Your company just raised $1 million from a venture capital firm at a $10 million post-money valuation. Awesome. Your 10% percent of the company is now worth a million dollars. Or is it? If you talk to entrepreneurs who have sold a company, you’ll find that the math isn’t quite that simple.
This may not be news to some, but it’s important to understand how this plays out. Because even when a company has a big exit, owners with a sizable percentage of shares may not get that same percentage of the cash. Sometimes they get nothing at all. Hence, the difference between “economic ownership” and “accounting ownership”.
Economic Ownership vs. Accounting Ownership
Entrepreneurs, and even investors (though much less frequently), often focus on accounting ownership rather than what we have termed “economic ownership.”
Accounting ownership is most easily understood as your percentage of the fully-diluted equity structure of a company. If you own 25 of 100 shares of a company, your accounting ownership would be 25%. However, your economic ownership could be 0%.
How? The layers of the equity cake can be full of surprising features.
Most venture and private equity backed startups have both preferred stock and common stock, as well as options and warrants. Many, if not most, companies have multiple classes of preferred stock.
Classes of stock can be arranged from most senior—which receive liquidity in an exit first—to less senior— which receive liquidity only after more senior classes of stock have been paid.
Preferred stock and any warrants on preferred stock typically have a liquidation preference. This is usually expressed as a multiple of the original share price that must be paid before the next most senior class of stock gets anything. This creates a layer cake of returns as shown in graph below.
This graph is a hypothetical company. As you can see in the graph, only the Series C shareholders receive any value from $0 to ~$60K. The common stock doesn’t receive any value until ~136K. Common stock is typically what most founders and employees (i.e., all non-investors) receive.
So even if you own 25% of the company in common stock, you could end up receiving $0 if the company is sold for less than $136K. Options are even worse off because it costs the optionee money to convert the option into common stock.
If an option has a strike price of 12 cents, this means it costs the optionee 12 cents for every share she wants to convert to common. Because of this, it makes no sense for the optionee to exercise her options until common is worth 12 cents per share. In the graph below, we have broken out just the 12 cent options from the layered cake above.
As you can see from this graph, the 12 cent options are worth nothing until the company is worth ~$251K or more.
Only some entrepreneurs understand the mechanics of their cap table in depth. And most startup employees have little to no information. The typical venture capitalist or private equity investor, on the other hand, is working on multiple deals every day. They have forgotten more about Excel models than most entrepreneurs will learn in a lifetime. They understand the nuances of cap tables and how they can move a deal to their advantage.
This is not to say that investors are out to take advantage of the entrepreneurs. Most investors are not only ethical but concerned about the entrepreneurs they work with. They understand that they need entrepreneurs to be happy and successful so that they will return to the investor later for more money and recommend their friends.
However, that doesn’t mean that investors won’t make smart, self-interested decisions that may not hurt an entrepreneur, but that may tilt the scales in the investor’s favor.
Many entrepreneurs are typically at a disadvantage here. This is where Shareworks Startup Edition comes in. We give you the tools to slice and dice your cap table without spending hours in Excel. Both investors and entrepreneurs can benefit by understanding how a proposed term sheet can affect the economic value of their ownership, and not just the accounting value.