You’ve researched your market and industry.
You think you understand what products you’ll sell at what price to what target markets.
You and your co-founders already purchased, say, 1,000,000 (common) founders shares at $.001 per share.
You have built pro forma income statements for five years and see that you expect to achieve revenue ($19,000,000) and profitability ($7,500,000) compatible with your goals. Here is what your pro forma income statements might look like:
You have also built pro forma cash flow statements and have learned that you need two infusions of cash: $400,000 during the first year of operations and an additional $800,000 during the second year.
After that, the company will grow without infusions of cash. Here is what your pro forma cash flow statements might look like (Note that the cash balance at the end of the first year is negative $337K, which is why we concluded you need $400,000 in cash. Note that the cash balance at the end of the second year is negative $1.17K, which is why we concluded you need $800,000 more in cash.):
The next big questions you must answer concern the two investment rounds:
- What class of shares should you sell the investors?
- At what price should the shares be sold?
Most outside investors in startup companies want preferred, not common, stock. The reason is simple. Unlike company founders, outside investors typically have little or no influence over decisions and outcomes because they are not part of the management team.
With so little control, they take on much more risk, and thus deserve a higher return. Preferences (specifically Liquidation Preferences, but often others as well) provide that higher return.
At What Price per Share?
Determining price per share is an iterative process. In the scenario being discussed, let’s start by guessing that a price per share of $5.00 might work. See figure below.
Next, take a look at the Internal Rates of Return (IRR) in the last column of the following table.
In this case notice that two problems exist:
- The IRRs (21.9% and 28%) for both rounds are below external investor expectations.
- The IRR received by the second set of investors (Series B) is higher than by the first set of investors (Series A). That is inappropriate since earlier investors always take higher risk and therefore deserve a higher return.
With that in mind, let’s adjust the prices per share for the two rounds to $1.25 and $4.00, respectively.
This time the relative returns of the two rounds are appropriate, but the Series B investors are still receiving a return too low for outside investors; in fact they’d be better off making a safer investment in the public markets (they would receive a lower return but with a much lower risk).
In this specific case, iteratively adjusting the prices per share will eventually demonstrate that prices of $1.25 and $2.75 result in IRRs of 44.1% and 35.5% for the two classes of investors.
Personally, I tend to plan for larger returns for my investors, so I would likely plan my rounds at around $.75 and $1.50 per share to at least plan for returns of 51% and 45%, respectively.
Of course, this exercise is a planning exercise only. When you get around to actually raising capital, many other factors are going to come into play including whether or not you have met key milestones, the general availability of capital, the negotiation strengths of both parties, competition, and so on.
Now you have determined the right prices per share to use during the planning stage of your company so that your shareholders receive fair returns. There is just one more step left. It is to look at the cap table for your company to verify that you have not sold too much of the company in the process of attracting investors. If necessary, read How to Read a Cap Table: Advice for Entrepreneurs.
As you can see above, Series A sold 19% of the company, and Series B sold 18% of the company, leaving 63% for the founders and optionholders.
If you are comfortable selling more of the company and offering a larger return (and thus making it more likely to receive investments), lower the price per share for each round.
The price per share is your “lever,” which is equivalent to manipulating the valuation of the company or the “pre-money valuation”.
Planning your investment rounds at company inception enables you to understand the impacts of seemingly small changes to deal terms at a time when you are not under duress. Then when the time comes to deal with investors you can apply the knowledge you learned previously to remain calm.
Dealing with investors requires precision, patience, and a keen understanding of your company’s present and forecasted finances. Operating with the finances as your fulcrum allows you to balance everyone’s interests and give your company the best possible chance of success.
High Wire Photo courtesy of orangebrompton (Creative Commons)