Jay Parkhill July 17th, 2008
This post may get a bit wonky. I’ll do my best to keep it straightforward.
I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company. A venture-oriented company has two or more different kinds of shares with different values attached. Here’s how to keep them separate.
Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in. Let’s say the value is $10M. If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00. This is the price investors will pay to buy stock in the company.
If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares. The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M. We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.
Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees. Preferred stock has superior rights, especially including a right to get paid first when the company is sold. By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock. Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.
This works well for the most part. Investors want certain rights that employees don’t care about and pay extra for them. Employees would rather get low-priced options than the preferred rights. Everybody is happy.
But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2. At the same time, we say that common stock is not worth $2 and is only worth $0.30. Which is true? Both. Here is how and when to use each number.
Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold. We take into account all of the economic preferences and assume that all stock is converted to common. Every share is the same at that point. In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2. The valuation is really forward-looking to an eventual exit.
Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred. The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price. The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.
The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees. Be aware that pricing is set differently for each.