Key Term Sheet Provisions: Price, Valuation and Dilution
Price per share is one of the most important terms to nearly every entrepreneur. Price is inextricably tied with valuation. How much an investor will pay per share depends on the value the company is calculated to be worth.
Premoney valuation is the value of the company before the investors’ contributions are factored in. Postmoney valuation is the value of the company after the investors’ contributions are factored in. For example a company might have a premoney valuation of $5 million. An investor may agree to contribute $3 million at an $8 million postmoney valuation. When discussing valuation terms make sure that both sides are talking about the same type of valuation. As you can see in the charts to the right, whether the valuation being discussed is premoney or postmoney can have a significant impact in the relative holdings of the parties.
Another important part of price is dilution. The company and the investors will generally want to make sure that the company has sufficient equity (stock options) available (authorized, but not issued) to compensate and motivate its workforce. This is sometimes called the employee pool. The size of the pool is taken into account when valuing the company. If there is no existing pool and additional shares have to be authorized after the financing, existing shareholders holdings will become diluted. If the company with the $8 million postmoney valuation authorizes and issues $2 million worth of stock from an employee pool, the investors would now only own a 30% interest in the company rather than a 37.5% interest. You can see why investors want companies to have a larger stock option pool before the financing. But company shareholders will not want to have a larger employee pool because it will come out of the premoney valuation. If the $5 million company needs to have a $2 million employee pool, that means the existing shareholders’ stock will be diluted so as to only be worth $3 million. Even if the $2 million employee pool has not yet been issued, they will be factored in to the premoney valuation because such valuations are determined on a fully diluted per share basis. Thus, the negotiations around the employee pool have a direct impact on price.