Valuing a company is serious business. A company’s valuation and pro-forma cap table are the bedrock of any equity financing and all parties, from the company, to the investors and the professionals (lawyers, accountants and financial analysts) need to be on the same page prior to closing any equity financing transaction. A wrong valuation of the company today may detrimentally affect the exit of the company in future years. We’ve recently helped to rectify some of the consequences of bad valuation practices in a series A company where both the lead investor and founders miscalculated ownership and price per share in their pro forma cap table. The mistake was picked up over a year later when outside auditors were valuing the lead investor’s stake in the company. Here’s a couple of dos and don’ts for founders in the process of valuing their companies and preparing their pro-forma cap table:
Numbers have to add up
From a deal closing perspective a valuation is not about: (i) the company’s projected profits and cash flow; (ii) any capital expenditure that has been planned for or will be needed in the future; (iii) the strength of the company’s customer base; (iv) value of company’s intellectual property, if any; (v) any previous valuation of the company, etc. In venture capital financing, valuation is all about the pro forma cap table. The numbers in the excel spread sheet really have to add up and be reconciled. Basic and more complicated math comes into play and both the venture capitalists (“VC”) and founders must understand this.
Do Not Value Your Company on a Napkin
Remember those amazing stories of deals being negotiated at lunch and signed on a napkin in Berlin? Believe it or not there are VCs that have become “famous” thanks to their napkin valuation deals, however, never do that when calculating the value of your company. We have seen business people agreeing on a napkin without actually verifying their calculations. In valuing the company, you are evaluating all aspects of your business and if you believe that this can be done on a napkin, then, you are going about it the wrong way. The valuation should be done using an excel spreadsheet not a napkin. Best practice is to generate the pro forma cap table in Carta or Capshare. Using an excel spreadsheet or Capshare/Carta prevents basic calculation errors and makes the process transparent both for VC and founders and effectively reduces the closing costs down the road. It is also a good practice to have the CFO of the VC to sign off on the numbers.
Do Not Value the Company Solely to Maintain Share Ownership Percentages
When preparing for a financing, we see a lot of companies start the valuation process with the intent that the existing shareholders (founders and preferred shareholders) maintain a certain ownership interest in the company. For example founders should keep 50% existing investors keep their 10%, while new VC takes 15% and the ESOP increases by 5%. Do you see what’s wrong with this example? For starters it is not clear if the percent blocks are based on fully diluted basis or issued and outstanding shares (read our blog post here about the difference between fully diluted capitalization versus issued and outstanding shares). While we agree that ownership thresholds should also be factored into a company’s valuation, making this the sole or even the primary factor in valuing your company is a bad idea. Why? Because using this as a sole or primary factor may limit the company’s ability to control the number of shares it is authorized to issue and the number of shares it actually issues during the financing round. This is because for every investor who agrees to invest in the Company in that round, the company will have to re-calculate the number of shares being issued and price per share, which may lead to an increase in the authorized and issued shares in order to ensure that the ownership interests are maintained. While this seems minor, it is particularly relevant because the number of issued shares a company has may increase or decrease the amount of franchise tax a company is required to pay.
Do Consider How Convertible Securities Affect the Pro-Forma Cap Table and How to Reflect this in the Charter
A well-prepared pro-forma cap table is even more important where a particular equity financing involves the conversion of convertible securities, e.g. convertible notes or SAFEs, with discounts and/or valuation caps. Discounted or capped convertible securities may create an assortment of price per share (“PPS”) for the same type of shares during the same financing round. The PPS has a direct connection to the investors’ liquidation preferences upon an exit (e.g., liquidation preference per share is usually calculated as 1x PPS; 2x PPS). So, for instance, where the original PPS for a particular series of shares is $1.00, and $0.80 for other investors (i.e., as a result of a discount), this should be mentioned in the Charter otherwise it is possible for those investors with discounted PPS to get an unfair and unintended advantage over other investors upon exit.
To understand this better, using the same figures above (original PPS of $1.00, and discounted PPS of $0.80), an investment of $10.00 at $1.00 PPS gets 10 shares while $10.00 at $0.80 PPS gets 12.5 shares. If the different PPS are not clear on the face of the pro-forma cap table and as a result not adapted in the Charter, upon exit and at a liquidation preference of 1x PPS the investor with the original PPS gets $10.00 while the investor with the discounted PPS will get $12.5 ($2.5 more than what was invested by the investor). Also, since the PPS is also integral for calculating conversion of shares from preferred stock to common stock, it is important that the PPS is gotten right in the documents. In terms of documenting this a series of stock can be divided to correctly reflect these price differences. For example, a series seed could be described as series seed 1–1 for the priced round and series seed 1–2 for the convertible or SAFE investors assuming all convertible notes and SAFEs were sold at the same price.
Rounding of Shares
In preparing the pro-forma cap table one will often come across the question of rounding share numbers i.e. whether to round up or down. This usually happens because most of the times in calculating the number of shares to be issued to the investor, which is done by dividing the investment amount by PPS, you will get a fractional number. Companies do not generally grant fractional shares and therefore in a pro-forma cap table you will have to round the share numbers either up or down to make it whole. Rounding up or down depends on the company’s and investor’s preference as laid down in the transactional documents of the financing. However, one should bear in mind that in rounding up the shares the company will end up issuing more percentage of its equity than it received the investment for even though it might seem like a small difference.
It is important to note that an excel spreadsheet will typically automatically round the numbers after a certain decimal point. Thus, where you want to compute the exact numbers such as a wiring amount number you can stop the automatic rounding by selecting the respective cells in the excel spreadsheet and then going to the ‘Number’ portion of the ‘Home’ tab at the top of the excel window and increasing the decimal point to the decimal places desired.
Wiring Amounts vs Investment Amounts
Do not let a discrepancy in the investment amounts and the actual wiring amounts of the investors fool you into thinking that the proforma calculations are wrong. In a proforma cap table there will always be a slight difference between the investment amounts that the investors agreed to contribute in the financing and the actual wiring amount. This is again because of the rounding of shares as explained above. For example, consider Investor A agreed to invest $10 in a financing round where PPS is $0.3. Here, Investor A should ideally receive 33.3 shares in the financing (Number of shares = investment amount/PPS = 10/0.3 = 33.3). However, since fractional shares are generally not granted by companies and let’s say in this case the shares are to be rounded down, Investor A will receive 33 shares. Thus, the actual wiring amount that Investor A will pay for the financing would be $9.9 (Wiring amount = number of shares * PPS = 33*0.3 = 9.9). Thus, even though Investor A committed to contribute $10 in the financing, he will actually wire $9.9 to the company.
Always Involve the Professionals
We always recommend involving the professionals (lawyers and accountants) when valuing your company. A qualified accountant would help spot any computation inaccuracies that arises on the pro-forma cap table during the company’s valuation (and conversion of notes, if any) and help simplify the cap table for future investors or future executives of the company. On the other hand, the lawyer with financing experience would ensure that the nuances in the cap table are properly adapted into the financing documents. Some of these nuances include: ensuring the interests on each note are waived by the investor if not calculated during a conversion and including the different PPS for each share in a round into the Charter so that current and future investors know from the face of the documents what their respective liquidation preferences is upon an exit.