We refer to “financing round” as the process whereby a company raises funds from investors in exchange for a stake in the company’s share capital. After agreeing on the general terms of the financing (reflected in the Term Sheet) and negotiating the main agreements (subscription agreement and shareholders agreement), the financing round concludes in the increase of the company’s share capital resulting in the investor becoming a shareholder or increasing its stake in the company’s share capital. Therefore, determining the price per share to be paid by the investor is a key aspect of a financing round.
Valuation of the company and the investment
The first step in determining the price per share being issued in a financing round shall consist of setting the pre-money valuation, understood as the company’s total value prior to the contributions by the investors. The aggregate of the pre-money valuation and the total amount invested in the financing round is referred to as the post-money valuation. The different valuation methods used by the investors are not analysed in this newsletter.
When deciding to invest in the company, the investor expects to receive a percentage of the share capital equivalent to the result of dividing its contribution in the financing round by the post-money valuation of the company. This calculation is undertaken by the investor in strictly economic terms, without paying regards to the number of shares in which the share capital is divided or the existence of securities that give third parties the right to acquire shares in the company.
Determination of the price per share
Upon the formalization of the share capital increase, the investor receives a number of shares resulting from dividing the invested amount by the price per share. In turn, the price per share is set by dividing the pre-money valuation of the company by the total number of shares representing the share capital on a fully diluted basis.
Legal capital and fully diluted
The process of determining the price per share in a financing round shall not take into account exclusively the shares in which the share capital of the company is divided (commonly referred to as the legal share capital). The investor will most likely demand that the price per share be determined on the basis of the fully diluted capital, defined as the total number of issued and outstanding shares of the company’s share capital, assuming the exercise of any options and warrants and any other securities that give the right to purchase, or that are convertible into shares or that give the right to a compensation based on the price of the shares (such as phantom shares).
Convertible loans, for example, are commonly seen in financing rounds. Some investors (new or existing), finance the company by means of loans, agreeing beforehand to a right to convert the amount into equity at a discounted price in the subsequent financing round. Convertible loans are an agile way of financing the company, postponing the valuation to a later period. The existence of convertible loans shall be taken into account when setting the price per share, including the shares created after the conversion within the fully diluted capital.
Implications of the calculation of the price per share
The proceeds arising out of a liquidity event are frequently distributed, not only among the shareholders owning shares in the legal share capital of the company, but also among all holders of any rights in the fully diluted share capital. We hereby refer to events such as the liquidation or sale of the company (through sale of shares or assets), corporate transactions entailing a change of control in the company, or even the distribution of dividends after the sale of key assets or business units.
Not considering the aforementioned rights in the company when determining the price per share in a financing round does not seem appropriate, taking into account that these rights will indeed be considered in the distribution of proceeds of a potential liquidity event.
Determining the price per share to be paid by the investor on the basis of the legal share capital, disregarding the existence of other rights convertible into shares, will lead to the dilution of the investor’s stake, both economically and politically, as a consequence of the exercise of the aforementioned rights. Therefore, the price per share in a financing round shall be determined on the basis of the fully diluted share capital.