes packed into a hard ball of ice which will give you a black eye. Every statement and example in this post has variations and exceptions.

Founders

Step 0 is to split initial ownership among the founders.

If you are a single founder, this step is quite easy. Most of our examples will use a 2575 split between two cofounders, just to make the math interesting.

Seed round

If you raise a seed round in Silicon Valley, odds are that you are getting money from Angels. Odds also are high that using something called a convertible note.

This means that the angels are essentially loaning you money, and expect to be paid back when you raise a Series A in the form of Stock.

The thing about raising money is that you need a valuation. If you don’t know how much a company is worth, then people cannot buy shares. In the stock market, the buyer and seller agree to a price of some shares and multiply that by all outstanding shares and you have a simple calculation of the value of the company.

During the fundraising process, this is flipped around. The investors and the founders usually start with a ballpark number of how much money the company wants to raise. Our example here is 1 million dollars. Starting with that, the parties negotiate out how much percentage ownership of the company that 1 million dollar buys. The actual valuation is then just simple math:

Founders want = 1 million
VC wants = 20% ownership

ownership calculation:
---------------------------
founders  |  VCs  | total
   80%    |  20%  |  100%

valuation calculation:
---------------------------
founders  |  VCs  | total
   4MM    |  1MM  |  5MM

Back to convertible notes:

The problem, is that early, early seed stage companies cannot accurately set valuations. During the seed round, convertible notes allow angels and other early, early investors to give money to the company without setting a valuation. Basically, the angels are saying that “I will give you this money now, and later during your series A, when you do set a valuation, use that number to issue me the right number of shares.” In practice angels can get essentially bonus shares issued to them as a reward for taking higher risk that comes with investing so early. These bonus shares are usually done through caps or discounts, but for now, just be aware of the terms and their purpose.

So the typical Seed Round looks like this:

ownership calculation:
----------------------------
founders  |  Angels  | total
   100%   |   TBD    |  100%

valuation calculation: 
----------------------------
TBD, but angels have put in $X in convertible notes with a 50% discount.

Series A

Here’s where things get fun. In our story, the founders are doing well. They raised money from angel investors, launched a product and got traction.

This is a story, so we skip the part about self-doubt, the valley of sorrow, the struggle to grow and the lack of communication and accusations of level of commitment between co-founders.

In our story, the founders started with a 7525 split. Got 200k from angels & now want to raise 2 million dollars (2MM) in the form of a Series A.

We now have to get a little bit into the mechanics of ownership. Ownership is done through shares. In the simple case, your ownership is the number of shares you own divided by all outstanding shares. Fairly simple. Our founders originally issued 1 million shares, so Founder A, got 750,000 shares and Founder B got 250,000 shares.

Initial ownership calculation:
------------------------------
founders  | total
   1MM    |  1MM


Series A ownership calc (in shares):
-----------------------------------
founders  |  Series A  | total
   1MM    |     TBD    |  1MM + TBD

If the Series A investors and the founders agree to give up 20% of the company for the 2MM dollars, then we can start filling in the table:

Series A ownership calc (in shares):
-----------------------------------
founders  |  Series A  | total
   1MM    |     TBD    |  1MM + TBD

Series A ownership calc (in %):
------------------------------
founders  |  Series A  | total
   80%    |     20%    |  100%

At this point, basic algebra kicks in, just solve for TBD:

Series A ownership calc (in shares):
-----------------------------------
founders  |  Series A  |  total
   1MM    |     250k   |  1.25MM

Also, at this point, we calculate the price of a share. The VC’s paid 2MM and got 250k shares: 1 share is 2MM/250k or 8 dollars a share.

Series A ownership calc (in shares,%):
-----------------------------------
founders  |  Series A  |  total
   1MM    |     250k   |  1.25MM
   80%    |     20%    |  100%

What about the Angels? Normally they would get their own column, but Here, the angels got rolled up into the Series A. In our example, the Angels got a discount on their price of their shares of 50%. That means, they were able to buy shares at 4 dollars a share. Their original convertible note is now magically transformed into 50,000 shares. For the sake of the simplifying the math, assume that 50k of the 250k Series A shares belong the angels above.

Pre, Post

We also see that there are 1.25 million shares outstanding, worth 8 dollars a share. Simple math gets us a total company post-money valuation of 10 million dollars.

Since the founders raised 2MM, the pre-money valuation is 8MM.

The simple formula works like this:

pre-money val + size of round = post-money val

Series B

The real fun comes with Series B. We two basic ways things can go from here: better or worse. In the case of better, The founders can raise more money at a higher price, (an up round). In the case of worse, the founders raise more money at a lower price (a down round).

Let’s be optimistic: The founders are doing very well. They’ve got product market fit, and good cash flow and now want to raise 20 million dollars to accelerate the business. Time for a Series B.

Series A ownership calc (in shares,%):
-----------------------------------
founders  |  Series A  |  Series B  |  total
   1MM    |     250k   |    TBD     |  1.25MM + TBD
   ???    |     ???    |    ???     |  100%

The math is similar, but we have a reference point.
In this round, the founders and Series B investors have agreed that the company is doing well and worth much more than before.

When a startup is doing well, the Series B is usually made up all of the Series A investors plus some new ones.

In this case, the founders and investors have agreed to a 20 million round at a pre-money valuation of 180 million dollars.

Our post money valuation is 200 million dollars. It also means that the Series B investors have 10% of the company:

Series B ownership calc (in shares,%):
-----------------------------------
founders  |  Series A  |  Series B  |  total
   1MM    |     250k   |    TBD     |  1.25MM + TBD
   ???    |     ???    |    10%     |  100%

To solve for TBD, we know that 1.25MM/TBD = 90%/10% TBD resolves to 138,888 shares at 144 dollars per share. At this point, we can use algebra to solve for ???

Series B ownership calc (in shares,%):
-----------------------------------
founders  |  Series A  |  Series B  |  total
   1MM    |     250k   |    139k    |  1.39MM
   72%    |     18%    |    10%     |  100%

One more quick term: dilution

See how the founders % of ownership drops at each round? That’s called dilution. When you join a startup and have X%, you have to expect your % to go down. This is okay, though because the shares you owned are essentially worthless the day you start the company. But after every up round, they are worth more. In our fictitious case here, the price per share went from 0 to 8 to 144. Dilution is no fun, and unfortunately, built in to the system.

Series B(ad)

In our optimistic example, we saw an up round. What about a down round?

Imagine our founders have not quite yet nailed product-market fit or are trying to add a bit more features to reach critical mindshare or need an influx of funds to finally do a huge marketing push. As long as the investors believe in you, you are okay.

If the investors have lost faith, you might be in trouble. A down round looks like this:

Instead of a humongous 200MM post-money valuation, you get a much smaller X valuation and are only able to raise 2.5MM instead of the 20 you wanted. Further more, that 5 MM is at 2 dollar per share. That means the Series B team bought two thirds of the company (5MM/2 = 2.5MM):

Series A ownership calc (in shares, ~%):
-----------------------------------
founders  |  Series A  |  Series B  |  total
   1MM    |     250k   |    2.5MM   |  3.75MM
   27%    |      7%    |    66%     |  100%

At 2 dollars per share, the new post-money valuation of company is 2 * 3.75MM or just 7.5 million dollars.

Also, notice how much more severe the dilution is during a down round. Your pride and joy and blood and sweat and tears just got gobbled up. Furthermore in the event of an exit, your personal stake is cut sharply.

Nobody (not even the investors) like down rounds.

There’s one last variation called an even round. Those aren’t great, but they are better than down rounds.

Series C and beyond.

Series C works just like Series B. So does D-Z.

On last point. That table we made above? It’s called a cap table. It’s usually a rather unremarkable excel spreadsheet, that investors and founders have been fighting over for months.

Conclusion

These are fictitious examples with numbers pulled out of thin air for the purpose of education. No founders or investors were harmed in the authoring of this post.

Do you want a real education? Go buy this book: Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

Let’s revisit our pithy lead: “We raised 4mil A round at 20 pre”

Now you know that 20MM pre-money + 4MM round = 24 MM post money valuation. The series A investors got 17% of the company and the founders and seed/angels got the rest.

Concepts you should have learned:



you may also be interested in some of the greatest hits of amattn.com:

〜 You Should Foster a Culture of Readability

〜 The Customer's Semi-Lucid Trance State

〜 ARC Best Practices

〜 Weighted Credit Pools for API Rate Limiting




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