The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.
Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.
Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.
The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.
Calculating Share Price
For some reason, many people consider this exercise to be very complicated and often make costly mistakes. I will try to simplify this as much as possible.
In early-stage deals, investors may simply put in their money and get whatever you give them. However, it’s naïve to expect that; so be prepared. So, here is the sample problem to be solved. Hopefully going through this will help clarify and value the various elements of the equation and give us some insight into fairly and successfully navigating this in real life.
You have established the pre-money valuation of the company at $2.5 million. Your investor has indicated that they are willing to invest $500,000. How much of the company do they own, as a percentage, (a) 20% or (b) 16.667%?
Believe it or not many entrepreneurs have gotten this wrong.
Calculation: Pre-money valuation = $2,500,000, Add in the newly invested $500,000 for a post-money valuation of $3,000,000 ($2.5M + $500K = $3M). Therefore, $500,000/$3,000,000 = .16667
That sounds simple, but there is more. How many shares do they get? The three founders collectively own 180,000 shares. Does the investor get (a) 30,006 or (b) 36,000?
Calculation: $2,500,000/180,00 = $13.8889/per share. $500,000/$13.8888 = 36,000
So far this is very straightforward. However, what happens frequently is this:
- Founders: founders shares (3 @ 60,000 ea.) = 180,000 shares
- Employees: stock options totaling (2 @ 1,500 ea.) = 3,000 stock options (vesting 1/24th, 1/3 vested today) Note: 36,000 shares in original option pool.
- Board Members: restricted stock (2 @ 3,500 ea.) = 7,000 restricted shares
A missing variable
Now, what is the share price for the investor, and how many shares does their investment purchase? Actually, this cannot be answered with the above information alone. There is a missing variable, the exact number of shares used in the calculation, which will then be divided into the amount of the investment, thus yielding the price per share. The number of shares necessary for this calculation is generated by the mutual parties, the company and the investor, agreeing on the definition of a key concept – dilution.
Dilution occurs when a company issues new shares that result in a decrease in existing stockholders’ ownership percentage of that company. Stock dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.9
Common classifications of shares
How could there be any debate or negotiations involving the number of shares? Isn’t that a very clear number? Well, in a word, no. There are several common classifications of shares for the purpose of this calculation.
- Outstanding share: those actually issued by the company with no restrictions
- Restricted share: those actually issued by the company, but with some restrictions
- Stock option: option to buy a share in the future, under specific terms
- Restricted Share Units: promise to issue a share in the future, under specific terms
- Warrant: option to buy a share in the future, under specific terms (only slightly different than an option
Grasp this concept
Here is the most important concept to grasp relative to this exercise—the more shares that are counted, when divided into the agreed-upon valuation, the lower the share price. The lower the share price, the more shares the investor gets for their money.
Using the numbers from the example above:
- Counting just the 180,000 founders’ shares, the share price is $13.8888, and the investor gets 36,000 shares.
- Adding the restricted shares that the board members have, yields 187,000 shares, and the investor gets 37,400 shares.
- Adding all the stock options granted, yields 190,000 shares, and the investor gets 38,000 shares.
- And finally, adding all the options in the EIP stock option pool, yields 223,000 (187,000 from b above, plus 36,000 from the note in #2 in the example), and the investor gets 44,600 shares.
There are two terms normally used to reference this. The first is ‘outstanding shares’; while this would normally mean just the shares actually issued (a), it should technically also include the restricted shares on an as-if-fully-vested basis. The second term is ‘fully-diluted’. This reference can include whatever anyone wants it to. The entrepreneur may wish to leave it as just including the issued and restricted shares – thereby assuming that they will all fully vest. On the other hand, the investor (usually an institutional one) will press for full dilution to include a + b + c + d +the remainder of unissued options in the pool + all outstanding warrants. This should give you a good idea of why it is very important that you have a seasoned expert at your side before you enter this type of negotiation.
This example clearly shows that which classes or types of shares are counted in the number used for determining the per share price, based on an agreed upon pre-money valuation, has a big impact on the dilution suffered by the founders, employees, and any previous investors. Entrepreneurs beware; negotiating this with a new investor can be a very delicate process, but extremely important to both sides.
The trouble with talking in percentages
Tip: one of the things that often gets early-stage entrepreneurs into trouble is talking in percentages. When you are discussing ownership in a venture, of course, your ownership can always be measured as a percentage. However, there are two problems with using a percentage as the metric for discussion, (a) stating ownership as a percentage is misleading, since it can be different depending on which share model is used (as we just discussed above), and (b) an ownership percentage number – e.g., “you own 20%”, will stick in someone’s mind, and a short time later, when there has been some dilution, they may be disappointed to learn that they no longer own 20% – this is a psychological phenomenon, not a mathematical one. [This can be an even bigger problem with an LLC. Denoting ownership as a percentage can incur unnecessary conversations and expenses. To bring in additional capital, or issue ownership to anyone new, it will most often require a re-write of the LLC’s Operating Agreement, which may require legal fees.]
Converting ownership to units
What is the alternative? I always recommend stating ownership in terms of the number of shares or units someone owns. That number does not change (unless of course they later acquire more ownership). With a corporation, ownership is automatically stated in terms of share numbers. In an LLC, for some reason, many attorneys (especially ones that I would not recommend) like to articulate ownership in percentages. I always recommend converting ownership to units as early in the company formation process as possible. Knowing the number of units they own; an individual can always convert their number into a percentage – one simply must know and understand what comprises the total they are using for the calculation.
As a reminder, this is yet another reason to form a fiduciary board, or at minimum, an advisory board early on, comprised of a variety of seasoned experts in various areas that complement and augment, your own experience, not duplicate it.
Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only. Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.
MORE SHADOW CEO
About the author:
Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.
A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”
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