It can be challenging to calculate the financial aspects of your company's capital raise. Startups, in particular, are known for being difficult to value. However, it is crucial that you thoroughly understand the capital raising process. This article highlights the key issues to consider when calculating the financial terms of your capital raise as a startup founder.
Setting the Pre-Money Valuation
Your company's pre-money valuation refers to its value immediately before the relevant investment round. Therefore, it is critical to determine how many shares a potential investor will receive for their investment.
There are various ways you can value your startup when capital raising. However, in the early stages of your startup, you will typically need to base this valuation on intangible considerations, such as the business' growth potential.
For example, if you agree to give an investor 10% of your company's equity for $100,000, your pre-money valuation will be $900,000, and your post-money valuation will be $1 million. But, of course, this does not necessarily mean your company would be worth $1 million if you decided to sell it today.
The pre-money valuation can be a reflection of several factors, including the:
- current and projected revenue of the business;
- reputation of the business and its business owners – founders with good reputations will attract higher valuations; and
- analysis of the market in which the business operates and its key competitors. If products or services are in high demand and there is a scarcity of supply or a lack of competition in a particular market, you may attain a higher valuation.
Ultimately, the company and the potential investors must agree on the valuation. A business accountant is a helpful partner to collaborate with when setting expectations for an appropriate pre-money valuation for your investment round.
Deciding Between an Undiluted or Fully-Diluted Basis
A key negotiation point when raising capital is whether to calculate the pre-money valuation on an undiluted or fully diluted basis. Undiluted capitalisation refers to the number of shares in your company that currently exist and are on issue.
In contrast, fully diluted capitalisation refers to:
- the number of current shares on issue; and
- any shares that the company could issue in the future if its options and convertible instruments are converted into shares. These could include employee share option pools, SAFEs and convertible notes.
For example, say your company has 100,000 shares on issue and an employee share option pool under which it has reserved a further 10,000 shares to issue to employees. In this case, the fully diluted share capital of the company is 110,000 shares. This comprises the shares on issue and shares reserved for future issues.
Incoming investors typically want to invest on a fully diluted basis to protect themselves from risk. This will mean that only the founders and existing shareholders will be diluted by issuing shares converted from the specified and convertible options.
Post-Money Valuation
The post-money valuation is the company's valuation immediately following an investment round. You can calculate this by adding the company's pre-money valuation to the amount invested during the financing round.
For example, say a company is about to undertake its seed investment round and agrees to a pre-money valuation of $15 million with its investors. The company proposes to raise $5 million in the round. Therefore, the company's post-money valuation is $20 million. That is, $15 million (pre-money valuation) + $5 million (funds invested in the round) = $20 million.
Calculating the Share Price
Once you have agreed on your company's pre-money valuation and the size of the investment amount, you can then calculate the issue price of the shares. This is the price per share payable by the investor and determines the number of shares they will receive in exchange for their investment.
Below is an example of a hypothetical investment round. This illustrates how to calculate the share issue price and the corresponding number of shares to be issued.
An Example
Suppose:
- the investor agrees to invest $2 million in the company on a fully-diluted basis;
- the company has a pre-money valuation of $4 million; and
- there are 2,000,000 shares on issue in the company and an additional 200,000 shares reserved for the company's employee share option pool.
You will calculate the issue price as the pre-money valuation / existing shares + shares in the company's options pool:
- 4,000,000 / (2,000,000 + 200,000) = $1.81818
The number of shares that the investor will receive is the investment amount / the share issue price:
- $2,000,000 / $1.81818 = 1,100,000
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In the above example, we can see that the investor will receive 1,100,000 shares for $1.81818. Following the raise, the company's fully diluted share capital will be:
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Key Takeaways
Determining the pre-money valuation of your startup is critical for determining the share issue price and the number of shares investors will receive for their investment. Startup founders may need to rely on intangible factors like market traction and reputation to reach a reasonable pre-money valuation. Once both parties agree on pre-money valuation, you can then determine the share issue price and the number of shares the investor will receive.
