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“SHARE AND SHARE ALIKE” A LAWYERS GUIDE TO SHARE PRICE AND

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“SHARE AND SHARE ALIKE” A LAWYERS GUIDE TO SHARE PRICE AND

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									“SHARE AND SHARE ALIKE” A LAWYER’S GUIDE TO SHARE PRICE AND SHAREHOLDER DILUTION IN CONNECTION WITH A VENTURE CAPITAL INVESTMENT IN A PRIVATE TECHNOLOGY START-UP

By R. Mark Richardson, Esq. Siavage Law Group, LLC

It’s easy to follow the share price of large Dow-component companies that have a highly developed market on the New York Stock Exchange and trade millions of shares every day, but how does the emerging company lawyer have any idea what the share price of its private company client is? How do you understand the numbers bandied about when a venture capital investor begins speculating that it might be interested in putting a desperately needed $4,000,000 into your favorite start-up client in the form of a stock purchase? The following provides lawyers with a simple introduction to determining the current share price of a private company that has had little financing activity when a venture capitalist offers a set of proposed investment terms. Such efforts can become complicated quickly, and there are many germane topics that cannot be addressed in a brief synopsis. The investor’s attempt to avoid dilution of its investment, however, will inevitably arise in negotiations, and therefore is singled out for additional explanation in this article. Here is a basic share price algorithm tied to a practical scenario with commentary, followed by some broader points about the ramifications of these calculations for a venture capital investment.

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1.

HOW MUCH MONEY IS THE VC PUTTING IN AND FOR WHAT SLICE OF THE PIE? Venture capital fund Money Bags, L.P. (“MB”) has approached your client, Next

Big Thing, Inc. (“NBT” or the “Company”), with a funding proposal. MB will invest $4,000,000 in exchange for a 40% stake in NBT. Importantly, NBT should understand that the 40% will, as is customary, be calculated after and including the infusion of MB’s money. This investment will be in the form of Series A Preferred Stock1, and will result in a “post-money valuation” of $10,000,000 for NBT, computed as follows: $4,000,000 investment / 40% interest to be held = $10,000,000 valuation, or $10,000,000 valuation * 40% interest to be held = $4,000,000 investment.

A discussion of valuation methodologies, or of the disparate interests of investors and entrepreneurs in establishing valuations, would unduly lengthen this piece. Suffice it to say that, in many instances, MB wields the power to name pre- and post-money valuations for NBT. MB has experience investing in NBT’s market segment, has provided complicated spreadsheet models, and, perhaps most significantly, is NBT’s only chance to continue making payroll. So, despite the belief of NBT’s principal, Frances Founder, that her technology alone is worth $17,000,000 before the first actual NBT product is shipped to a customer, and despite your valiant attempts to negotiate better terms, $10,000,000 ends up being the agreed post-money valuation figure.
1

For the sake of simplifying the calculations and discussions here, we will presume that the Series A Preferred Stock is convertible into common stock at a rate of one-to-one, upon the investor’s election or various other triggers provided in the Company’s certificate of incorporation. Typically, preferred stock has any number of rights and privileges that make it more valuable to hold than common stock and, at least theoretically, affect share price computation, but such factors will be set aside for purposes of this article.

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2.

HOW MUCH EQUITY WAS OUTSTANDING BEFORE THE VC CAME ALONG? Immediately following the corporate organization of NBT, Frances, the

Company’s first and only executive, was issued 1,300,000 “founder’s shares” of NBT common stock. The Company had only a good idea and very few assets at that point. The value of the shares given to Frances at the time of their issuance was therefore de minimis and is not particularly relevant to our present exercise. A few months into NBT’s existence, it was able to hire Developer Dan to work on a software module that NBT hoped would serve as the centerpiece of its first technology offering to the market. There wasn’t a lot of cash around to pay Dan, but he was lured, in part, by the issuance of 200,000 options to purchase NBT common stock. The Company has also set aside another 300,000 stock options that may potentially be issued to help compensate exceptional performance of existing personnel or to lure additional talent.2

3.

THE “FULLY-DILUTED” DISCUSSION WITH THE VC While there were only 1,300,000 common shares actually outstanding before MB

came along, MB kindly pointed out to you at the very beginning of discussions that Developer Dan’s stock options have the potential to dilute MB’s future holdings in NBT if they vest and Dan exercises them. MB thus wants Dan’s options counted as part of the Company’s fully-diluted equity interests (“FDEI’s”) prior to its investment.

2

To simplify the example, but without neglecting anything conceptually relevant for our purposes, we will presume that NBT does not have outstanding any warrants to purchase common stock, any debt convertible into common stock, or any other rights to equity that could affect the portion of the Company held by existing stakeholders.

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FDEI’s are traditionally calculated giving effect to the exercise of all outstanding options, warrants, convertible promissory notes, and other existing rights to purchase or acquire any common stock of the Company; in other words, an FDEI calculation supposes that everyone who holds issued options, warrants, etc., has exercised their rights in such instruments and now holds the resulting common stock. The reason that MB is concerned with FDEI calculations is because dilution from various equity instruments, if not accounted for from the outset, would eventually reduce MB’s effective percentage holding in the Company below the 40% MB wanted. For example, presume Developer Dan’s options are not included in the calculation of NBT FDEI’s before MB’s investment. Dan’s future exercise of those options and ownership of the resulting common stock would then reduce what was MB’s 40% holding at the time of its investment. MB wants to hold 40% of the larger pie that includes Dan’s potential 200,000 shares, rather than 40% of the smaller pie that does not account for that fairly sizeable piece of equity. You recognized early on that a broader calculation of FDEI’s is less advantageous to your client (NBT is, in effect, giving up more of the Company for the same $4,000,000 investment), but came to understand MB’s perspective on the issue. You were, however, taken aback when you saw the first draft of the actual term sheet for MB’s investment, which not only included Developer Dan’s options as part of the FDEI’s, but also: (i) counted the other 300,000 stock options that are reserved in NBT’s stock option pool as part of FDEI’s, though they have not even been issued to anyone yet; and

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(ii)

contained a provision that the Company option pool had to be expanded by an additional 450,000 shares before the close of this investment (with MB’s argument being that NBT must be prepared to reward other new personnel with options as the Company grows).

Inclusion of the entire option pool (issued options plus unissued reserve) in an FDEI calculation is a very common position for the venture capitalist to advocate. Fullpool inclusion and the requirement that the pool be expanded before consummation of an investment are measures that protect MB from the get-go against dilution that would result from later stock issuances.

4.

HOW MUCH EQUITY WILL BE OUTSTANDING AFTER THE VC INVESTS, AND HOW MANY OF THOSE SHARES WILL BE HELD BY THE VC? At this stage, you are able to determine how many FDEI’s there will be after the

venture capital investment. If MB will hold 40% of the Company post-investment, it is clear that all other equityholders will own 60% of the Company in the aggregate. Assuming that the pre-money FDEI’s equal 2,250,000 (with MB getting its wish for both the inclusion of NBT’s remaining option reserve and the expansion of that reserve), the total number of post-money FDEI’s after the investment will be 3,750,000 shares, computed as follows:

2,250,000 shares / 60% = 3,750,000 shares, or 3,750,000 shares * 60% = 2,250,000 shares, with the 3,750,000 post-money FDEI’s comprised of outstanding common stock plus outstanding options plus remaining option reserve plus shares to be issued to MB.

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You now also know that MB will be issued 1,500,000 shares because: 3,750,000 post-money FDEI’s 2,250,000 pre-money FDEI’s 1,500,000 shares for MB

– =

5.

COMPUTING THE SHARE PRICE FOR THIS SALE TO THE VC After this last computation, you have enough pieces of the puzzle assembled to

figure out the share price at which shares will be sold to MB. In step 1 above, we determined that the post-money valuation of NBT is $10,000,000. We also know that $10,000,000 will be spread over the 3,750,000 FDEI’s that will exist after MB’s investment (again, using the broadest FDEI definition). Thus, the “unabridged” share price for the sale to MB is $2.666666667: $10,000,000 valuation / 3,750,000 shares = $2.666666667 per share3

SUMMARY OF CALCULATIONS Here is a summary of what we have figured out in the course of performing the above calculations (showing the variation in results obtained with parallel calculations depending on whether the entire reserved option pool is not or is considered part of the Company’s FDEI’s):

3

Believe it or not, it will sometimes be necessary to use this many decimal places where millions of shares are involved to avoid discrepancies resulting from too much rounding. MB has agreed only to contribute $4,000,000, and if a truncated share price of $2.67 is used, MB will have to put in $5,000 too much based on the known number of shares it is to purchase. Of course, there are workarounds, though they are sometimes unwieldy. For example, MB could purchase one less share at a share price carried out to only five decimal places, and also be given a refund check by the Company for the excess money contributed over $4,000,000. In practical application, however, it is best to keep the number of shares to be issued constant and consistent with full-blown calculations wherever possible, as the number of shares held will be the measure used in the final Company capitalization table to show what percentage of the Company various shareholders control.

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CALCULATION METHOD

ISSUED OPTIONS ONLY

FULL-POOL INCLUSION PLUS EXPANSION OF RESERVE $4,000,000.00 40.00% $10,000,000.00 2,250,000 60.00% 3,750,000 1,500,000 $2.666666667

Investor Contribution in Dollars: % Ownership to be Accorded Investor: Post-Money Valuation: Pre-Money FDEI's: Pre-Money FDEI's as % of Post-Money FDEI's: Post-Money FDEI's: Number of Shares Going to Investor: Share Price for Investor's Shares if No Discount:

$4,000,000.00 40.00% $10,000,000.00 1,500,000 60.00% 2,500,000 1,000,000 $4.00

PRACTICAL EFFECTS OF THESE CALCULATIONS With the whole picture in front of us after the share price calculations, here are some salient facts that emerge: a. If the number of FDEI’s had been calculated using only the options actually issued and outstanding before MB’s investment (instead of the entire reserved option pool and an expansion of that reserve) there would have been only 2,500,000 post-money FDEI’s instead of 3,750,000. The size of the pie has grown significantly, and the much larger denominator has a profound effect on the share price (a change of approximately $1.33 in this instance).

b.

Not only is the share price to MB less under the full-pool inclusion method, but MB also receives 500,000 more shares that way.

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Recall that percentage holdings in a company are computed on this basis, which can have significant effect on voting issues and the dilution of pre-existing shareholders.

c.

The deal memorialized in the term sheet will result in MB owning 40% of the Company’s fully-diluted equity following its investment (including all possible instruments known at this time that could dilute its holdings). We knew from the beginning that 40% was the percentage on the table, but much discussion was required to determine “40% of what, exactly?”

d.

The company seeking funding must understand that a new investor will want to protect itself from dilution. The company will likely have to sell the venture capitalist more shares at a lower price than it may have originally anticipated, thereby ensuring that the investor gets the promised slice of the expanded pie.

While Frances Founder may not have much leverage to adjust the calculation method used when a venture capital fund proposes an investment, the above algorithm will at least allow you to show Frances how the end result is being computed, and help you explain the practical effect on existing and future shareholders. The law firm providing counsel to the emerging company can add significant value to its services by being conversant with these formulas.

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Mark Richardson is an associate at Siavage Law Group, LLC, an Atlanta boutique firm specializing in the general corporate counseling of emerging technology companies and the investors who capitalize them. He was a Robert W. Woodruff Scholar during his undergraduate years at Emory University, received a Robert T. Jones, Jr. Post-Graduate Scholarship to attend the University of St Andrews in Scotland, and received his law degree from New York University. Information on the attorneys of Siavage Law Group, LLC and their practice is available at www.siavagelaw.com. With particular regard to the subject matter of this article and the funding of early-stage businesses, the firm represents companies seeking and receiving investment, as well as venture capital funds. The author wishes to acknowledge the helpful comments and guidance of Michael R. Siavage, managing partner of the firm.

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