The Mechanics of Preferred Stock Financing
by Anthony Nassar

Armed with a strong team, a proof of concept, and a large market opportunity, they are able to attract a Series A Preferred investment of $1,500,000 from an early stage venture firm (ESVC - $1.2M), and 2 angels (Donna - $180K, and George - $120K) at a pre-money valuation of $2,250,000. In other words, the company is valued at $2,250,000 immediately prior to the close of the financing transaction. Its post-money valuation is $3,750,000, the sum of the pre-money valuation and the amount invested. The investors would end up owning 40% ($1,500,000/$3,750,000) of the company, and the founders and employees would own 60%. Please note that the valuation of an early stage startup is often driven by qualitative considerations from the investor's point of view, especially in a buyer’s market. As the company reaches later stages of development, more quantitative metrics are relied upon to derive valuation.

The founders have agreed with the investors to increase the stock option pool from 1,400,000 shares to 2,000,000 shares in order to continue to retain and attract good talent. Prior to the close of the Series A transaction, only 900,000 shares had been granted out of the stock option pool, 120,000 of which had been exercised at the exercise price of 1c/share. Also, the founders’ shares were not fully vested. The ownership structure just before the Series A funding event is now as follows:

Based on the above table, the price per share is $0.30, which is derived by dividing the pre-money valuation of $2,250,000 by 7,500,000, the total common shares outstanding and those reserved for the stock option pool prior to the close of the transaction. Please note how the entire option pool is included in the computation of the valuation although not all options in the pool have been granted, and not all options granted have been exercised. Also, the total founders’ stock is included in the ownership table, while these are typically restricted shares which were not fully vested at the time of the transaction.

The Series A investors will receive 5,000,000 shares (investment of $1,500,000 divided by the price per share of $0.30). The total shares outstanding and those reserved for the option pool are now 12,500,000. The post-money capital structure of the company is as follows:

*The option pool includes options that may have been granted but not exercised and shares that may not have been granted.

The founders’ shares, initially valued at $5,500, have been revalued in this round of financing at $1,650,000 (5,500,000 shares times $0.30/share). This is a 300X multiple, although only on paper, since at this stage there is no obvious liquidity path for their investment.

We now have all the elements to develop A Preferred Startup’s capitalization table (cap table), which details the ownership of the company before and after the funding event (please click on above link to see the cap table).

You can apply a similar approach to subsequent rounds of financing. Keep in mind that things can get more complicated in certain cases, including events involving down rounds, warrant coverage or other factors triggering the issuance of additional shares, or rights to buy shares to a certain class of shareholders.