Determining how much equity your investment is buying
When VCs invest in a company, they typically have an equity ownership target they want to maintain in the company. This ownership varies by stage and investor, but it is usually the case in the earlier stage, and with smaller checks, the equity stake is smaller. For example, many accelerators will take a 4-7% equity stake in an early-stage startup. As we get further into institutional capital, VCs will shoot for 15-35% in most cases for each investor.
There are a few reasons VCs do this. Firstly, VCs are very strategic in calling and deploying capital and managing their fund’s financing. They’ve likely mapped out several returns scenarios for a startup. Therefore, they need to maintain an equity target in individual companies to get a meaningful return on their capital and return their fund. Also, to hold board seats and voting control in a company, typically, there is an equity threshold that VCs need to meet. We already talked about how VCs can maintain equity over time through Pro Rata and Anti-Dilution tools, but how do they know how much equity their investment is purchasing when they go into a deal?
Price per Share determines how many shares each investment is purchasing. As the company continues to issue new shares and increase its valuation, each Share becomes more valuable, and the price per share increases.
Price Per Share Calculation
The actual calculation is relatively simple:
- Price Per Share = Pre-Money Valuation / Pre-Money Fully-Diluted Capitalization
As you can see, we need specific information to get to this number. We’ve talked about valuations before, which you can read about here. But what about Fully-Diluted Capitalization? This term is referring to all outstanding shares that the company has issued, including:
- Outstanding Common stock
- Outstanding Preferred stock
- Outstanding stock options
- Outstanding warrants
- Restricted shares
- Options reserved for a future grant (the “option pool”)
It’s important to note that we calculate all Preferred stock and warrants on an as-exercised and as-converted to Common basis.
Let’s walk through a simple example. Say XYZ Company has issued 8M shares. The solo founder owns all 8M shares. Sutton Capital decides to invest $2M at an $8M pre-money valuation Series A ($10M post-money) to own 20% of XYZ. To ensure this is the case, we calculate:
- Price Per Share = $8M Pre-Money / 8M Fully-Diluted
- Price Per Share = $1.00
A $2M investment would therefore buy 2M shares at $1/share. When VCs invest in a company, they aren’t purchasing existing shares (unless it’s a secondaries market, but that’s a separate topic). So instead of Sutton Capital buying 2M of the existing 8M shares owned by the founder, 2M new shares are being created. There are now 10M shares in existence, and Sutton Capital owns 2M (20%) of them. The VC has diluted the founder down to 80% ownership.
The above is a very simplified example. Imagine how complex this gets when you include convertible notes, warrants, option pools, and complex deal terms. For this reason, it’s essential to keep deal terms clean (as terms typically build on top of each other) and cap tables clean as well. Remember, each round will issue new shares at a new price, so existing investors who want to take advantage of their Pro Rata will have to factor the new price into their follow-on investment and portfolio financing!
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.