Updated: Jan 17, 2022
The following storyline is meant to be illustrative of venture math principles. We will follow the lifecycle of a fictional early-stage venture in order to highlight some of the most common investment vehicles and provisions such as SAFEs, Convertible Notes, Priced Rounds, option pools, valuation caps, and anti-dilution provisions.
Two founders, William Theodore Door (W. T. Door) and Lillie Pearson Sijan (L.P. Sijan) started a tech startup one year ago. Their company, GiGline, enables users to take a test that indicates their political and fiscal leanings. Based on the results of the test, users are algorithmically fed news articles that are curated to offer viewpoints more centrist than their own views. This allows users to be exposed to ideas and information outside of what they might normally seek, thus creating a more receptive environment for open communication. The two founded their venture exclusively through bootstrapping thus far. To hire outside talent and fund their initial product launch, they realize they need to take on outside investors as they have both already depleted their savings (and their family’s savings).
Pre-Seed - SAFE With a Discount and Valuation Cap
William and Lillie attempt to raise $400K from Pre-Seed investors through pre-money SAFEs (Simple Agreement For Future Equity), with the included provisions of a $5M valuation cap and a 20% discount. After engaging the investing community, they have four separate investors commit to contributing $100K apiece. After this round, the cap table looks as follows. The SAFE investors do not yet have equity in the company. Once the company raises money through a priced round, the SAFE investors will see their investment converted into shares of the company.
It is worthwhile to quickly note the difference between a pre-money and post-money SAFE. Y Cominbator (a notable accelerator) introduced SAFEs in 2013. Initially, they only offered pre-money SAFEs, but slightly changed the terms to create a second form: the post-money SAFE. This was in response to the increased size of funding achieved in the first financing rounds. Post-money SAFEs allow founders and investors to transparently and immediately calculate how much ownership is being sold. You can read more about the differences and see example term sheets on Y Combinator’s website.
Seed - Convertible Note With a Discount and Valuation Cap
Six months after closing the Pre-Seed round, the company launched the first commercial version of its product. User growth numbers were initially very strong and the company enjoyed impressive revenue growth numbers. However, both metrics recently stagnated at $80K in monthly revenues and total paid users at 1,000. After testing their product, the founders have a hypothesis for a product change to reinvigorate their early success. In order to fund the pivot (new talent hires, technology investments, etc.), the founders once again approach the investment community. This time, they are raising $1M through convertible notes with a $10M valuation cap and a 15% discount. These notes will convert on a pre-money basis based on provisions in the term sheet. After closing the round, the company’s cap table and debt picture look as follows. Because equity has yet to be offered, the SAFE investors from the Pre-Seed round still have not seen their investment convert to equity.
Series A - Priced Round
The product changes were a huge hit. Paid users exploded as well as monthly revenue growth. However, BookFace launched a competing product. GiGline is confident they offer a superior product, but the team fears the threat of competition from such a large incumbent. Also, the team wants to expand its product into new, overseas markets. In order to rapidly scale, the team initiates a priced round to raise $10M at a $50M pre-money valuation. The company is selling two million shares at $5.00 apiece. The company is also initiating an option pool in this round. The option pool will be 15% fully diluted post-money. This means that after the round is closed, 15% of the company will be set aside in an option pool for employees. Because this is a priced round and the first time a valuation has been attached to the company, it triggers the SAFE and convertible note conversions to equity. The conversion will be based on the $50M pre-money valuation since both were pre-money. We will first walk through the SAFE conversion, then the convertible note conversion, and finally the calculation of the option pool.
GiGline will issue preferred stock to the SAFE holders based on the valuation cap or the discount rate. Which one applies depends on which yields a lower price per share for the investor and thus greater percent ownership of the company. We will calculate the share price using both the $5M valuation cap and the 15% discount to see which offers the lower share price.
Each investor contributed $100K.
The valuation cap for the SAFEs was $5M, which is 10% of the $50M pre-money valuation for the round.
Applying the valuation cap yields a $0.50 price per share vice the $5.00 being offered to new investors.
(Valuation Cap / Pre-Money Valuation) * Share Price = Price Per Share
($5M / $50M) * $5.00 = $0.50 (Price Per Share)
$100,000 investment / $0.50 Price Per Share = 200,000 shares
As you can see, applying the valuation cap results in 200,000 preferred shares per SAFE investor for a total value of $1M per SAFE investor (200,000 shares * $5.00 per share in Series-A = $1M value).
Now, let us look at how many shares the SAFE investors would have received by applying the discount. In this instance, applying the 15% discount yields a share price of $4.00 which in turn yields 25,000 shares. Because the discount yields a less advantageous outcome for the investor, the valuation cap is used to calculate their share price and subsequently the number of preferred shares they receive.
Share Price Offered in Priced Round * (1-Discount) = Price Per Share for SAFE Investors
$5.00 * (1-0.20) = $4.00 Price Per Share
$100,000 investment / $4.00 Price Per share = 25,000 shares
2. Convertible Note Conversion
Convertible notes can either convert at the pre-money or post-money valuation based on the conditions of the term sheet. For this example, we will assume a pre-money conversion in our calculations (in this case, the founders suffer additional dilution). As with the SAFEs, the convertible notes had both a valuation cap and a discount. The most advantageous of the two for the investor determines which is used to calculate the conversion price. The logical path for calculating this number is as follows:
Each convertible note investor contributed $250K
The valuation cap was $10M which is 20% of the $50M pre-money valuation
This means the share price for Convertible Note Investors is $1.00 vice $5.00 offered to new investors in the Series-A round.
(Valuation Cap / Pre-Money Valuation) * Share Price for Series-A Investors = Conversion Price
($10M / $50M) * $5.00 = $1.00 price per share
This translates to 250,000 preferred shares per convertible note investor.
Applying the 15% discount yields a price per share of $4.25.
Share Price * (1-Discount) = price per share
$5.00 * (1-0.15) = $4.25 price per share
This translates to 58,824 shares per convertible note investor.
As you can see, applying the valuation cap results in a lower conversion price and thus more shares for the convertible note investors. Therefore, this price per share is used to calculate their ownership.
Option Pool Calculation
Now that we know how many shares each investor is getting, we can calculate the size of the option pool. As stated earlier, the option pool is set to be 15% of the post-money valuation. To calculate this, we do the following math:
(Sum of all founder's, SAFE, Convertible Note, and Series A shares) = 85% of the sum of ALL shares
Founders' shares = 8,200,000 shares
SAFE Investors = 800,000 shares
Convertible Note Investors = 1,000,000 shares
Series A Investors = 2,000,000 shares
Sum = 12,000,000 shares
12,000,000 shares = 0.85 *(12,000,000 shares + Option Pool)
Option Pool = 2,117,647 shares
A simpler, one-stop-shop equation for a post-money option pool is:
Option Pool = (sum of all non option pool shares)*(1/(1-option pool %)-1)
Option Pool = (12,000,000) * (1/(1-0.15) -1)
Option Pool = 2,117,647 shares
The final cap table after all the effects of Series-A fundraising looks as follows. As you can see, the Return on Investment (ROI) for the SAFE investors is 10x or 900% ($100,000 initial investment now worth $1M; ROI = Profit on investment / Initial investment amount) while the ROI for the Convertible Note investors is 5x or 400% ($250,000 investment now worth $1.25M). Meanwhile, the founders have each seen their percent ownership diluted by ~14%. They still own 29.04% of a now $60M company - a $17.42M stake.
Updated Company Data
Series-B - Priced Round and Anti Dilution Provisions Highlighted
The competition was much more fierce than initially expected. Not only did BookFace launch a competing app, but so did TweetTweet and TakTuk. To add insult to injury, there was also a cyber attack affecting millions of users’ data. The management team at GiGline has a new strategy but needs to raise more money to fund the new product direction. Since their need for new cash is significant and urgent, they are willing to do so at a lower valuation. They decide to raise $15M at a $45M pre-money valuation. Two new investors come in during this round, each contributing $7.5M.
To calculate the new share price, you take the new pre-money valuation and divide it by the total number of shares.
$45,000,000 / 14,117,647 shares = $3.19
Looking at the updated cap table above, you can see the Series-A investors were diluted from 4.72% ownership down to 3.54% ownership. Now let’s assume that Series-A Investor #1 had a full ratchet anti-dilution provision and Series-A Investor #2 had a weighted average anti-dilution provision.
Series-A Investor #1 (full ratchet provision, note full ratchet provisions are not very common)
This investor’s full ratchet provision fully protects their investment from becoming diluted as new shares are issued at a lower price. The dilution they would have otherwise experienced will be absorbed by the founders who hold common stock. This investor is able to convert their preferred shares into common shares at the price per share of the offering. Therefore, their original $3.33M investment converts to 1,045,752 shares instead of the original 666,666 shares.
Original Investment Amount = $3.33M
Conversion Price = Down Round Share Price = $3.19
Original Investment / Conversion Price = New Number of Shares
$3.33M / $3.19 = 1,045,752 shares
Series-A Investor #2 (Broad-based weighted average anti dilution provision)
Similar to Series-A Investor #1, this investor has an anti dilution provision. However, it is a broad-based weighted average anti dilution provision. This type of provision is less advantageous for the investor but is generally viewed as more fair across the board. As you saw with the full ratchet example, that investor made off extremely well (assuming the company rebounds and continues its original growth). However, their gain came at the loss of the common shareholders who in this case were the founders.
Weighted average anti dilution provisions are more equitable for all parties involved - the investor sees their money protected (albeit to a much lesser extent than via full ratchet) and the founder’s don’t see their stake in the company as dramatically diminished. There are two common types of weighted average anti dilution provisions: narrow-based and broad-based weighted. We will focus only on the later, but you can read about the differences here.
The formula to convert the broad-based weighted average conversion price is:
X = B * ( C+D) / (C+E)
X = New Conversion Price
A = New Money Raised in Round (Series-B)
B = Old Conversion Price (Series-A)
C = Number of Prior Shares
D = New Money Raised / Old Conversion Price
E = Number of New Shares Issued (Series-B)
X = $5.00 * (14,117,647 + ($15,000,000)/$5.00)) / (14,117,647 + 4,705,882)
X = $4.55
GigLine went on to become a unicorn (a billion-dollar startup) because duh...they had two veteran founders who could overcome any challenge.
The storyline followed in this article was meant to highlight some of the most common funding sources for early-stage ventures and how they affect both the founders, company employees, and investors. We want to emphasize that we only focused on some of the more basic concepts and provisions. Like with most things rooted in law, term sheets can get complicated and convoluted quickly.
Please refer to our previous educational offerings on our website and be on the lookout for future content.
If you have additional questions, please contact Emily McMahan (Emily@academyinvestor.com) and/or Sherman Williams (Sherman@academyinvestor.com). To contact the authors of this article, please email Erik Hoffstadt (firstname.lastname@example.org), Edward (E.J.) Leo (email@example.com), Ashley Sogge (firstname.lastname@example.org), and Brian Hwang (email@example.com).
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