Funds investing in portfolio companies need to understand how a company-level pre-money valuation may become distorted (to the detriment of new investors) when that valuation is analyzed through the prism of the pre-money capitalization table and the related post-money capitalization table (referred to as the "cap chart(s)"). The ramifications may significantly alter the price per share in the new investment round.
In the simplest new-round investment, this should not be an issue. All pre-closing common stock equivalents (CSE) in the company remain unchanged as a result of the issuance of shares (or other equity interests) in the new round, and the purchase price for each share in the new round is calculated simply by dividing the agreed-upon pre-money company valuation by the number of pre-closing CSE. The new round shares purchased at that price are reflected as additional CSE in the post-closing cap chart.
But life is not always simple. In many cases, the company and its investors (existing and new) must make a judgment call regarding certain increases or decreases in the company's CSE attributable to the new round, but not directly related to the type or number of shares being purchased in the new round. The consequences of missing, misunderstanding or ignoring these issues can be expensive.
If a post-closing increase in the company's CSE is inappropriately ignored (i.e., it is not added to outstanding pre-closing CSE) for purposes of calculating the new round purchase price, then the new round purchase price (calculated by dividing the agreed-upon pre-money company valuation by the number of pre-closing CSE) will be artificially (and incorrectly) overstated as a result of the understated CSE. This, of course, has the same effect as increasing the actual pre-money company valuation (that is, the actual new round purchase price multiplied by the correct number of pre-closing CSE including the "ignored" increase in CSE) above the agreed-upon valuation. A similar result occurs if a post-closing decrease in the company's CSE is inappropriately taken into account to reduce outstanding pre-closing CSE.
As an example, assume a new-round purchase price is set at $2.00 per share based on a pre-money company valuation of $50 million and 25 million outstanding pre-money CSE. If a proposed post-closing increase of 5 million CSE is inappropriately ignored in calculating the 25 million CSE, the correct number of pre-closing CSE is 30 million and the correct new-round purchase price is not $2.00 per share ($50 million divided by 25 million CSE), but rather $1.66 per share ($50 million divided by 30 million CSE). In effect, the 5 million understatement of CSE increases the pre-money company valuation from $50 million to $60 million (that is, 30 million CSE at $2.00).
Consider the following examples:
Example 1: The company's "equity incentive plan" is increased from 1 million shares to 3 million shares because most of the existing 1 million shares already are reserved for issuance under outstanding employee options. The company (and existing investors) may be justified in treating the 2 million increase in CSE as a post-money event (incentivizing management and the company's workforce to grow the company after the new round). As a result, those 2 million CSE are ignored in determining the pre-money CSE and have no direct effect on the per-share purchase price in the new round. But new investors may argue that the existing 1 million CSE was inappropriately low (the 2 million increase simply corrects that mistake), and, as a result, those 2 million additional CSE should be added to the pre-money CSE, driving down the per-share purchase price in the new round.
Example 2: The company strikes a deal with early investors to redeem (at a significant discount) 2 million CSE held by those investors, and the redemption is funded by a portion of the proceeds from the new round. The company (and existing investors) may be justified in treating the 2 million reduction in CSE as a pre-money event (e.g., "cleaning up" the capital structure and the balance sheet). This drives up the per-share purchase price in the new round. But new investors may argue that they should share in the "accretion" in value attributable to the "clean-up" being funded by the new investors, and, as a result, those 2 million CSE should be included in the pre-money CSE and taken into account in determining the per-share purchase price in the new round.
Example 3: The company's outstanding Class B Convertible Preferred stock has anti-dilution protection triggered by the price per share of the new Class C investment round. As a result, upon closing the new round, the conversion ratio of the Class B shares is adjusted so that, upon conversion of all outstanding Class B shares, the investors holding Class B shares will receive an additional 2 million CSE. The company (and existing investors) may be justified in treating the 2 million increase in CSE as a post-money event (a post-closing "issuance"). New investors may argue that the dilutive consequences of early-round investor rights should not adversely affect the new investors. This difference would have the same ramifications on valuation as those in Example 1 above.
The bottom line is this – investors must carefully examine all actual changes in CSE during the period leading up to the new round and all proposed or anticipated changes in CSE between the company's pre-money cap chart and post-money cap chart. If those changes include items other than simply the issuance of new shares to new-round investors, those changes (and the rationale for making them) must be examined, discussed and understood. Otherwise, the investor may be overpaying for the new shares as a result of an overstated per-share purchase price and company-level pre-money valuation.