A Capitalization Analysis Tool
to determine how much of your company you will own at exit
If you are the founder(s) of an early-stage company or on its management team with equity incentives, you will probably want to read this. So will your investors who want to better forecast their exit returns.
From the time you begin to raise third-party funding as an early-stage company, you will want to do capitalization analysis. In order to do this, I introduce in this essay a Capitalization Analysis Tool in order to map out your ultimate company ownership and stakeholder returns. Lack of such planning can leave you holding the (empty) bag.
For those who are familiar with the elements of a capitalization table, please skip to the Capitalization Analysis Tool itself below. For others keep reading.
Investors like to see who owns how much of your company. This is best expressed in a list of equity holdings in your capitalization table at a given point in time. Issues arise, however, when there are obligations the company has made to potential stockholders, usually in connection with funds they have raised.
Have you raised money using convertible securities (SAFEs and Notes)? Have you issued options or warrants? If you have, your current cap table may not reflect your ownership in the company.
Points to remember about capitalization analysis planning:
You will not know your percent ownership of the business until you exit
Planning cash needs until exit helps you better forecast your ownership
Convertible securities (e.g., SAFE and CONV. NOTES) will likely convert into securities which have preference rights over the available cash at exit.
Common comes last to the table of available cash at exit (i.e., when the company is acquired, goes IPO, or otherwise has a change of ownership)
Capitalization Analysis helps you understand impacts on your ownership from:
Amounts you raise
Your company valuations at the time you seek investments
Securities you use
The amounts you raise at acceptable valuations often will be impacted by:
The key milestones investors believe you can reach with their investment
The annualized revenue and revenue growth, based on recent quarters
Your cash balance, GOMs, and runway when you are seeking new money
The company’s valuation will be a function, among other things, of:
Time to exit and your company’s value at exit
Investor assessment of business risks (tech, market acceptance, execution and financial performance)
Revenue growth rate and customer traction
Also, you will want to increase investor comfort with your possible exit valuation. Highlight the M&A in your business sector and look for metrics (e.g., a multiple of revenues) in other transactions. Then successfully defend the assumptions in your financial forecast and the believability of the timing and level of your revenue stream.
The Securities you use also will impact your capitalization and your ownership: This is a typical sequence of equity growth as you grow your company:
Starting out: Founders common stock issued
Options and warrants issued to key employees, advisors
SAFE’s … upon conversion (or KISS’s)
Convertible Notes … upon conversion
Preferred stock rounds as priced
Assume a priced Preferred Stock round, say a Series A, triggers a conversion of the prior issued SAFEs and Convertible Notes. The conversions are based on the conversion valuation price per share used to calculate the number of shares of Preferred Stock into which the SAFEs and Conv. Notes are converted.
Why Capitalization Analysis Matters
For Founders: It enables you to optimize the percent ownership for founders and other stakeholders at exit. It helps you assess how much dilution you can be happy with and helps you determine the impact of key variables you control.
For Investors: It shows stakeholder ownership at exit, which will impact their return multiple, based upon a forecast company revenue, and an exit multiple.
Building an investor facing cap table
Investors want to see a fully diluted capitalization table because often the securities you use to raise funds and incentivize your employees are not considered equity until they are converted into equity by a future event. Options are not equity until they are vested and exercised. SAFE NOTES and Convertible Notes are not equity until a future qualified raise forces a conversion. Then, the number of shares of equity will be determined by the price per share of that raise, adjusted for a previously agreed discount and/or capped conversion price. But this is where it gets tricky.
Conversions of equity obligations into equity
There are three different ways convertible securities can be converted, with differing impacts on company founders and investors. These stakeholders need to understand these three methods when drawing up the investor legal documents.
When a qualified (by its size) raise for priced shares of common or preferred stock takes place, it usually forces conversion of the equity obligations (other than options) into equity, typically into the equity provided in the raise itself. The SAFE Notes and Convertible Notes will convert, for example, into Preferred stock, but at some discount to, or capped percentage of, the Preferred price per share. The Preferred price per share is determined by the valuation of the company before the preferred investment divided by:
All shares of issued common stock and promised options
Usually all converting securities, but not always
And including the unissued option pool
But excluding any increases in the unissued option pool from the equity financing
The conversion method most friendly to company founders is when the Preferred Stock pre-investment valuation is fixed for the purpose of determining the price per share used for all convertible securities, before adjustment for percentage discounts or caps. It is often called the Pre-Money Method (Method A in the conversion box of the tool). It is also the most prejudicial to the investors in the converted securities and the Preferred. This is because the number of shares used to determine the price per share for the conversion of the convertible securities is limited to the equity before those conversions take place. This will increase the price per share used for the conversion and lower the number of shares the convertible security investments will receive. It is shown in the Capitalization Tool described below. Meanwhile, the Preferred investment of the new investors will be priced, based upon the number of shares including the converted securities, thereby lowering the Preferred share price and increasing the number of shares their investment will buy.
Another method, often called the Percentage Ownership Method, is most prejudicial to founders, but it provides the best outcome for the convertible securities investors, and it guarantees a percentage of the company by the preferred investors based on their dollars invested as a percent of the post-money invested in the company.
A compromise between these two methods is a third approach, often called the Dollars Invested Method. It adds to the pre-money preferred valuation the prior investments and the Preferred investment to calculate the preferred price per share.
For founders and investors, knowing your ultimate ownership and returns from an exit is impossible without knowing a priori what that conversion price per share will look like at some future time. The capitalization analysis tool helps you better estimate those metrics.
The issue for investors holding convertible securities is that their conversion terms only apply to their investments. The subsequent investors in the qualifying Preferred raise can specify a favorable conversion method for themselves, which can adversely impact the earlier investors.
The Capitalization Analysis Tool
The tool explained below enables you to better estimate:
How much dilution you will have
The impact of key variables on stakeholder shareholdings and returns
Your investors’ target valuations and returns at exit
The Excel version of this tool is modeled as an iterative spreadsheet representation of your company over its ownership lifetime, iterative because it can determine the impact (sensitivity) of different variables on your ultimate returns. To be represented in this paper, the tool itself is broken into several pdf boxes, or sections, and explained in this essay.
In a future essay, we will run sensitivities in the Excel spreadsheet on the different key variables to help both company owner-founders and investors view with curves and other diagrams which variables will give them their optimal outcomes.
The tool starts with your assumptions in Sections A and B:
Section A shows the revenue and revenue growth assumptions pulled from your company’s financial model forecast, at the time your investment funds are banked.
Section B shows capitalization tool fundraising assumptions in the yellow cells. These are the data you must estimate and input, based upon the forecast metrics in your financial model. They include:
The total amount of money you expect to raise before you exit
The sequence of individual raises and securities you expect to utilize. For this exercise, we assume the convertible securities do not have any interest or that the interest is accrued and included in the amount of the principal converted.
The conversion terms for those securities
In this example, we raise funds in two Safe Notes, then a Convertible note, and finally the balance in a Series A priced Preferred Stock, before exit.
Gary V. Awad
In Section 1 below, we start with the four founders’ capitalization of the company. In this case, we assume one million common shares are issued to John, Paul, George and Ringo.
Initial raises in this example are made in the form of Simple Agreements for Future Equity (SAFEs). Section 2 shows a SAFE Note 1, which will convert into the Preferred Stock of a future priced round of funding at a percentage discount to the price paid by the Preferred Stock investors. Since the conversion price of SAFE Note 1 is discounted from the price paid by future investors in the Preferred Stock Round, it is not known at the time the SAFE is issued.
In Section 3, SAFE Note 2 converts at a discount or a capped price, whichever gives these SAFE investors a better conversion price for their investment. For the Section 3 raise the valuation for converting this SAFE Note 2 is capped at a price lower than the price paid by future investors in the Series A Preferred Stock Round.
SAFE Notes with only a discount likely will favor the founders as compared to Safe Notes which have a capped price as an alternative. Thus, the discount only SAFEs will likely have a higher discount (30% in this example) than the SAFEs which also have a cap (20% here). If you are successful with a higher valuation for the Preferred round, however, your capped price SAFEs will do better for the investors than the SAFEs with only a discount. If your SAFEs are investors who are family and friends, you may end up with some disappointed friends who have only the discounted SAFEs.
Now, with a capped price for a SAFE conversion, you need to look at where you stand with valuation. Look at what your financial model is telling you in Section A. For this example, Section A assumptions show annualized revenues of $600,000 with a 40% quarterly growth rate during the time when you are raising funds with SAFEs. You need to decide if the $5 million capped valuation assumption in Section B looks reasonable with those financial model metrics for the business sector in which you operate.
In Section 4, we show your Convertible Note raise, which typically will convert into the Preferred round at a discount or a capped price, whichever is better for the Note investor. Again, you will need to refer to Sections A and B to decide if the capped valuation is a reasonable assumption. In this example, the $12 million capped valuation for the conversion of the Convertible Note represents a 7.5 multiple of annualized revenues growing at 30% quarterly. We deem that to be reasonable for this scenario. At this point, if you and your Note investors can estimate the raise amount for the future Series A Preferred round and the company’s exit value, you can get a good fix on your stakeholder shares of the company and their exit returns. Of course, this assumes there will not be a Series B.
Section 5 details metrics for a Series A Preferred Stock round. The raise in this round and its valuation, as well as the method of conversion of the convertible securities (discussed below), will determine your stakeholder shares and returns. In this example, we set a valuation of $20 million, which we deem reasonable, given it is 4 times the annualized revenue, with a 20% quarterly growth rate at the time of the raise. You assumed at the outset how much investor funding you needed before exit, so the funds raised in SAFEs and convertible notes determined the remaining amount required for the Series A Preferred. Note also that the Preferred investors will often insist upon a post investment option pool percent, so we provided for a post-money pool of ten percent.
Now you have mapped out your raises at different times, based on your financial model. Assume you have successfully defended the assumptions in that model and the reasonable valuations and terms for each raise. Assume investors accept your estimate of exit values, based upon exit multiples of other companies in your business sector. Then you and your investors will be able to agree upon likely stakeholder returns.
This is shown in Section 6. We estimated an exit multiple of 3 times revenues of $50 million in year five. Your investors and option holders have taken 53.5% of your company (Section 5) and received return multiples on their investments of from 4 times to 17 times (Section 6), depending on which raise they invested in. The SAFEs with the capped price (Safe Note 2) came out with the best return multiple, and you as founders will walk away with $70 million.
No matter what stage of the funding process you are in, Section 7 shows your investors what their returns could be if the forecast in your financial model proves out and the raises follow this pattern. If you include a Section 7 in your pitch to investors you should use a disclaimer of the kind that accompanies any financial forecast provided to potential investors.
Section 8 allows you as founders to quickly see what your ultimate percentage share of the company will be, given the model’s forecast of raises, the securities used for those raises, and the conversion valuations of those securities.
In Section 9, we compare the impact on founders’ shares for different sequences of funding over the company’s lifetime of fundraising through a Series A. All these sequence scenarios assume a conversion of securities based on Conversion Method A below. Similar sections can be developed to compare impacts for other key variables in the investment process, such as for cap levels and valuations. This kind of sensitivity analysis can help us determine which variables will most impact founders while still providing returns attractive to investors.
Sensitivity analyses that iterate on a number of variables then can be shown in diagrams with curves or spiders to help your decision process when it comes to raises and valuations that make sense at every stage of your company’s growth. As mentioned earlier, in a future essay, we will run sensitivities on different variables to show you how company owner-founders and investors can determine with curves and other diagrams which variables will give them their optimal outcomes.
Finally, even for any given sequence of raises such as the ones above, the returns to stakeholders at the exit can also differ, depending on the method used for conversion of the convertible securities. If the method of conversion is not highlighted and understood early in the investment process, it can lead to unexpected, sometimes disappointing, outcomes for founders and investors alike.
In the two boxes below, I highlight the percentage ownership of stakeholders at the exit for one of those sequences of raises, using two of the three different methods described earlier for calculating conversions. As an example, we used Method A (below) in the Capitalization Tool to make the conversions. It provides founders with the best ownership outcome, 46.5% for this sequence of raises and valuations. Series A investors will often insist on Method B for the conversion, which will reduce the founder share at the exit to 37.5%. This is a decrease in founder ownership of over 19%. Convertible Note shares will increase from 16.5% of the company to 19.3%, an increase of almost 17% in ownership, while the Series A investors will also increase their share of the company at exit.
Gary V. Awad