The Arithmetic of Deal Structuring Using a Capitalization Table
The first step in structuring a deal is to determine how much capital your company needs to raise using a capitalization table. This calculation should be determined by your milestone plan translated into numbers within the financial model. You will be able to see how much is needed to get you through the next critical stages of your company’s growth and the cash flow needed to do so. Be realistic about two things. First what you plan for will likely take twice as long and will cost twice as much than you expected.
The second step is to determine the pre-money valuation. This is the tricky part because it’s a pricing decision that affects the share price you will be setting for the next round of financing.
As you determined in the prior round the milestones to get your company to the next level of development and you succeeded in accomplishing them then you have built enterprise value or the worth of your company. This means the value or price of shares in your company would have increased and from your perspective you can give investor a good argument why an increase in share price is warranted.
The other part of the equation is that the investor will have a say as well as to what they see as the pre-money valuation. The preceding is part of the negotiating process around valuation.
But keep in mind these principles when filling out your capitalization table:
- You will be asked what the previous valuation or price per share was for your company. If in the ensuing time the economy tanks yet you hit your milestone don’t expect a bump in share price because investment may have dried up and you have to look like a bargain to those investors left willing to invest.
- Use comparable value metrics of similar companies in your sector. Investors will be up on these and you should be too. These figures are used more often than formula’s such as discounted cash flow particularly if you are a startup.
- Raise enough money to ensure you can achieve the big milestones that create value. Typically raise enough to give you the runway (time) you need between funding rounds.
Now for the math of your capitalization table
Let’s say your pre-money valuation is $1 million with 2 million shares issued.
The next calculation is to establish the share price and ownership percentage position you and your founding partners are willing to relinquish for the capital. Remember this – deals are negotiated by percentage ownership and structures in shares. So if you need to raise $500,000 and an investor steps forward indicating she wants 30% of the company. Here is the calculation:
Founders – two partners 50%/50% split = 1,000,000 shares each
Pre-money valuation – $1,000,000/ 2,000,000 shares = $.50 per share or $1,000,000
Now with the new investor investment of $500,000 for 33.33% of the company and receives 1,000,000 shares
Founders now own 66.6% of the company
Post-money valuation is now $1,500,000
Next round you wish to raise $1,000,000
Pre-money valuation is – 3,000,000 shares * $.50 = $1,500,000 but you hit your milestones and you believe your shares are now worth $.75 per share. The valuation is set at pre-money at 3,000,000 shares *.75 per share =$2,250,000.
An investor with deep pockets wants 30% of the company for $1,000,000. He will receive 1,333,333 shares and owns 30.77% of the company. Founders own 46.16% and the first investor 23.08%.
Note the following:
- The ownership percentage of the company has to always equal 100%.
- That ownership decreases for Founders and the initial investor decrease not in a straight line as a percentage of current ownership. The calculation is 66.66%*(1-.3077%) = 46.16%. Likewise, the original angels’ share decreases to 33.33%*(1-.3077%) = 23.08%. You can check the math by adding percentages 30.77%+46.16%+23.08% is equal to 100%.
- The percentage ownership is often calculated to the second decimal point. Think about how this will affect a) the number of shares allocated and b) overall ownership position if rounded up.
The Capitalization Table
Structuring an equity capital deal requires a capitalization table (download the YCE Capitalization Table product it’s free on our site), which summarizes the ownership position of all shareholders of a company. It helps stakeholders understand pre- and post-money valuations and shows how ownership positions may change with each round of financing.
Written by Lyn Blanchard, February 20th, 2012 | No Comments »
Filed under: Entrepreneur tips, Financial Forecasting | Tags: Capitalization Table, how to raise capital for your business, raising equity for new ventures, share structure of a company, structuring business deals with capitalization tables