Your VC’s Cap Table Math Could Be Hurting You

[Contributed by Mike MacKeen, originally published on Raising the Next Round] This post includes some geeky accounting issues, but read it. It can change how much dilution you take in the next round.Later-stage investors are delivering our companies attractive valuations. Just look at the latest Unicorn list.However, many companies are not really getting the headline valuation in their term sheet. Ultimate ownership and dilution is driven by pre-money share price, not a headline valuation. When follow-on investors are calculating share price, many use an outdated method that is adding dilution to existing shareholders, most often hurting founders and employees.The trap is that many investors use a fully-diluted share count that treats options and warrants as a full share of stock. This matters because investors divide the headline valuation by share count to reach a share price. The more shares outstanding, the lower the share price.If you are reading this blog, it is likely you have been an option holder. You understand that options and warrants have a purchase price. The right to buy a $20 stock for $10 is not worth $20, it is worth $10. Surprisingly, standard practice among many venture investors ignores this reality. These investors add up outstanding shares, options and warrants to reach a “fully-diluted” share number that treats options and warrants as a full share of stock. That is not a material concern if the strike price on the options is a few pennies, but when the strike price is several dollars per share, the practice becomes unfairly dilutive. That dilution hits those not investing in the round – usually founders and employees – the hardest.Investors are not ignoring option proceeds out of malice. It is a standard practice that made sense 20 years ago when start-ups were valued in the single digits and option exercise proceeds were too small to bother calculating. However, the world has evolved and investor practice on pricing calculations has not kept up. A few key issues that have changed:

  • The 2005 implementation of IRS Rule 409a impacted option issue practices, forcing option strike prices to be mapped to market value more frequently
  • A more robust private capital market is allowing companies to stay private and independent longer. This has increased the number of financing rounds and the volume of “in-the-money” stock options
  • More mature private companies and a healthy financing market have driven valuations into the hundreds of millions or billions, resulting in high option strike prices

It is not uncommon for one of our companies raising a C or D round to have notional option exercise proceeds of $5,000,000 or more. This is actual capital the company receives (or a reduction in shares converted if the company has cashless exercise provisions). When exercise proceeds reach this level, it is fair for the company to get credit for the proceeds in a calculation of shares outstanding.The fair method for setting share price when financing a later-stage company is to reach a share count by applying the notional option exercise proceeds to reduce the notional number of shares outstanding when calculating share price. That is the core of an accounting principle called the Treasury Stock Method. The Treasury Stock Method is a standard accounting practice. In fact, it is so common outside the venture world that GAAP compliance requires a company use it for determining share count when reporting Earnings Per Share. If you are interested in the accounting details more information about it can be found here.A quick example will show why you should care. Let’s look at a company pricing a Series D round. The company has 4,000,000 existing shares, including options, notional option exercise proceeds equal to $7.5M and is raising capital at a $100M pre-money valuation.Option CalcGiving the company proper credit for its option proceeds changed the share price by $1.79. On a base of 4M shares, that is an effective swing in the pre-money valuation in excess of $7,000,000.Option accounting is not sexy stuff, but can make a material difference to how much management and employees retain in a financing. If you have a late-stage company raising capital, this should be a topic you discuss with prospective investors.

Posted on March 18, 2015 in Capital Markets, Financing Trends, Insights, Private Equity