[Stockmoose16]

Hi,

I'm starting up a new company and am going to need 2 capital equity raises. The first, for $50,000. The second for $250,000. I want to own 50% of the company at all times, but I'm not sure I've done the math correctly. Can someone please verify?

1st Raise:  (Raise: $50,000, company value: $50,000)
                   $ invested       Shares issued          % ownership

Owner              -                     50,000                  $50%

1st Investors   $50,000              50,000                  $50%

2nd raise: (Raise: $250,000, Company Valuation: $1,000,000... which means 2nd round investors will want 25% of company for a $250,000 investment.

                     $ invested        Shares owned                  % ownership
Owner                       _                   200,000                          50%

1st investors         $50,000               100,000                          25%

2nd investors         $250,000             100,000                         25%

Using the following equation, I determined I need to issue

Let X= # of new shares to be issued.

(x/current number of shares+x)= % ownership 2nd investors require

(x/100,000+x)= .25

.25x+25,000=100,000

75,000/.25x=300,000 shares

So, for the second investors to get 25% of the company, I need to issue 300,000 new shares. Since 100,000 shares were issued in the first raise, there is now a total of 400,000 outstanding shares. 100,000 shares go to the 2nd investors (25% of the company). 200,000 go to the founder (to ensure 50% ownership) and 100,000 go to the 1st round of investors, who've now had their equity stake diluted by 25%, even though they've gained 50,000 shares. Is this math and logic correct? Something must be wrong here. Can someone help?

[akula]

Originally Posted by Stockmoose16

Hi,

I'm starting up a new company and am going to need 2 capital equity raises. The first, for $50,000. The second for $250,000. I want to own 50% of the company at all times, but I'm not sure I've done the math correctly. Can someone please verify?

1st Raise:  (Raise: $50,000, company value: $50,000)
                   $ invested       Shares issued          % ownership

Owner              -                     50,000                  $50%

1st Investors   $50,000              50,000                  $50%

2nd raise: (Raise: $250,000, Company Valuation: $1,000,000... which means 2nd round investors will want 25% of company for a $250,000 investment.

                     $ invested        Shares owned                  % ownership
Owner                       _                   200,000                          50%

1st investors         $50,000               100,000                          25%

2nd investors         $250,000             100,000                         25%

Using the following equation, I determined I need to issue

Let X= # of new shares to be issued.

(x/current number of shares+x)= % ownership 2nd investors require

(x/100,000+x)= .25

.25x+25,000=100,000

75,000/.25x=300,000 shares

So, for the second investors to get 25% of the company, I need to issue 300,000 new shares. Since 100,000 shares were issued in the first raise, there is now a total of 400,000 outstanding shares. 100,000 shares go to the 2nd investors (25% of the company). 200,000 go to the founder (to ensure 50% ownership) and 100,000 go to the 1st round of investors, who've now had their equity stake diluted by 25%, even though they've gained 50,000 shares. Is this math and logic correct? Something must be wrong here. Can someone help?

yah...ummm...your projected cap table is incorrect
your calculations are wrong because they're missing the founder's round, premoney val, postmoney val and discount rates.

essentially, the correct calculations to achieve "2 capital equity raises" and "own 50% of the company at all times" are in the tables I've included. It works like this...there's three (not two) equity rounds (one of them is sweat equity), and the discount rate is decreasing from 1st to 2nd round, and then from 2nd to 3rd..namely:





Round 1) In round 1, you do your financial forecasts, and determine a premoney val of $50k for the company (using a high discount rate to reflect the uncertain nature of the cashflows)...that's what the venture is potentially worth, and if you wanted to buy a 50% ownership in your company, you as a founder will need to pay $50k (to own 50% of the postmoney val, at $1k per 1%)...but not necessarily in cash...it's usually in the form of your employment contract with the company..where you pay the firm $50k worth of your labour, and the firm gives you 50% of outstanding shares (and retaining the remaining 50% ownership in itself through a custodian, marked for sale to Investors #1 and #2)

Round 2) In the first round (the founders round), you achieved a postmoney value of $100k for the firm. Because of your investment, the future cashflows of the firm are now less uncertain, so the discount rate drops, and increases the $100k postmoney value in round 1 to a $150k premoney value in round 2. In this second round, the custodian sells 25% of equity to investor 1 for $50k (at $2k per 1%), creating a $200k post money value for the firm, where your original 50% equity is now worth $100k rather than $50k (giving you a 2x return on your investment).

Round 3) In the 3rd round, the story repeats. Because of investor's 1 investment, the discount rate is now even lower (by this stage the company has sales etc), pushing up the premoney val in round three to $750k. To participate in this round, investor 2 has to pay the custodian $10k per 1% of equity, where he ends up buying the outstanding 25% for $250k, creating a $1m postmoney val for the firm. By this stage, your original $50k sweat equity investment is worth $500k, and investor 1's 25% of equity is worth $250k, rather than $50k (giving you a 10x return, and giving him a 5x return).

That's basically how shares are properly allocated..using the founder's round, premoney val, postmoney val and discount rates.

is this making sense?

[Stockmoose16]

Wow, this is much more complex than I originally thought. Thanks for taking the time to make the charts-- I definitely have some follow-up questions.

1) How can the company be valued at $100,000 before a single dollar of capital inflow arrives? Based on your chart, in the first round of investing, the founder owns $50,000 and the custodian owns $50,000-- why would the company be valued at anything when its just a piece of paper at this point? And, if it is worth anything, wouldn't it be valued at $50,000, not $100,000, since $50,000 will be coming in from investors? Why wouldn't the pre-money valuation in Rd 1 be "0" and the post-money be $50,000? Although, come to think of it, there's still no money injected in the company until round 2, so I don't see how even a $50k valuation makes sense.

2) At the beginning of Round 2, the pre-money valuation is $150,000. Why did the value of the company jump from $100,000 to $150,000? Then, at the end of round two, it's worth $200,000. So now, with only $50,000 in real capital (cash) from investors, the company has jumped in value by 4x the capital inflow.

3) Finally, in round 3, the pre-money valuation jumps to $750,000 from the previous post-money valuation of $200,000. How can this be, when only an additional $250k will be raised in this third round?

This is really confusing... Round 1 doesn't make any sense to me. If you have no money and just a piece of paper, how can the business be valued at $100k?

[Cole Taylor]

Originally Posted by Stockmoose16

Wow, this is much more complex than I originally thought. Thanks for taking the time to make the charts-- I definitely have some follow-up questions.

1) How can the company be valued at $100,000 before a single dollar of capital inflow arrives?

It's not, it's valued at 50k. Remember: post-money valuation = pre-money valuation + amount of money raised. If you're getting a 50k investment in exchange for 50% by default your setting your pre money valuation at 50k. whether it's worth 50k as seen by your investors is the real question.

Why wouldn't the pre-money valuation in Rd 1 be "0" and the post-money be $50,000? Although, come to think of it, there's still no money injected in the company until round 2, so I don't see how even a $50k valuation makes sense.

If the pre-money valuation was 0 than any dollar in equity would represent 100 percent ownership from your investors. Not to mention why would anyone invest in something worth zero?

Another way to look at it moose is to take the investment amount / the percentage you're giving away in that round = post money. Subtract the $ of investment and you get the pre-money valuation.

[akula]

Originally Posted by Stockmoose16

Wow, this is much more complex than I originally thought. Thanks for taking the time to make the charts-- I definitely have some follow-up questions.

1) How can the company be valued at $100,000 before a single dollar of capital inflow arrives? Based on your chart, in the first round of investing, the founder owns $50,000 and the custodian owns $50,000-- why would the company be valued at anything when its just a piece of paper at this point? And, if it is worth anything, wouldn't it be valued at $50,000, not $100,000, since $50,000 will be coming in from investors? Why wouldn't the pre-money valuation in Rd 1 be "0" and the post-money be $50,000? Although, come to think of it, there's still no money injected in the company until round 2, so I don't see how even a $50k valuation makes sense.

2) At the beginning of Round 2, the pre-money valuation is $150,000. Why did the value of the company jump from $100,000 to $150,000? Then, at the end of round two, it's worth $200,000. So now, with only $50,000 in real capital (cash) from investors, the company has jumped in value by 4x the capital inflow.

3) Finally, in round 3, the pre-money valuation jumps to $750,000 from the previous post-money valuation of $200,000. How can this be, when only an additional $250k will be raised in this third round?

This is really confusing... Round 1 doesn't make any sense to me. If you have no money and just a piece of paper, how can the business be valued at $100k?

Great questions there mate. Let me cover them one by one, and compliment Cole's outstanding answers.

1) How can the company be valued at $100,000 before a single dollar of capital inflow arrives?

The answer to the question lies in understanding the difference between the words price and value. To understand the difference, think of the stock market. Ordinarily, an investor would come to nasdaq and find that the price quoted for 1 share of stock XYZ is $100. The investor, however, thinks that the value of the share is more than $100 (i.e $120), so she buys the share hoping that the rest of the market will agree with her perspective, erase the disparity and price the share at the same level as it's value. In other words, price is what we pay, value is what we get and the investor would not buy the share at $100 if she thought it's value was less than that price.

The same principle applies with private equity transactions. To buy shares in their companies, entrepreneurs must first forecast what those shares might be worth in the future. These figures are derived from the business plan, and then they are discounted using a present value calculation to put a premoney valuation on the investment. That's why in these transactions entrepreneurs pitch investors a forecasted value of the company, ask for a cash price that's lower than this value and tell the investor "congrats, you've got your self a bargain!".

2) At the beginning of Round 2, the pre-money valuation is $150,000. Why did the value of the company jump from $100,000 to $150,000?

Ok, this process depends on understanding discount rates which quantify the riskiness of a company. When a company is just a piece of paper, with no customers, no product and no management - the future cashflows and profitability are highly uncertain. At this stage, the entrepreneur can extend the discount rate on those cashflows to infinity % (or lets say 100,000%), at which point the premoney value of the company would approach 0.

However, after this first financing round where the entrepreneur bought shares in her company at a discount rate of 100,000% and a premoney valuation of $1, things start to change. The company is now more than just a piece of paper. It has an employee, a plan, some filled out customer surveys and sales leads, some borrowed equipment and even an office at a converted garage. Suddenly, the cashflows are less uncertain...there's now a better chance that the startup "has legs", and thus the discount rate decreases, which in turn increases the present value of these future cashflows.

That's exactly what's happening in the provided example. The founder says to investor 1, "In round 1, I bought stock at premoney of $50k and discount rate of 5000%. The company was a real long shot back then, but now we've achieved a lot milestones, so you're gonna be taking less risk with your investment than I did (so it wouldn't be fair for you to get 50% equity for your $50k investment, even though I got 50% equity for my 50k investment). To reflect this point, I wanna sell you shares that were valued at a discount of 200%, meaning that now the firm is 25 times less riskier to invest in than it was when I invested in it. If you agree with me, the premoney valuation I'm offering equates to $150k, but if you still think that the firm is a real long shot, I'm willing to negotiate down to a 300% discount rate, at which point the premoney valuation will decrease and you can buy more than 25% of equity for your $50k"

3) Finally, in round 3, the pre-money valuation jumps to $750,000 from the previous post-money valuation of $200,000. How can this be, when only an additional $250k will be raised in this third round?

Awesome. So the answer here depends on what investors refer to as value add. When a financier pitches the entrepreneur to take money, they say, "We will pay you in cash for those 1000 shares, but we want an extra 500 shares in return for all the advice, connections and credibility that we will be making available to your business". In other words, as in point 2, after the second round of funding, the company would presumably have moved forward, become less riskier and accumulated off balance sheet assets, such as the value add from investor 1.

The result is what's called an "up round", where the premoney valuation of the company is higher than the post money valuation of the last round. There could also be a "down round", where the situation is the opposite, the company is in trouble and now presents a more riskier investment in round 3 than it did in round 2.

Finally: The example I've provided uses a custodian for handling the issued securities and does away with the problem of issuing new shares. I can of course, post an alternative example where a custodian is not used. In this scenario, the founder buys 100% equity in the first round at a discount rate approaching infinity and a premoney valuation of $0.01. After this time, new shares are issued in rounds 1 and 2 for the respective investors, to dilute the founder to a holding of 50% of total issued stock by the end of round 3. Do you need that example?