How Startups Are Born: Part Two

In Part 1, Fred (you) and Fran (your partner) founded a hypothetical startup in order to fully grasp the process that founders go through to bring to market an investment opportunity. You and Fran discussed the concept of pre-money valuation and which fundraising strategies to follow and are now poised for choosing investors. In this section dive deep into the nitty-gritty of issuing shares and clear up on a number of new concepts. Here we go…

Sharing is Caring? Depends on the startup’s stakeholders

Ready to meet Mike? Mike is a savvy angel who negotiates to invest $750K at a $3M pre-money valuation for Preferred seed shares, but doesn’t quite know what that means. He has secured preemptive rights, but unfortunately disregards many other important rights. Mike’s ownership is calculated by his investment amount divided by the fully diluted post money valuation. I.e., 750K (investment amount) /3.75M (pre-money valuation plus investment amount, ie, post money valuation) = 20%. It reasons that an incoming investor can increase their stake in the company by either increasing the numerator of the equation (investing more capital) or by reducing the denominator of the equation (reducing the pre- money valuation).

Common vs Preferred shares… what gives?

Preferred shares are a class of shares that provides certain rights, privileges, and preferences to investors, primarily through liquidation preferences (explained later). Compared to common shares, which are normally held by the founders (and allocated to employees in the form of ESOP), it is a superior security.

The money is wired, docs are signed, whiskey glasses are clinked and you and Fran get back to work.


Of course, if ownership is allocated to the new investor, it reasons that the incumbent shareholders must be giving up some of their own ownership in order to accommodate the incoming investors. This is referred to as dilution, or nicknamed “the haircut”. Based on the equation above it follows that the same investment dollar amount will pack a bigger punch on relatively smaller valuations and that the founders’ ownership is most exposed to dilution at low valuations and early stage rounds. In this scenario, the founders take a 10% hit each, and the corresponding aggregate of 20% is allocated to the investor.

I like to think of dilution as “compressing” the pre-money cap table into the residual percentage of the company that isn’t being sold off during the current round. In our example, the two founders’ ownership effectively is reduced to just 80% of the pie, as 20% is allocated in the round to Mike. Mark Suster, of Upfront Ventures, explains dilution really well here.

Pre-money Dilution/”compression” Post money

The post Seed Series cap table follows:

10 months later…

Now things get interesting. More KPIs are met, development is on schedule and there are even a handful of betas in the market. With six months of cash left, you realize that now is the time to start fundraising again. Note to founders: always start fundraising earlier rather than later! This process can take many months, and the later you leave it, the worse the terms will be. Professional investors are going to need time to test the market, follow your company’s progress over a few months or even quarters and conduct ‘deep dili’. Leveraging Mike’s Rolodex, you’ve gone on the road and are pitching to some mid-tier VCs. Unlike angels who are generally more hands off, unless asked for specific help, VCs typically have a responsibility to their partners — both the partners in their firm and the partners who fund their firm — to be highly hands on in the business. So like it or not, your VC will oftentimes be strongly opinionated in the board room.

Here’s a term sheet that makes its way to your inbox:

The terms are attractive and the valuation is appreciating. Looks like the young paralegal who drafted the docs got a little confused regarding the ESOP. Did she mean pre-money or post money?! Also, the rights seem insignificant, as they don’t impact the cap table at all! Take whatever rights you want, so long as it doesn’t impact my ownership percentage!

Let’s explore some of these terms:

Preemptive Rights

According to Fred Wilson, preemptive rights are “the single most important term anyone can negotiate for in a venture capital investment”, as they allow you to maintain your stake in the company in subsequent financings. This can be particularly relevant when it comes to aggressive term sheets or recaps with low valuations. Without this important right, fresh money can dilute your position in the company to being (a) insignificant and therefore the required exit to generate a meaningful ROI unreachably high, or (b) diluted below particular thresholds which may lead to the forfeiture of your board position, information rights, and other associated preferred rights.

A more strategic reason why investors would want to exercise their preemptive rights and avoid dilution is that they, presumably, would have a diversified portfolio of many high-risk investments, and at an early stage don’t know from where their successes are going to emerge. As some of these companies manage to break away from the pack and raise additional funding, investors are going to want to increase their stakes in these companies which are now showing signs of success. And now, the golden rule of venture capital… drum roll please… The Power Law.

Venture returns are incredible skewed and actual distributions follow the power law, with just a handful of companies radically outperforming the others. In fact, the return of the few should offset all the gains and losses of the combined balance of the portfolio.

Here’s a real example from Andreesen Horowitz: in 2010 the firm invested $250K in Instagram. Just 2 years later, Facebook acquired that company for $1B, and Andreesen Horowitz netted $78M! That’s a 312x return, and almost two thousand percent IRR! (Need to brush up on your IRR knowledge? See my other blog here). However, in a strange way, this wasn’t nearly enough, because the fund held $1.5B AUM (assets under management): assuming they only wrote checks for $250K, they would have had to make this kind of return 19 times just to break even!

It’s important to point out that preemptive rights represent an investor’s minimum legal right to invest in a financing round in order to mitigate his/her dilution. It should not necessarily be seen as the ‘correct’ amount to invest in follow on rounds. In fact, a good case can be made for those strong companies that are excelling, in which investors would want to double down their investment and do way more than their mere minimum (#PowerLaw). As Mike successfully negotiated preemptive rights in his term sheet, he has the right to protect his stake in the company by putting up $476K of the round. Mike decides to slightly increase his stake by taking the full remaining portion of the round, being $500K.

Let’s look at this preemptive calculation a little deeper: If Mike owns 20% of the company (pre-money), shouldn’t his preemptive amount be 20% x $3M (which is $600K). Really, Mike’s pre-money ownership is significantly less than 20% due to the additional ESOP that is to be issued prior to the Preferred A round. This ESOP pool will dilute Mike to 15.9% pre-money ownership. Here’s why:


An Employee Stock Ownership Plan (ESOP) is an employee-owner program that provides a company’s workforce with an ownership interest in the company. In an ESOP, companies provide their employees with stock ownership as a means of incentivizing them towards the ultimate outcome: growing the value of the company’s equity. Another practical reason for issuing ESOP as part of an employee’s overall compensation package is that cash is limited in startups, and ESOP is a cashless transaction until a successful exit.

A final reason, and perhaps the most critical from management’s perspective, is that ESOP vests over time. That means that although a certain number of shares are earmarked for a particular employee, they only accrue to him/ her over many years. This is a way for the company to retain top talent in the company for the long term.

Looking at our quantitative example: the pre-money valuation is $8M. Three million is coming in fresh funding, and therefore the post money valuation is now $11M. But the ESOP term is cranking down on the valuation chain. The term sheet is saying that additional shares need to be issued in the pre-money, such that the post -money ESOP amount will equate to 15% of the company’s issued shares. In this case, ESOP was granted to account for 20.6% of the company’s pre- money ownership, such that the additional investment of $3M will dilute this amount down to 15%. As the PPS is simply equated as the pre-money valuation divided by the pre-money share base, any increase to the pre-money shares (for example, through an ESOP pool creation or expansion) will drive down that share price. This means that the incumbent shareholders’ fixed number of shares are now owning a smaller portion of the variable pre-money share base.

Looking at our cap table above, the pre-money shares of 1,574,803 includes the original 1,250,000 issued shares from the previous round, plus an additional 324,803 shares of unallocated ESOP. And you’d never guess who weathers the dilution of those additional issued shares. Hint: The Preferred A shareholders still hold 27.3% of the company ($3M/$11M post money valuation, or 590,551/2,165,354 shares).

The way of thinking about the difference between issuing ESOP in the pre-money or post money is by asking who should the ESOP dilute? Pre-money: only those shareholders previously invested. Post-money: all investors, including the new shareholders participating in the current round in which the ESOP is issued. However, it should be said up front that negotiating ESOP into the post-closing is rather uncommon, and theoretically redundant, as the company can create new options at any time if necessitated. Founders going into negotiations should not have the expectation of pulling this card from out of their sleeve.

Had the 15% ESOP been issued in the post-money (ie, after the new capital had been invested), the cap table would look quite different.

To summarize these scenarios by share class:

As a common shareholder, you may be asking yourself if a 3% difference is really that material. We will discuss the ‘waterfall’/exit calculations in Part 3, but for now, suffice it to say that the impact will be compounded at each additional financing and then finally again on the exit.

Let’s fast forward 18 months. The company is now two months away from a major milestone which will position itself for a significant uptick in its valuation, but the cash position is tough. Doing the Series B prematurely will impact the valuation and cause unwanted dilution to the existing shareholders. The board, therefore, agrees on the issuance of a convertible loan to give the company a short term life line until the next equity round. Ever Line Ventures fronts $550 thousand to support operations for the next three months. Of course, nothing comes for free. The debt carries 8% interest, and will convert at the lower of a 20% discount to the next equity round of financing or a pre-money valuation cap of $15M. You and Fran are relieved that the belt is loosened a little, but immediately feel the pressure of the ticking time bomb of the loan’s maturity. (For further reading — check out these new-ish loan structures called SAFEs that alleviate the repayment pain point, and are becoming more common place). Stay tuned for the loan conversion as part of the next equity round’s pre-money valuation.

To help with your product efforts you have also allocated some of your ESOP to two new senior hires: VP R&D and VP S&M. Now your product is getting the attention it deserves and that minimum viable product that you initially piloted has undergone some significant upgrades and product tweaks.

However, with market conditions turning against you, the company is forced to accept a term sheet from another VC with terms much less favorable than initially expected:

What’s interesting about this term sheet is that the sticker price of the pre-money valuation ($12.5M) is actually higher than the previous post money valuation ($11M), certainly implying an upround. However, due to the issuance of the additional ESOP in the pre-money share base and the fact that the outstanding convertible loan will convert into shares which will also form part of the pre-money share base, the price per share is actually lower than the previous share price, thereby denoting a downround.

Circular referencing

Let’s take a minute to discuss a very practical side of all of these calculations: circular referencing. As mentioned above, any shares that are added to the pre-money share base will draw down the company’s share price. The lower share price results in more shares being issued in the equity round, which therefore necessitates even more ESOP options, anti-dilution shares and conversion shares from convertible loans to also be issued in the pre-money, which further brings down the contemplated share price and results in an endless loop. The way to get around this in excel is by enabling circular referencing.

Conversion price adjustment (aka anti-dilution protection)

Remember those forgotten Preferred A rights? With the current downround at play, the anti-dilution protection kicks in. A quick word about the different ratchets and how they impact the repricing structure: In a draconian “full ratchet world” if the company sells new stock at a price lower than previous issued stock, all of the older, more expensive stock would be repriced to the current, lower issuance price. In a “weighted average world,” the number of shares issued at the new, reduced price are considered in the repricing of the old stock. Although less common, you can also get narrow-based or partial ratchets, such as “half ratchets” which work very similarly. Here’s an example of the language and math for a broad based-adjusted conversion

As per our discussion on circular referencing, the anti-dilution shares that we are calculating now, the ESOP and loan conversion all need to be input into the pre-money share base of the anti-dilution calculation itself! This is the only way to ensure that the new equity investors don’t get diluted by any pre-money activities/adjustments.

So, plugging in our numbers into the above quoted formula:

= 3% adjustment (increase) of the original Pref A shares, which results in an additional 15 thousand Pref A shares. Note — the company doesn’t actually issue new shares to the Preferred A shareholders. Rather, there is a “conversion price adjustment” which will become relevant in a liquidation event (specifically, an IPO).

Conversion of Convertible Loans

After four months, the notes have accrued approximately $15 thousand of interest which will convert into equity in the current round. The question is, at what price? The language of the CLA was “the lower of a 20% discount to the next (qualified) equity round of financing or a pre-money valuation cap of $15M”. So the point of indifference is calculated as the cap divided by (1 — the discount) i.e. $15M/0.8, which equates to $18.75M. i.e., any round with a valuation above $18.75M will have the loans capped at a $15M pre, and any round with a valuation below $18.75M will have the loans converted, subject to a 20% discount to the round’s PPS. Put differently, any valuation higher than the cap will result in minimum discount of 20%. Or in other words, the cap acts as a sliding discount, depending on the round’s valuation. As mentioned above, these 153 thousand shares have already been included in the pre-money share base and have actually impacted the round’s price per share.

What’s interesting about the loans, is that when they convert to equity, they usually adopt the rights of the class of shares into which they convert. So not only are the note holders coming into the round at a cheaper price than the new investors (discounted or capped), but their capital (and oftentimes accrued interest too) will also take on the liquidation preferences of those shares. It really depends on what’s been negotiated. Make sure that you understand what terms are associated with the loans. Now is as good a time as ever to point out that there really is no such thing as a ‘standard’ deal. Of course, some terms are more plain vanilla than others, but each term sheet needs to be carefully reviewed and considered.

If we were to compare an investment of $550 thousand given to the company in the form of debt, as opposed to a direct equity investment for the same amount, you can see that the loan benefits from accruing interest and converts at a lower price per share, resulting in many more shares than a direct equity investment.

The above pre-money cap table for the Series B round is the same as the post money cap table of the Series A round, adjusted for (1) the increased ESOP, (2) the Preferred A adjusted conversion price (anti-dilution) and (3) additional shares issued in respect of the converting the loans.

With a $5M round ($4.5M in fresh capital and approximately $0.5M in the CLA), Ever Line Ventures exercises their preemptive amount of $1.1M ($4.5M x 24.8% — being the adjusted pre-money ownership), and Mike invests an additional $400K.

This leaves $3M available for the new investor.

The post Series B cap table is as follows:

Ever Line Venture’s investment breakdown in the Preferred B round follows:

With a well-capitalized business, Fred and Fran are running up revenue.

Ready for an exit? Let’s explore in Part 3.

Shmuel Bornstein is a Senior Associate at OurCrowd, working closely with the funds 100+ company strong portfolio on post-investment management and follow-on rounds. Prior to joining OurCrowd as an early employee, Shmuel caught the startup bug during his tenure as Financial Controller of a privately- held company that underwent its own acquisition. Shmuel lives in Jerusalem with his wife and three gorgeous kids. Find him on LinkedIn.