VC Methods
This note is based on the course Engineering Entrepreneurship at Penn.
Single Round Financing
Initial Investment
When venture capital (VC) investment occurs, a significant amount of capital is injected into the company at a predetermined moment (\(I_0\)) in return for equity shares. The returns from this investment are realized during a future liquidity event.
A liquidity event is a specific occurrence that allows the exchange of a company’s stock for liquid assets, such as cash or marketable securities. Examples of such events include:
- Acquisition: The company is purchased for cash or stock from a publicly traded entity.
- Initial Public Offering (IPO): Shares of the company are sold on public markets for cash.
- Buyout: The company undergoes recapitalization, allowing investors to cash out their shares, which can be bought back by the company or other buyers
Company Value
Valuing a company can sometimes be more art than science, involving various methodologies that depend on revenue, earnings, and market conditions. One common approach is to estimate the company’s terminal value at a successful exit or liquidity event, such as an acquisition or IPO.
To compute the terminal value at a future point (N years), you can use multiples of earnings (E) or revenues (R):
- \begin{equation}V_N = E_N \times \frac{P}{E}\label{eq:terminal_value_pe}\end{equation}
- \begin{equation}V_N = R_N \times \frac{P}{R}\label{eq:terminal_value_pr}\end{equation}
Where \(\frac{P}{E}\) and \(\frac{P}{R}\) are the price to earnings and price to revenue multiples, respectively. These multiples are often derived from comparable companies in the same industry or sector.
Let’s give an example of a company with projected earning of $2.5MM in 5 years.
Table 1: An example of running a company for 5 years.
| Item | Value |
|---|---|
| Sales Projected in 5 years | $30MM |
| Cost of Goods Sold (COGS) | -18 |
| ___ | ___ |
| Gross Margin | $12MM |
| Sales, Marketing, R&D, G&A expenses | -7.5 |
| Taxes | -2 |
| ___ | ___ |
| Net Income (earnings) | $2.5MM |
If the price to earnings multiple is 15 (based on comparable companies), the terminal value of the company in 5 years would be: \(V_5 = 2.5 \times 15 = 37.5 \text{MM}\).
Value of Investment
Time value of money (a dollar today is worth more than a dollar tomorrow) is critical to Venture Capital. The target return for VC investors after N years can be written as:
\begin{equation} VI_N = I_0 \times (1 + \text{ROI})^N \label{eq:target_return} \end{equation}
Where ROI is the target return rate, which usually corrponds to the stage of the company:
- Seed Stage: 50-70%
- Round #1: 40-60%
- Round #2: 30-50%
- Bridge: 20-35%
- …
For example, expected return of a $0.5M investment in year 5 with a 50% ROI would be: \(VI_5 = \$0.5\text{MM} \times (1 + 0.5)^5 = 3.8\text{MM}\).
Ownership
We now can compute the percentage of the company the VC must own to realize the required ROI.
\begin{equation} \%_N = \frac{(1+\text{ROI})^N \times I_0}{\frac{P}{E} \times E_N} \label{eq:ownership} \end{equation}
For example, at a liquidity event in year 5 with a terminal value of $37.5MM, the VC would need to own 10.13% of the company to realize a 50% ROI on a $0.5MM investment: \(\%\_5 = \frac{(1+0.5)^5 \times 0.5}{15 \times 2.5} = 10.13\%\).
Furthermore, we must determine the number of shares the VC will receive for the initial investment. These stocks have to be newly issued instead of taken from existing shareholders. The number of shares can be calculated as:
\begin{equation} \%_{\text {ownership }}=\frac{\text { # of Shares Owned }}{\text { Total # of Shares Issued }} \label{eq:ownership_2} \end{equation}
Since total shares equal the sum of the old shares (pre-investment) and the new shares (purchased). We can write:
\begin{equation} \%_{\text {ownership }}=\frac{\text {# of New Shares }}{\text {# of Old Shares }+ \text { # of New Shares }} \label{eq:ownership_3} \end{equation}
so that
\begin{equation} \text { # of New Shares }=\frac{\%_{\text {ownership }}}{ 1 - \%_{\text {ownership }}} \times \text {# of Old Shares } \label{eq:new_shares} \end{equation}
and
\begin{equation} \text { Price per share }=\frac{\text { Investment }}{\text { # of New Shares }} \label{eq:price_per_share} \end{equation}
For example, if there are already 1,000,000 shares outstanding before the round of investment, the VC would receive 112,350 shares at a price of $4.45 per share for a $0.5MM investment.
Pre-Money and Post-Money Valuation
Post-money valuation is the value of the company after the investment has been made. It’s the most commonly used to discuss the value of a company. It can be written as:
\begin{equation} \text { Post-Money Valuation }=\frac{\text { Investment }}{\%_{\text {ownership }}} \label{eq:post_money_val} \end{equation} or
\begin{equation} \text { Post-Money Valuation }= \frac{\text { New Price }}{\text { Share }} \times(\text {# of Shares Post-Money }) \label{eq:post_money_val_2} \end{equation}
Once we know the post-money valuation, pre-money is as simple as: \begin{equation} \text { Pre-Money Valuation }=\text { Post-Money Valuation }- \text { Investment } \label{eq:pre_money_val} \end{equation}
For example, in the prior example, the post-money valuation would be $4.95MM based on the $0.5MM investment and 10.13% ownership. The pre-money valuation would be $4.45MM.
Multiple Rounds Financing
It’s common for a VC-backed company to raise multiple rounds of financing as it grows. Each round involves a new investment, which dilutes the ownership of existing shareholders. Let’s consider a example of a company that has raised three rounds of financing:
- Year 0: Seed round of $0.5MM.
- Year 1: Series A round of $3MM.
- Year 3: Series B round of $1MM.
- Year 5: Liquidity event.
Percent Ownership
Assume the gradual reduction of risk in the business, the required ROI decreases over time.
Table 2: The calculation of the terminal ownership for each round of financing.
| Round | Invested | Target ROI | $VI_N$ | Terminal Ownership |
|---|---|---|---|---|
| Seed | $0.5MM | 50% | $3.8MM | 10.13% |
| Series A | $3MM | 40% | $11.52MM | 30.73% |
| Series B | $1MM | 25% | $1.56MM | 4.17% |
NOTE: the terminal ownership is calculated based on the terminal value of the company in year 5 using the formula above. This will leave ~55% of the company for the founders and employees.
Retention Percentage
Because the ownership percentage is diluted with each round of financing, a investor needs to acquire more at the time of their investment to realize their target terminal ownership. For example, the seed investor wants to end up with 10.13% of the company in year 5, but due to the dilution from the Series A and B rounds, they need to acquire >10.13% at the time of their investment.
\begin{equation} \text { Retention } \%=100 \%-\sum \text { (Final } \% \text { of Later Rounds) } \label{eq:retention} \end{equation}
and
\begin{equation} \%_{\text {Acquired }}=\frac{\text { Terminal } \%}{\text { Retention } \% \div 100 \%} \label{eq:acquired} \end{equation}
Table 3: The calculation of the retention and acquired percentage for each round of financing.
| Round | Retention % | Acquired % |
|---|---|---|
| Seed | 100% - 30.73% - 4.17% = 65.1% | 10.13% / 65.1% = 15.55% |
| Series A | 100% - 4.17% = 95.83% | 30.73% / 95.83% = 32.07% |
| Series B | 100% | 4.17% |
Number and Price of Shares
Now we know the retention percentage, we can calculate the number of shares the investor will receive at the time of their investment. The number of shares can be calculated as:
Recall Eq. \eqref{eq:new_shares} and Eq. \eqref{eq:price_per_share}:
Table 4: The calculation of the number and price of shares for each round of financing.
| Round | % Acquired | # New Shares Purchased | Investment | Price per Share |
|---|---|---|---|---|
| Seed | 15.55% | 15.55% / (1 - 15.55%) * 1,000,000 = 184,173 | $0.5MM | $2.715 |
| Series A | 32.07% | 32.07% / (1 - 32.07%) * (1,000,000 + 184,273) = 559,027 | $3MM | $5.367 |
| Series B | 4.17% | 4.17% / (1 - 4.17%) * (1,000,000 + 184,273 + 558,843) = 75,791 | $1MM | $13.194 |
Post-Money Valuation
Similarily, we can calculate the post-money valuation for each round of financing. Now recall the Eq. \eqref{eq:post_money_val}:
Table 5: The calculation of the post-money valuation for each round of financing.
| Round | Investment | % Acquired | Price per Share | Total # Shares Post-Money | Post-Money Valuation |
|---|---|---|---|---|---|
| Seed | $0.5MM | 15.55% | $2.715 | 1,184,273 | $3.215MM |
| Series A | $3MM | 32.07% | $5.367 | 1,743,200 | $9.355MM |
| Series B | $1MM | 4.17% | $13.194 | 1,818,991 | $24.000MM |
Pre-Money Valuation
Also, we can calculate the pre-money valuation for each round of financing.
Table 6: The calculation of the pre-money valuation for each round of financing.
| Round | Post-Money Valuation | Investment | Price per Share | # Shares Pre-Money | Pre-Money Valuation |
|---|---|---|---|---|---|
| Seed | $3.215MM | $0.5MM | $2.715 | 1,000,000 | $2.715MM |
| Series A | $9.355MM | $3MM | $5.367 | 1,184,273 | $6.355MM |
| Series B | $24.000MM | $1MM | $13.194 | 1,743,200 | $23.0MM |
Terminal Price per Share
Finally, to complete the scenario, we can calculate the terminal price per share for each round of financing. This is the price per share at the time of the liquidity event in year 5.
\begin{equation} \text { Terminal Price per share }=\frac{\text { Value of Company }}{\text { Total # of Shares }} \label{eq:terminal_price} \end{equation}
For example, the terminal price per share for the seed round would be \(\frac{$ 37.5 \text{MM}}{(1,000,000+184,173+559,027+75,791) \text { shares }}=\frac{$ 37.5 \text{MM}}{1,818,991 \text { shares }}=$ 20.616 / \text { share }\)
Back-Check
In order to check the calculation is correct, we should confirm the return of investment (ROI) for each round of financing. The ROI can be calculated as:
\begin{equation} \text{ROI} = \left(\frac{\text{Price per Share}_{\text{sold}}}{\text{Price per Share}_{\text{purchased}}}\right)^{\frac{1}{N}} - 1 \label{eq:roi} \end{equation}
Table 7: The calculation of the ROI for each round of financing.
| Round | Price per share at the time of purchased | ROI |
|---|---|---|
| Seed | $2.715 | 50% p.a. |
| Series A | $5.367 | 40% p.a. |
| Series B | $13.194 | 25% p.a. |
If thre ROI calcualted matches the target ROI, then we know the calculation is correct.
Multiple Rounds Financing [Cont.]
Convertible Preferred Stock
Convertible preferred stock is a common security used in venture financing that allows investors to convert their preferred shares into common stock, typically at the time of a liquidity event. Here are some key aspects of convertible preferred stock in multiple round financing:
- Priority in Distributions: Preferred shareholders are paid before common shareholders in the event of a liquidation or dividend distribution. This provides a level of security for venture capitalists, especially in early-stage companies where the risk of failure is high.
- Dividend Payments: Preferred shareholders may receive a fixed annual dividend, often cumulative (i.e., unpaid amount roll over to next year) and compounding. This ensures a minimum return on their investment, even if the company doesn’t experience rapid growth.
- Conversion to Common Stock: At the time of a liquidity event, like an IPO or acquisition, preferred stock can be converted into common stock. This allows venture capitalists to participate in the upside potential of the company as if they had invested in common stock from the outset. The accumulated dividends are converted into additional shares of common stock often at the original price-per-share paid by the investor.
In the example above, suppose the investor in Series A negotiated for Convertible Preferred Shares having a non-cash, cumulative and compounding dividend of 5% per year, and we’ve seen the investors invest $3MM four years prior to the planned liquidity event and receive 559,027 shares at the price of $5.367 per share. At the time of liquidity event, the cumulative and compounding dividend would be worth:
\[\text { Dividend }=\mathrm{I}\left[(1+\mathrm{i})^{\mathrm{N}}-1\right]=\$ 3,000,000\left[1.05^4-1\right]=\$ 646,520\]At the original share price of $5.367, this would convert to:
\[\text { Additional Shares }=\frac{\$ 646,520}{\$ 5.367 / \text { share }}=120,462 \text { shares }\]Therefore, the Serias A investor’s total shares at the time of the liquidity event would be \(559,027+120,462=679,489\) shares.
Thereby, the Series A investor’s distribution from the liquidity event would be:
\begin{equation} \text { Distribution }=\text { Value of Company } \times \frac{\text { Total shares owned }}{\text { Total # of shares issued }} \label{eq:distribution} \end{equation} which is \(\$ 37,500,000 \times \frac{679,489}{1,818,991+120,462}=\$ 13,138,000\).
The new return of investment (ROI) for the Series A investor would be: \([\$ 13,138,000 / \$ 3,000,000]^{1 / 4}-1=44.7\%\) p.a., which as expected is higher than the original 40% p.a. target ROI.
On the other hand, if the dividend had been culmulative and non-compounding, at the time of the liquidity event, the dividend would be worth:
\[\text { Dividend }=\mathrm{I} \times \mathrm{i} \times \mathrm{N}=\$ 3,000,000 \times 0.05 \times 4=\$ 600,000\]and the same calculation follows.
Participating Preferred Stock
Basically it’s like the Convertible Preferred Stock, but with an additional benefit that allows the entire original purchase price is also repaid to the investor on a priority basis before any other distirbution to shareholders are calculated, at the time of the liquidity event.
Let’s reuse the example above in Convertible Preferred Stock for Series A investor, but now with Participating Preferred Stock. The distribution would be:
\begin{equation} \text { Dist. }=\mathrm{I}+[(\text { Val. of Comp. })-\mathrm{I}] \times\left[\frac{(\text { Total shares owned })}{(\text { Total }\text {# of shares issued })}\right] \label{eq:distribution_participating} \end{equation} which is \(\$ 3,000,000+\left([\$ 37,500,000-3,000,000] \times\left[\frac{679,489}{1,939,453}\right]\right)=\$ 15,087,000\), and the new ROI would be 49.75% p.a. which is higher than the original 40% p.a. target ROI and 44.7% p.a. if of the Convertible Preferred Stock.
Convertible Note
Now we will introduce a very popular security in early-stage financing, the Convertible Note. It initially acts as a interest-bearing loan from an investor to a start-up company. The loan converts to equity shares of the company when, and if, the company raises a subsequent round of financing. Typical terms of a convertible note include:
- The principal amount of the note.
- The interest rate on the note, typically 6-8% per year.
- The duration of the note, usually 12-24 months.
- The minimum size of the next round of financing that triggers the conversion.
- The discount rate applied to the conversion price, typically 20-30%.
- The potential pre-money valuation cap, which limits the conversion price.
- If a liquidity event occurs before the note converts, the note issuer receives a premium over the note principal.
- The right to participate in the next round of financing.
- The seat(s) on the board of directors.
- The consequences if the note duration is exceeded prior to next round of financing.
Assuming the trigger threshold is met in Series A financing, to determine the pricing and the number of shared acquired by the note’s investor at the time of conversion, we first determine the post-money value of the note as follows:
\begin{equation} (\text { Post-Money Val })_{\text {Note }}=(\text { Pre-Money Val })_{\text {Series } \mathrm{A}} \times (1-\text { Discount }) \label{eq:post_money_val_note} \end{equation}
Then, the percentage of the company acquired by the note’s investor at the time of conversion is:
\begin{equation} (\% \text { Acquired })_{\text {Note }}=\frac{(\text { Principal }+ \text { Accrued Interest on Note })}{(\text { Post-Money Valuation of Note })} \label{eq:acquired_note} \end{equation} where the numerator \((\text { Principal }+ \text { Accrued Interest on Note })\) is \(\mathrm{PI}_{\mathrm{N}}\):
\begin{equation} \mathrm{PI}_{\mathrm{N}}=(\text { Principal of Note }) \times (1+\text { Note Interest Rate })^{\mathrm{N}} \label{eq:principal_interest} \end{equation} and N is the time between the issue of the note and Series A financing.
The number of shares acquired by the note’s investor at the time of conversion is: \begin{equation} \mathrm{S}_{\text {Note }}=\frac{\%_{\text {Acquired }}}{1-\%_{\text {Acquired }}} \times(\text {# of Old Shares }) \label{eq:shares_note} \end{equation} where the number of old shares is the shares issued prior to the convertible note (i.e., founders’ shares).
And finally, the price per share at the time of conversion is: \(\mathrm{P}_{\text {Note }}=\frac{\mathrm{P I}_{\text {Note }}}{\mathrm{S}_{\text {Note }}}\). One last step is to check the pre-money valuation cap of the convertible note has not been exceeded. Otherwise, the conversion price would be the cap. The price per share of the cap is:
\begin{equation} \mathrm{P}_{\text {Note Cap }}=\frac{\text { Pre-Money Valuation Cap }}{\text {# of Old Shares }} \label{eq:price_cap} \end{equation}
As long as \(\mathrm{P}_{\text {Note Cap }} > \mathrm{P}_{\text {Note}}\), then the \(\mathrm{P}_{\text {Note}}\) and \(\mathrm{S}_{\text {Note}}\) are valid. Otherwise, the \(\mathrm{P}_{\text {Note Cap }}\) is used and \(\mathrm{S}_{\text {Note}}\) shall be recalculated accordingly.
Let’s again run through an example, assuming the seed financing in the prior example is a convertible note subject to the following terms:
- Principal: $0.5MM
- Interest Rate: 6% p.a.
- Duration: 18 months
- Minimum Round to Trigger: $1MM
- Discount Rate: 20%
- Pre-Money Valuation Cap: $6MM
As before, the Series A round occurs one year after the seed round, which is within 18 month duration. The Series A investment is $3MM, which triggers the conversion of the note. The principal and accrued interest on the note would be:
\[\mathrm{PI}_{\mathrm{N}}=\$ 500,000 \times(1.06)^1=\$ 530,000\]The pre-money valuation of the Series A round is $6.355MM as found before. The post-money valuation of the note is then:
\[(\text { Post-Money Valuation) })_{\text {Note }}=\$ 6,355,000 \times(1-0.20)=\$ 5,084,000\]The percent of the company acquired by the note’s investor at the time of conversion is:
\[(\% \text { Acquired })_{\text {Note }}=\frac{(\$ 530,000)}{(\$ 5,084,000)}=10.42 \%\]The number of shares acquired by the note’s investor at the time of conversion is:
\[S_{\text {Note }}=\frac{0.1042}{1-0.1042} \times(1,000,000)=116,320 \text { shares }\]And finally, the price per share at the time of conversion is:
\[\mathrm{P}_{\text {Note }}=\frac{\$ 530,000}{116,320 \text { shrs }}=\$ 4.56 / \text { share }\]Let’s check the pre-money valuation cap:
\[P_{\text {Note Cap }}=\frac{\$ 6,000,000}{1,000,000}=\$ 6 / \text { share }\]so the conversion price is valid.
In the situation where the convertible note precedes the Series A round, the convertible note shares must be included along with the founder’s shares when determining the number of “old” shares to use in the calculation of the Series A shares.
Table 8: The rewrite of Table 4 with the seed round as a convertible note.
| Round | # New Shares Purchased | Price per Share |
|---|---|---|
| Seed | 116,320 shares by conversion | $4.56 |
| Series A | 32.07% / (1 - 32.07%) * (1,000,000 + 116,320) = 527,019 | $5.69 |
| Series B | 4.17% / (1 - 4.17%) * (1,000,000 + 116,320 + 527,019) = 71,509 | $13.98 |
NOTE: the $5.69 Series A price found here is consistent with the convertible note price of $4.56 which is discounted by 20% from the Series A price.
The post-money and pre-money valuation of Series A and Series B rounds would be the same as before. To complete the example, we calculate the terminal price at the time of the liquidity event in year 5.
\[\frac{\$ 37.5 M M}{(1,000,000+116,320+527,019+71,509) \text { shares }}=\frac{\$ 37.5 M M}{1,714,848 \text { shares }}=\frac{\$ 21.87}{\text { share }}\]As before, in order to check our calculation, we should confirm the return of investment (ROI) for each round of financing. The ROI can be calculated as:
| Round | Price per share at the time of purchased | ROI |
|---|---|---|
| Series A | $5.69 | \((\$ 21.87 \div \$ 5.69)^{1 / 4}-1=40 \%\) p.a. |
| Series B | $13.98 | \((\$ 21.87 \div \$ 13.98)^{1 / 2}-1=25 \%\) p.a. |
The results match the target ROI. We can also find the overall return on the convertibe note:
\(\left(\frac{\text { Terminal Distribution to Seed Investor }}{\text { Seed Investment }}\right)^{1 / 5}-1=\left(\frac{\$ 21.87 \times 116,320 \text { shrs }}{\$ 500,000}\right)^{1 / 5}-1=38.4\%\) p.a. Despite the discount on the conversion price of the note, the ROI on the note is less than that of the Series A investment. This is because the ROI on the note during the one-year period between this seed round and the Series A round is only 6% p.a. pursuant to the stipulated interest rate on the note prior to conversion. This low, one-year interest accrual reduces the overall 5-year ROI on the seed investment.
Post-Money SAFE
Another popular security in early-stage financing is the Simple Agreement for Future Equity (SAFE). It’s similar to the Convertible Note but it’s not interest-bearing and has no preset expiration term. It initially represents an interest-free investment from an investor to a start-up company. The investment converts to equity shares of the company when, and if, the company raises a subsequent round of financing. Typical terms of a SAFE include:
- The principal amount of the SAFE.
- The minimum size of the next round of financing that triggers the conversion.
- The discount rate applied to the conversion price, typically 20-30%.
- The post-money valuation cap, which limits the conversion price.
- If a liquidity event occurs before the SAFE converts, the SAFE issuer receives a premium over the SAFE principal.
- The right to participate in the next round of financing.
- The seat(s) on the board of directors.
Assuming the trigger threshold is met in Series A financing, to determine the pricing and the number of shared acquired by the SAFE’s investor at the time of conversion, we first determine the post-money value of the SAFE as follows:
\begin{equation} (\text { Post-Money Val. })_{\mathrm{SAFE}}=(\text { Pre-Money Val. })_{\text {Series } \mathrm{A}} \times (1-\text { Discount }) \label{eq:post_money_val_safe} \end{equation}
NOTE: that the post-money valuation of SAFE to be used in the following calculation is the lesser of the post-money valuation calculated above or the post-money valuation cap provided in the terms.
Then, the percentage of the company acquired by the SAFE’s investor at the time of conversion is:
\begin{equation} (\% \text { Acquired })_{\text {SAFE }}=\frac{(\text { Principal Amount of the SAFE })}{(\text { Post }- \text { Money Valuati } n \text { of SAFE })} \label{eq:acquired_safe} \end{equation}
The number of shares acquired by the SAFE’s investor at the time of conversion is:
\begin{equation} \mathrm{S}_{\mathrm{SAFE}}=\frac{\%_{\text {Acquired }}}{1-\%_{\text {Acquired }}} \times(\text {# of Old Shares }) \label{eq:shares_safe} \end{equation}
where the number of “old” shares is the shares issured prior to the SAFE (i.e., founders’ shares, other SAFE shares, etc.). And finally, the number of shares acquired by the SAFE’s investor at the time of conversion is:
\begin{equation} \mathrm{P}_{\mathrm{SAFE}}=\frac{\text { Principal Amount of SAFE }}{\mathrm{S}_{\text{SAFE}}} \label{eq:price_safe} \end{equation}
Again, let’s run through an example, assuming the seed financing in the prior example is a SAFE subject to the following terms:
- Principal: $0.5MM
- Minimum Round to Trigger: $1MM
- Discount Rate: 20%
- Post-Money Valuation Cap: $6.5MM
As before, the Series A round triggers the conversion of the SAFE. The pre-money valuation of the Series A round is $6.355MM as found before. The post-money valuation of the SAFE is then:
\[(\text { Post-Money Valuation) })_{\mathrm{SAFE}}=\$ 6,355,000 \times(1-0.20)=\$ 5,084,000\]The value is less than the post-money valuation cap, and thereby will be used in the following calculations. The percent of the company acquired by the SAFE’s investor at the time of conversion is:
\[(\% \text { Acquired })_{\mathrm{SAFE}}=\frac{(\$ 500,000)}{(\$ 5,084,000)}=9.83 \%\]The number of shares acquired by the SAFE’s investor at the time of conversion is:
\[\mathrm{S}_{\mathrm{SAFE}}=\frac{0.0983}{1-0.0983} \times(1,000,000)=109,016 \text { shares }\]And finally, the price per share at the time of conversion is:
\[\mathrm{P}_{\mathrm{SAFE}}=\frac{\$ 500,000}{109,016 \mathrm{shrs}}=\$ 4.59 / \mathrm{share}\]In this situation where a SAFE precedes the Series A round, the SAFE shares must be included along with the founder’s shares when determining the number of “old” shares to use in the calculation of the Series A shares.
Table 9: The rewrite of Table 4 with the seed round as a SAFE.
| Round | # New Shares Purchased | Price per Share |
|---|---|---|
| Seed | 109,016 shares by conversion | $4.59 |
| Series A | 32.07% / (1 - 32.07%) * (1,000,000 + 109,016) = 523,570 | $5.73 |
| Series B | 4.17% / (1 - 4.17%) * (1,000,000 + 109,016 + 523,570) = 71,509 | $14.07 |
NOTE: the $5.73 Series A price found here is consistent with the SAFE price of $4.59 which is discounted by 20% from the Series A price.
To compelt the example, we calculate the terminal price at the time of the liquidity event in year 5.
\[\frac{\$ 37.5 M M}{(1,000,000+109,016+523,570+71,049) \text { shares }}=\frac{\$ 37.5 M M}{1,703,635 \text { shares }}=\frac{\$ 22.01}{\text { share }}\]As before, in order to check our calculation, we should confirm the return of investment (ROI) for each round of financing. The ROI can be calculated as:
| Round | Price per share at the time of purchased | ROI |
|---|---|---|
| Series A | $5.73 | \((\$ 22.01 \div \$ 5.73)^{1 / 4}-1=40 \%\) p.a. |
| Series B | $14.07 | \((\$ 22.01 \div \$ 14.07)^{1 / 2}-1=25 \%\) p.a. |
The results match the target ROI. We can also find the overall return on the SAFE:
\(\left(\frac{\text { Terminal Distribution to Seed Investor }}{\text { Seed Investment }}\right)^{1 / 5}-1=\left(\frac{\$ 22.01 \times 109,016 \text { shrs }}{\$ 500,000}\right)^{1 / 5}-1=36.8\%\) p.a. Despite the discount on the conversion price of the SAFE, the ROI on the SAFE is less than that of the Series A investment. This is because the ROI on the SAFE during the one-year period between this seed round and the Series A round is 0% pursuant to the interest-free nature of SAFE prior to conversion. This interet-free period of the SAFE reduces the overall 5-year ROI on the seed investment.