Understanding Startup Investments
Chapter 2
Different types of equity are available to various stakeholders within a startup; equity generally breaks down into common stock and preferred stock.
Preferred stockholders (also called preferred equity holders) have greater claim to the company’s assets than common stockholders. They are first in line to collect a payout if solvency event lower than the company’s valuation occurs (think: bankruptcy, mergers, acquisitions).
Companies will sometimes divide common stock/equity into two classes, Common A stock, and Common B stock; Common A stockholders taking priority over Common B stockholders.
Startup investors typically hold Preferred Stock/Equity, whereas founders generally hold Common Stock/Equity. Employees often hold options that grant them the right to purchase shares of Common Stock/Equity, subject to vesting schedules.
Valuation refers to the amount that a startup is worth. Because most startups aren’t turning a profit yet, a startup’s valuation describes the amount that founders, investors, and shareholders decide that the company is worth. This number is based on the price per share that investors are willing to pay in order to invest in a startup during a particular round or stage.
EXAMPLE
Ashton Kutcher and investment partner, Guy Oseary, invested $500,000 in Airbnb’s Series C round for an estimated .25% equity stake. At the time, Airbnb had a $200 million valuation. Airbnb is currently valued at $30 billion, as of August 2016, making Kutcher and Oseary’s shares currently worth an estimated $75 million, assuming no share dilution in later rounds.
Valuation can change every time an event occurs that impacts the worth of investors’ shares in the company. Share value can also fluctuate depending on how many additional shares the company issues to later-stage investors in follow-on rounds of funding.
Events That Can Impact Startup Valuation:
To calculate the value of an individual investor’s shares in a startup at any given time, multiply the number of shares the investor owns and the company’s current price per share.
Startup valuation before a new priced equity round occurs is called a pre-money valuation.
Post-money valuation refers to the change in valuation after a priced-equity round occurs – this is generally a higher number than the pre-money valuation, though in a down round, post-money valuations can be lower than the pre-money valuation.
Preferred stock rights help to minimize investor's exposure to risk in future funding rounds.
Investors who receive preferred stock can negotiate a set of terms that are favorable to them in the event of a drop in the value of their investment, such as a down round (when a company raises funding at a lower value than in a previous round), or when a company issues additional shares, which dilutes an individual investor's percentage of equity in the company.
In most cases, all investors in each round will be granted the same set of preferred stock rights and terms.
The actual rights included in a given investment will vary, and we recommend conducting legal diligence on each individual investment:
Liquidation Preference: terms of investment specifying which investors get paid first, and how much they will get paid if a liquidation event occurs. Liquidation preference is typically used to protect preferred investors by making sure they get their initial investments back before common shareholders (including founders, employees, and previous investors).
Pro rata rights: Pro rata rights help existing investors maintain their percentage of ownership in the company via additional investments. Often, companies will grant larger investors in early rounds of funding the right to participate in subsequent rounds via this right. Investors can decide whether to exercise their pro rata rights in subsequent rounds of financing depending on their investment strategy.
However, pro-rata rights aren’t entirely future proof. Investors at later rounds may attempt to waive the pro-rata rights of earlier investors. Pro rata rights also typically only apply to a single subsequent round and typically do not apply in perpetuity to all future rounds.
EXAMPLE
Twitter founder, Biz Stone, invested $42.7 million in Slack’s Series C Round at a $2.8 billion post-money valuation, for a 1.525% equity stake. When Slack raised its $200 million Series D Round at a $3.8 billion post-money valuation, they gave away 5.26% of the company, diluting all existing shareholders by 5.26% as well.
Biz’s initial holdings in the company are diluted to 1.44%. Pro-rata rights would dictate that Biz could have chosen to invest an additional $3,040,000 (.08% of Slack at the $3.8 bil valuation) in the Series D round to restore his holdings to 1.525%.
Anti-dilution: Shares granted with anti-dilution rights protect early equity investors in the event of a future decrease in the value of their shares. In the event of a down round, anti-dilution rights kick in and issue additional shares to previous investors who invested at a higher valuation. Most, but not all, equity financings led by venture capital investors include anti-dilution rights for preferred investors. However, investors in later rounds may request to waive anti-dilution rights granted to investors in previous rounds.
Follow-on funding will almost always result in a small amount of dilution for previous investors, as the company valuation is increasing, while the investor’s amount of ownership interest remains the same (which is why pro-rata rights, explained above, help investors maintain their percentage of ownership interest in the company).
Anti-dilution rights can protect investors from their percentage of ownership interest shrinking dramatically in the event of a drop in valuation, or down round. A drop in valuation is generally a negative outcome for a company, and investors tend to hope that their anti-dilution rights never have to kick in.
The exact calculations governing how investors are compensated for any lost value depend on the type of anti-dilution rights initially granted to the investors.
To better illustrate how each type of anti-dilution right can impact investor share value, we’ve created several fictional sketches surrounding Foursquare’s down round in January, 2016:
Note: All price-per-share information used in these examples is for illustration only, and should not be taken as investment advice.*
No Anti-Dilution Rights: Common shareholders, such as founders and startup employees, generally do not hold anti-dilution rights, and are therefore not protected against a loss in the value of their shares.
EXAMPLE
Imagine that you invested $500,000 in Foursquare’s Series D round, at a $700 million post-money valuation. You bought 38,640 shares of common stock at $12.94 per share, with no anti-dilution rights. Foursquare later goes on to raise a Series E round at a $307 million post-money valuation. The overall value of your $500,000 investment is now $154,496.
Furthermore, the price-per-share [drops by 69%, to $4.01](http://blogs.wsj.com/digits/2016/01/14/foursquare-ceo-steps-down-as-valuation-plummets/). Now, your shares are worth $154,496 (about 69% less than their value at the time of your initial investment). As a common shareholder, you would not be entitled to any additional shares to make up for the decrease in share value.
1. Full Ratchet Anti-Dilution: The company agrees to issue shares to investors to make up for 100% of lost share value, if the price-per-share drops below the amount of the investor’s initial investment, in order to return the investor’s holdings to their full value.
EXAMPLE
Taking the same scenario as above, if you had invested in Foursquare with full ratchet anti-dilution rights, we’ve sketched out a possible outcome:
Imagine that you invested $500,000 in Foursquare’s Series D round, at a [$700 million post-money valuation](https://www.crunchbase.com/funding-round/6a11c556a4bd9f4120c5fc1f50069021). You bought 38,640 shares at $12.94 per share, with full ratchet anti-dilution rights. Foursquare later goes on to raise a Series E round at a [$307 million post-money valuation](https://www.crunchbase.com/funding-round/140ade1ab8a80108d48c4a51f96bfd24), and the price-per-share [drops by 69%, to $4.01](http://blogs.wsj.com/digits/2016/01/14/foursquare-ceo-steps-down-as-valuation-plummets/).
Now, your shares are worth $154,496 (about 69% less than their value at the time of your initial investment).
Full ratchet anti-dilution rights dictate that, in this scenario, Foursquare would need to issue you additional shares, to make up for the 69% decrease in share value.
To return your holdings in the company to their initial $500,000 value, Foursquare would have to issue an additional 86,410 shares to you (at a $4.01 per share valuation), to compensate for the $346,504 in lost value of your initial investment.
2. Broad-Based Weighted Average Anti-Dilution: this is the most common type of anti-dilution right granted to investors. Investors receive additional shares if the company valuation takes a hit, but are not reinstated at 100% of the value of their initial investment.
To calculate how many shares a company owes to investors with broad-based weighted average anti-dilution rights, founders use a formula that factors in the value of the investor’s shares at the time of her initial investment, how much the price-per-share decreased as a result of the lower valuation, and determines a “new” conversion price for the shares. The company then issues additional shares to the investor as if the original investment was made at the conversion price.
Effectively, investor compensation via broad-based weighted average anti-dilution rights is proportionate to the percentage of value that investors lost when the company valuation decreased and share price went down.
If the price-per-share only took a hit of a few percentage points, and the down round itself was relatively small (few additional shares were granted during that round), the resulting decrease in value of investor's shares would be relatively small, and investor compensation would be proportionately low.
The company then issues additional shares to the investor until they reach the agreed upon new share value (generally some point between the initial investment amount and the new price-per-share upon the lower valuation).
EXAMPLE
Taking the same scenario as above, if you had invested in Foursquare with broad-based weighted average anti-dilution rights, we’ve sketched out a possible outcome:
Imagine that you invested $500,000 in Foursquare’s Series D round, at a [$700 million post-money valuation](https://www.crunchbase.com/funding-round/6a11c556a4bd9f4120c5fc1f50069021). You bought 38,640 shares at $12.94 per share, with broad-based weighted average anti-dilution rights. Foursquare later goes on to raise a Series E round at a [$307 million post-money valuation](https://www.crunchbase.com/funding-round/140ade1ab8a80108d48c4a51f96bfd24), and the price-per-share [drops by 69%, to $4.01](http://blogs.wsj.com/digits/2016/01/14/foursquare-ceo-steps-down-as-valuation-plummets/). Your shares are now worth $154,496 (about 69% less than their value at the time of your initial investment).
According the broad-based weighted average anti-dilution formula, in this scenario, Foursquare recalculates your initial holdings as being worth $11.53/share. If you had invested $500,000 at $11.53/share, you would have bought 43,365 shares.
Therefore, Foursquare has to issue you an additional 4,726 shares. These additional shares, plus your initial holdings, are worth $173,894 total after the Series E ($4.01/share) valuation. This provides a slight cushion to investors with broad-based weighted average anti-dilution rights, who lose 66% of their value, as compared to the 69% they would have lost if they did not have anti-dilution rights.
3. Narrow-based-weighted average anti-dilution: Investor outcome falls somewhere between broad-based and full ratchet anti-dilution rights. Investors recoup more of their initial investment value than they would with broad-based weighted average, but less than if they had been granted full-ratchet anti-dilution rights.
Narrow-based weighted average calculations differ from broad-based weighted average calculations in that we consider only the total common stock issued to investors, and disregard any {outstanding options} (Outstanding Options)(Options reserved to grant to any new employees hired between rounds of funding.), warrants, and convertible securities that have not yet converted to equity.
EXAMPLE
Taking the same scenario as above, if you had invested in Foursquare with narrow-based weighted average anti-dilution rights, we’ve sketched out a possible outcome:
Imagine that you invested $500,000 in Foursqauare’s Series D round, at a [$700 million post-money valuation](https://www.crunchbase.com/funding-round/6a11c556a4bd9f4120c5fc1f50069021). You bought 38,640 shares at $12.94 per share, with narrow-based-weighted average anti-dilution rights. Foursquare later goes on to raise a Series E round at a [$307 million post-money valuation](https://www.crunchbase.com/funding-round/140ade1ab8a80108d48c4a51f96bfd24), and the price-per-share [drops by 69%, to $4.01](http://blogs.wsj.com/digits/2016/01/14/foursquare-ceo-steps-down-as-valuation-plummets/). Your shares are now worth $154,496 (about 69% less than their value at the time of your initial investment).
According the broad-based weighted average anti-dilution formula, in this scenario, Foursquare recalculates your initial holdings as being worth $11.40/share. If you had invested $500,000 at $11.40/share, you would have bought 43,860 shares.
Therefore, Foursquare would have to issue you an additional 5,220 shares. These additional shares, plus your initial holdings, are worth $175,879 total after the Series E ($4.01/share) valuation. This provides a slight cushion to investors with broad-based weighted average anti-dilution rights, who lose 65% of their value, as compared to the 69% they would have lost if they did not have anti-dilution rights.
Many founders and investors believe that broad and narrow-based-weighted-average anti-dilution rights are more fair to all parties involved than full ratchet anti-dilution rights, because they protect the investors while not excessively diluting common shareholders.
Full ratchet anti-dilution rights run the risk of diluting the company founder’s shares of common stock too early. Many investors believe that it is very important for startup founders to hold a substantial amount of ownership interest in their business, which provides additional incentivize for them to lead the company to a successful exit and create a beneficial outcome for themselves and their investors.