VC Insights: Valuations in early-stage investments – beyond the headline price – further complications

Our last post in the VC Insights series looked at methodologies for taking the headline valuation and turning it into a price per share that accounted for cash, debt, and the option pool. We’re now going to look at some further necessary adjustments due to convertibles and non-diluting shares.

As a recap, this was our starting point:

SaaSco funding round table

And this is where we had got to after adjusting for £400k of debt and a 15% options pool:

option scenario cap table



Exactly how we adjust for a convertible loan depends on its terms. These might, for example, prescribe that the loan converts at a discount to the price in the next equity raise. We need to make sure, if conversion is not automatic, that the loan note holder agrees to convert at the same time that we invest. Let’s assume that SaaSco’s £350k loan is convertible and the holder has duly agreed to convert the loan on our investment; the conversion terms allow for them to subscribe the loan note for ordinary shares at, say, a 30% discount to the price that we pay. So, the true value (or, from the company’s point of view, cost) of the loan note becomes:

    • £350k / (1 – 30%) being £500k, a £150k uplift on the principal value.

Let’s revisit the cap table including the £350k loan conversion to £500k of equity just before we invest. This conversion leaves just the £50k of overdue taxes as debt, so the post money valuation is £4.95m.

The value of the option pool would increase slightly if we held it at 15% of the post-money share capital but, for simplicity, we have held the value constant and flexed the percentage instead.

So, this is what the convertible scenario cap table looks like, with £50k of debt, a £350k loan note converting into £500k of equity, and the option pool fixed at £690k value of shares:

option pool fixed at £690k value of shares table

The issue price of the new shares has fallen again, from £29.10 after inclusion of the options pool to £27.60, and the investor will again receive proportionately more shares. This reflects the dilution from the £150k conversion premium on the convertible.

The investor’s stake has decreased slightly (but as always, its value remains unaltered at £1m). This is because the post-money valuation has increased as most of the debt has been eliminated. The Founder now holds a slightly reduced share in a more valuable company.


Non-diluting shares

Non-diluting shares are a problem if they are allowed to persist indefinitely as they put the entire cost of future dilution on to the shoulders of the remaining shareholders. That makes their return more volatile and even more difficult to predict. So, we would expect that they be converted to plain ordinary shares as part of our investment.

Let’s assume that the management holding of 10% of pre-investment pre-dilution ordinary share capital have the right not to be diluted. They have the right to hold 10% of the share capital after the investment and after all the other diluting share issuance. The typical mechanism is that they are issued bonus shares sufficient to preserve shareholding at 10%. The agreement to waive future non-dilution rights means that, after the investment, they will rank alongside the other ordinary shareholders and be diluted pro-rata in any future funding rounds.

So how do we price in the cost of preserving their collective stake at 10%?

Our approach is to take the value of the bonus shares issued to the non-diluting shareholders and deduct it from the pre-money valuation. This gives the anti-dilution bonus scenario cap table as follows:

anti-dilution bonus scenario cap table

The cost of the anti-dilution bonus issue can be worked out by algebra. Having failed in that task, there’s no shame in using the goal-seek function in Excel.

The issue price per share has now fallen to £25.16, and the investor will receive, again, an increased number of shares compared to the previous scenarios. The investors’ stake remains at 20.2%; the percentage stake has been protected against dilution from management’s anti-dilution bonus.


The founders’ position

In negotiating an investment, the investor needs to be cognisant of, and sympathetic to, the founders’ position. They will look at the raw percentages – they own 90% of the current issued share capital in our illustration. Having raised £1m, they’re down to under 46% in our final scenario. How can that be right?

Each factor needs explaining – and the key issue is that most of these factors are pre-existing and have been used as currency by the company to get it to where it is. The company has debt, it has issued convertibles, it has an obligation to look after existing management, and it’s going nowhere if it can’t issue options to new hires. Whether the founders ultimately get comfortable with these arguments will probably indicate whether they’re ready for venture investment and to properly scale-up their business.



All these complications happen in reality. This isn’t an academic exercise – we use these calculations every time we make an investment. Most VC investments will have one or more adjusting factors; some have them all. If not factored in, then the investor may end up wondering why their share of the company on exit is so unaccountably small which wouldn’t make for a happy relationship between founder and VC!

It is essential that founders consider these factors when agreeing non-dilution clauses or convertible debt – they are a cost of building a business – just not one that is payable immediately. These calculations can and should be used to understand the potential cost of such agreements and also to properly understand the equity value of your business before a financing.

In SaaSco’s case, had we not done our homework, our entry price would have been a 59% premium to the final negotiated position. For a VC, this can be the difference between making a portfolio return and losing money – so founders should anticipate these costs and expect them to be included in the pre-money.


David Smith

David Smith

Partner, DSW Ventures