Congratulations. You’ve formed the start-up company, and you’re two founders, each holding 50% of the equity. You randomly decided to allocate 1M shares in the company, You’ve worked for six months, and finally finalized a term-sheet with a VC.
You agreed with the VC on the following terms: The VC will invest $1M, and you agreed that the pre-money valuation will be $4M. Agreeing on pre-money valuation (instead of post-money valuation) makes the math simpler, when you consider leaving the round open for a while, offering other investors to join in. You also agreed, to have a 10% ESOP pool for new employees that the company will hire.
Let’s summarize:
- $4M pre.
- $1M investment
- 10% ESOP pool post round
Now let’s build the CAP (capitalization) table.
Wait a moment… Are there few ways to build it? Let’s see. One way to build it, is to show the pre and post states.
If the pre-money valuation is $4M and the company has 1M shares, that means that the price-per-share (PPS) is $4. That also means that the VC will buy 250k shares.
Pre
|
Post
| |||
# Shares
|
% (Fully Diluted)
|
# Shares
|
% (Fully Diluted)
| |
Founder 1
|
500,000
|
50%
|
500,000
| |
Founder 2
|
500,000
|
50%
|
500,000
| |
ESOP
|
?
| |||
VC
|
250,000
| |||
So how many shares do we need to allocate to the ESOP to have a 10% ESOP pool post round?
Let’s do a simple math: X / (1,250,000 + X ) = 0.1
The solution is X = 138,888
So let’s write it:
Pre
|
Post
| |||
# Shares
|
% (Fully Diluted)
|
# Shares
|
% (Fully Diluted)
| |
Founder 1
|
500,000
|
50%
|
500,000
|
36%
|
Founder 2
|
500,000
|
50%
|
500,000
|
36%
|
ESOP
|
138,888
|
10%
| ||
VC
|
250,000
|
18%
| ||
Now let’s try another way. The VC says that we should allocate the ESOP pool, prior to their investment.
How many ESOP shares should we allocate? Aha. That’s a bit more complicated. You want the outcome after the round to be 10% (That’s what the VC wants). But the PPS for the VC is going to be calculated not based on the pre-state but rather on the pre-with-esop state.
Let’s denote the number of new ESOP shares as E.
So the PPS is now: PPS = $4M / (1M + E)
Since the VC invest $1M, they should get this number of shares:
VCS = $1M / PPS = $1M / ( $4M / (1M + E))
So, post round, the total number of shares should be 1M + E + VCS:
#Total = 1M + E + $1M / ( $4M / (1M + E))
ESOP percentage should be 10%, so we get:
E / #Total = 0.1
E / (1M + E + $1M / ( $4M / (1M + E))) = 0.1
We have one equation with one variable. That’s solvable.
E = 0.1 * (1M + E + $1M / ( $4M / (1M + E)))
E = 0.1M + 0.1E + $0.1M / ($4M / (1M + E))
0.9E = 100,000 + 0.025 * (1M + E)
0.9E = 100,000 + 25,000 + 0.025E
0.875E = 125,000
E = 142,857
And then VCS = 0.25 * (1,142,857) = 285,714
And total number of shares will be = 1,000,000 + 142,857 + 285,714 = 1,428,571
Pre
|
Pre With ESOP
|
Post
| ||||
# Shares
|
% (Fully Diluted)
|
# Shares
|
% (Fully Diluted)
|
# Shares
|
% (Fully Diluted)
| |
Founder 1
|
500,000
|
50%
|
500,000
|
43.75%
|
500,000
|
35%
|
Founder 2
|
500,000
|
50%
|
500,000
|
43.75%
|
500,000
|
35%
|
ESOP
|
142,857
|
12.4%
|
142,857
|
10%
| ||
VC
|
285,714
|
20%
| ||||
Do you notice the change? The VC gained 2% more, and the founders, combined, lost 2%.
Allegedly, the terms are the same; same pre-money valuation, same investment, same ESOP pool post-round. But the numbers are different.
That happened because the ESOP allocation was done prior to the round, and the PPS was lower (more shares, because of the ESOP).
Be aware.
