A question came up on the founders dating discussion boards about different VC structures, so I thought I’d put together a short model on some typical structures. Mainly, this looks at straight preferred stock vs participation, and allows us to put in a dividend on existing and new investments. Here’s the excel: Participating vs Preferred
Straight preferred stock is the most common type of vc investment. Basically, the investor has the option to get their preference back (how much they invested), or convert into common stock at an agree upon ownership percentage. So, if I invest $10 mm for 20% of the company, if the company sells for $10 mm, I can either take my $10 mm back, or convert for 20% of $10 mm, which is $2 mm. Obviously, I will keep my preference. I’m indifferent whether to convert or not at a $50 mm exit where my preference is worth $10 mm, and my common stock is worth 20% * $50 mm = $10 mm upon conversion. Above a $50 mm exit, I’ll want to convert to common and take my 20%.
Participating preferred basically means you take your preference, and then convert. So, in the case of the $50 mm exit, I take my $10 mm off the top, and then get 20% of the rest. This is clearly worse for the other common stock holders who now get 80% of $40 mm, not 80% of $50 mm. It’s worth noting that if you do a series A with participation, you’ll be pressured heavily to continue to have follow on securities that have participation.
Another confusion was on how the equity conversion is calculated. Basically, is it the amount invested divided by the pre or post money? The short answer – it’s the post money. Here’s why.
The value of stock = the value of your assets (IP, people, future cash flows, etc) + cash on hand – debt. For people with finance training, this is simply the equation for enterprise value (EV = stock + debt – cash) rearranged.
The value of your assets is your pre-money. What is your company worth right now given it’s future prospects. If you add cash, this adds value to the stock in a 1:1 ratio (every dollar going in adds $1 of value since as stock holders we could theoretically liquidate and get the $$ back. You can see the advantages of being a value added investor here, your dollars are worth more than 1:1, hopefully). So, the ownership percent = money invested/post money valuation.
One note, if money invested doesn’t go to the balance sheet, but instead goes to a shareholder’s pocket, then the post doesn’t go up for those dollars.
Check out the excel Participating vs Preferred – I always find this an easier way to understand this stuff. I also wrote a post a while back on convertible notes which is another common security for early stage companies.
If there’s an error in the excel, please let me know!! Enjoy!