Cap Table Basics

Throughout the series of modeling posts, I’ll be using the example of Sweet Co. because Canaan, the venture firm where I am an analyst, likes investing in sweet companies.

The founders of Sweet Co. own shares in the company.  They decided to make things easy and start with 1,000,000 shares of Sweet Co.

At a certain point, Sweet Co. needs more money than the business generates on its own, so the founders decide to raise $500k of venture capital.  From an entrepreneurs’ perspective, the process of finding an investor is a combination of art, hard work and luck – and though it’s important – it’s already covered in various places on the internet.

Assuming the founders of Sweet Co. have found an interested VC, the first thing that the VC and Sweet Co. have to agree upon is the valuation of the company immediately before the VC makes an investment.  This valuation is called the pre-money valuation because it’s the value of the company immediately before the VC invests their money.

The reason that this is important is because the pre-money valuation has a direct effect on how much of the company the founders need to sell to get that $500k.  If the company’s value is set at $100mm, then the founders only need to sell a small part of the company (think less than 1%).  That’s good for the founders because they retain most of their ownership. On the flip side, if the value of the company is to be only $100k, then the founders will have to give up a large portion of the company (think 50%+).  Don’t worry, there is a sample workbook attached to this post that will allow you to see the math.

Surprisingly, determining the value of a seed deal (usually under $1mm) or Series A stage deal (usually $1-3mm) has less to do with determining value and more to do with structuring an appropriate amount of ownership dilution for the founders.  In this sense, valuation is less of a science and more of an art (though art that requires lots of math).

1.) As a rule of thumb, most early stage VC investors (including Canaan) want to own at about 20-30% of any company they invest in – which means the founders’ ownership will be diluted by 20-30%. (In reality, VC’s often don’t want to own a huge percentage of an early-stage startup because investors want the founders to be motivated by their equity stakes)

2.) Most of the time, entrepreneurs have a rough idea for the amount of money they need to raise – in our case it’s $500k.

With these two inputs, we can back solve a pre-money valuation that satisfies both the entrepreneur and the investor.  In the case of a $500k raise and a 25% ownership requirement by the VC, the pre-money needs to be $1.5mm – a fairly typical seed stage valuation for a company.

See the attached work book to understand how the math for all of this stuff works.  Try playing around with different raise amounts and different pre-money valuations.  You’ll quickly see why pre-money valuation is so often talked about by both investors and entrepreneurs.

In my next post, I’ll tackle options.

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Stock Options

Without sounding too much like a finance textbook, an option is a contract that allows the owner of the option to purchase a common share of a company at some point in the future for a pre-determined price.

There are two important terms to know:

1.)    Options Granted – these are options already awarded to employees and others

2.)    Options in Pool Available for Grant – these are options that remain in the option pool and are available to be awarded in the future

Why do VC’s care about options?  We want the team at the startup to be highly incentivized to make the company succeed.  Also, it’s an important part of the compensation package for new hires.

From a modeling perspective, at Canaan we treat options as if they were shares.

Options “Baked” into the Pre-Money

When funding a new round, options can either be issued immediately prior to the round or created in the round itself.  In most cases, new investors will ask that a certain sized option pool (usually 5-15%, depending on stage) be created before an investment occurs.  When the options are issued immediately before the round, the founders and existing investors feel all of the dilution associated with the option pool creation. This approach is the most common and is called having the options “baked into the pre-money.”

Options Created in the Round

In some cases, new investors allow the options to be created as part of the round, which is less ideal for the new investors because they also experience the dilution associated with the option pool creation. This approach is much less common and is often used out of necessity.  For example, sometimes a company’s founders already have so little ownership, that an option pool created in the pre-money would dilute them to nearly 0% ownership. In this case, it makes sense to create the options in the round.

Check out the attached worksheet that highlights how option modeling works when the options are “baked” into the pre-money valuation vs. when they are created in the round. Notice that the dilution is felt by the founders (75% ownership à 65% ownership) the most when the options are “baked” into the pre. But don’t stress out – these options are given back to employees over time so it’s not as bad as you may think.

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Series A and Beyond

The Series A

Now let’s assume that it’s 2 years later and Sweet Co. needs to raise more money. Let’s assume two scenarios:

1.)    Things are going great

2.)    Things aren’t going so great

Up Rounds

Let’s assume that things are going great with Sweet Co. and the company raises money at an “up round” valuation (VC translation: pre-money valuation of the upcoming round is higher than the post money valuation of the last round).  However, before the new investor puts in money, it wants the employees to “re-up” the options pool back to 10% post-money (meaning after they make the investment, the option pool is once again equal to 10% of the total number of shares).

Notice that the founders continue to get diluted.  They started with 100% ownership before receiving funding, then held 75% after the Seed Round, and only hold 31.5% after the A round. A lot of founders get hung up on dilution, but what they should care about is the value of the shares they own (vs. the % of the company they own).  Check out lines 31-33 in the model. The founder’s ownership decreased by 43.5% from the Seed to Series A, but the value of the shares the founders own actually went up by $860k!

Down Rounds (ouch)

Let’s assume now that things aren’t going so great and the company has to raise money at “down round” valuation (VC translation: the pre-money valuation of the upcoming round is lower than the post-money valuation of the previous round).

Down rounds are bad for two reasons:

1.)    They’re bad for existing investors because the value of each dollar invested in the previous round created less than $1 of value (which is bad). Conversely, each dollar that the new investor puts in, buys it more shares of the company than the existing investors got for the same amount of money invested.  That means that the existing investors and founders get diluted more than in an up round (not good).

2.)    But wait – it gets worse.  There is a widely used clause in VC term sheets that states that in down rounds, the previous round investor gets issued additional shares so that the effective price per share the previous round investor pays falls in between the new round price per share and the previous round price per share. The math behind that calculation is pretty complicated, so I’ll spare it from my model.  The important point is that down rounds can be painful.

Check out the attached workbook to play around with up round and down round scenarios.

initial investment

Next week, I’ll tackle returns modeling!

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Preferred Shares and an Intro to Returns Modeling – an Introduction

Although investing and building companies is a hugely rewarding experience for VCs, the ultimate reason VCs exist is to generate a return to their limited partners (the guys that fund Venture Capital firms).

One way VC’s try to protect their investments is by usually purchasing Preferred Shares (vs. Common Shares that founders own). Owners of preferred shares get paid back first in the case of an M&A exit (about 90% of all VC exits / vs. 10% in the form of IPO).  However, at the time of an M&A exit, preferred shareholders have the option to convert their shares to common or keep their shares as preferred and get paid the liquidation preference value of those shares (usually 1x or a multiple of the per share invested amount). Note that in the case of an IPO, all the shares are converted into common shares.

To Convert or Not to Convert? That is the Question

The choice hinges on – you guessed it – whatever makes the VC get the highest returns.  In our case, let’s look at two scenarios for an exit for Sweet Co:

1.) Good Scenario: After the A Round, Sweet Co. does really well, and gets sold for $50mm.

In the attached workbook, you’ll see that the share price at exit for each share of Sweet Co. in section I is $9.18, which ishigher than either the Seed Round or Series A round price (that’s good!).  Because the value of the common shares is higher than the value of the preferred shares (in this case, the original purchase value), the VC will choose to convert their preferred shares to common stock.  Notice that in this scenario – everyone wins.  Founders get about $10.5mm, and investors get $35mm.  Also notice the multiples calculation columns AN-AQ.  This is one way how VC firms like Canaan looks at returns.

2.)    Bad Scenario: After the A Round, Sweet Co. doesn’t do well and is offered a low acquisition value of $5mm.

In the attached workbook, you’ll see that the share price at exit for each share of Sweet Co. for section II is only $0.92, which is lower than either the Seed round or Series A round price (that’s bad!).  Because the value of the common shares is lower than the value of the preferred shares (in this case, the original purchase value), the VC will choose to trade in the preferred shares for its cash value. What’s more, the investors take out their money first.

Since the investors have invested a total of $4.5mm, there is only $500k left for common shareholders.  However, because the preferred shares no longer exist (since those shares were traded in for cash), the total share balance drops to 1.5mm shares vs. 5.5mm shares.  In this case, the founders and option holders own 100% of the remaining shares so they only get $500k.  Notice that the venture capital firm got their money back (a 1.0x).


Next week – I’ll talk about more complex preference and liquation structures!

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Participating Preferred – VCs’ double dip (yum)

In the previous example, we reviewed the concept of non-participating preferred shares.  As a reminder, non-participating preferred shares give the VC the option to trade in those shares for their liquidation preference value.

However, there is a structure that is usually more beneficial for investors called Participating Preferred, which gives the investor the liquidation preference value for his preferred shares, but then lets him participate as if he were a common shareholder for the remaining sum of money.

Modeling returns for participating preferred shares holders is actually easier than for non-participating preferred share.  In the case of participating preferred there is no complex math when structuring returns because the VC will ALWAYS exercise their share’s liquidation preference value and then participate as if they were common shareholders.

Let’s look at the previous example, but this time using a participating preferred structure.

1.) Good Scenario: After the A Round, Sweet Co. does really well, and gets sold for $50mm.

In the previous example of non-participating preferred, the VC chose to convert to common shares because that would lead to better returns than exercising his liquidation preference.  However in the participating preferred scenario, the VC will always exercise his liquidation preference and then participate as if he were a common share holder. In the attached workbook, you’ll see that the VC investor gets a return of 8.2x on their money vs. the 8.0x on their money under the non-participating preferred scenario.

Notice that in this scenario – everyone still wins – but the investors win a little bit more.

2.)    Bad Scenario: After the A Round, Sweet Co. doesn’t do well and is offered a low acquisition value of $5mm.

In the attached workbook, you’ll see that the VC investors get 1.1x on their money vs. 1.0x in the non-participating preferred scenario.


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