editione1.0.2
Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
examplePext, Inc. raises its first external round as a priced round, closing a $250K raise with a $1M pre-money valuation. (If you have been reading carefully, you would rightly object to a priced round for a raise of only $250K, and suggest a SAFE or convertible note instead, but bear with us so we can illustrate the dilution!) If the pre-money is $1M, the post-money valuation in this case will be $1.25M (pre-money valuation plus amount raised), and the percentage of the company sold will be 20% ($250K/$1.25M). Let’s say that our savvy investors insist that their ownership should be calculated on a fully diluted basis.
Consolidating the cap table above (Figure 3) to aggregate founders and employees prior to investment:
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 96.67% | 86.96% |
| Employee 1 | 345,000 | 3.33% | 3.00% |
| Issued and Outstanding | 10,345,000 | 100.00% | |
| Option Pool Available | 1,155,000 | 10.04% | |
| Total Fully Diluted | 11,500,000 | 100.00% |
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 75.64% | 69.57% |
| Employees | 345,000 | 2.61% | 2.40% |
| Round 1 Investors | 2,875,000 | 21.75% | 20.00% |
| Issued and Outstanding | 13,220,000 | 100.00% | |
| Option Pool | 1,155,000 | 8.03% | |
| Total Fully Diluted | 14,375,000 | 100.00% |
Let’s assume that $250K lasts a year (founders are taking minimal salary), and Pext has made great progress. They now have a fully functioning app in the Apple app store with 10K downloads and great early customer engagement numbers. They want to hire a full time app developer and a full time marketing person. Based on the customer engagement and their execution to date overall, they raise another $750K round of funding, and convince investors that they are worth $3M pre-money. Again, they will be selling another 20% of the company: (750K/(3M + 750K)) = 20%. This would be a typical scenario.
The post-money valuation after the first round was $1M + $250K = $1.25M. So this is a great progress in the valuation from one round to the next ($1.25M post to $3M pre-money), and is called an “up-round.”
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 59.48% | 55.65% |
| Employees | 345,000 | 2.05% | 1.92% |
| Round 1 Investors | 2,875,000 | 17.10% | 16.00% |
| Round 2 Investors | 3,593,750 | 21.37% | 20.00% |
| Issued and Outstanding | 16,813,750 | 100.00% | |
| Option Pool | 1,155,000 | 6.43% | |
| Total Fully Diluted | 17,968,750 | 100.00% |
At this point, everything is going well and the founders own almost 56% of the stock on a fully diluted basis. The Round 1 investors have been diluted from their initial 20% down to 16% by the Round 2 investors.
For comparison now, let’s look at scenario B, where the founders raise $500K instead of $250K on the same $1M pre-money valuation. Now they are giving up a third of the company in the first external round.
| Shares or Options | Issued and Outstanding | Fully Diluted | |
|---|---|---|---|
| Founders | 10,000,000 | 62.13% | 57.97% |
| Employees | 345,000 | 2.14% | 2.00% |
| Round 1 Investors | 5,749,138 | 35.72% | 33.33% |
| Issued and Outstanding | 16,094,138 | 100.00% | |
| Option Pool | 1,155,000 | 6.70% | |
| Total Fully Diluted | 17,249,138 | 100.00% |