The company’s valuation is determined based on the value of the company’s assets, whether tangible or intangible (intellectual property, goodwill, and primarily the company’s future cash flow). The company’s estimated future profits as assessed today (also referred to as capitalization), together with the existing assets, constitute the company’s valuation. The company’s valuation is not dependent on the number of shares the company issues. A share represents a proportional ownership interest, meaning its value is the company’s total valuation divided by the total number of issued shares.
In principle, the explanation above may sound mathematical, but it is important to remember that when it comes to startups, valuation is often conceptual, theoretical. As a result, in many cases, the actual valuation of a company is derived as a function of negotiation between the founders and investors, as a function of supply and demand (how many investors want to participate in the company's investment round), and as a function of investors’ confidence in the company (investors will tend to agree to the founders’ demand for a higher valuation if they believe the company has a greater chance of success).
Therefore, it is customary to attribute to a private company the valuation determined in its last investment round, at least until its next investment round where a new valuation will be set. In a public company, the valuation is clear and is calculated by multiplying the share price in the stock exchange by the total number of shares in the company’s capital.
When referring to a company’s valuation in investment agreements, it is common to refer to one of two situations: “Pre-Money Valuation” or “Post-Money Valuation.” Pre-Money Valuation refers to the company’s valuation before entering the investment round, while Post-Money Valuation is the valuation after the investors’ investment.
When discussing valuation with investors, attention must be paid to the basis of the discussion. Pre-Money Valuation is the most commonly used basis in the industry. However, inexperienced founders often fall into the trap when investors negotiate with them based on Post-Money Valuation. This means that the investors' investment is included in the calculation basis, thereby entitling them to a larger percentage (since the company’s valuation without the investment is lower).
For instance, suppose there is a company in which an investor invests $500,000. If the valuation is based on a Pre-Money Valuation of $1 million, then after the investment, the company will reach a Post-Money Valuation of $1.5 million. In this case, the investor, who invested $500,000 out of $1,500,000 after the investment, will hold 33% of the company’s share capital.
If, in the negotiation, the valuation was discussed as a Post-Money Valuation of $1 million, then in this case, the investor, who invested $500,000 out of $1,000,000 after the investment, will hold 50% of the company’s share capital. Therefore, this must be carefully considered in negotiations with investors and even more so when signing a Term Sheet.
An option pool is essentially a "reserve" designated for future allocations of options, which is almost always directly linked to the company’s option plans.
Sometimes, companies that have not yet allocated an option pool from their share capital will be required by investors to do so immediately before the investment round (so that the allocation of the pool will actually dilute those who were in the company before the fundraising and not affect the investors).
This reflects investors’ concern that at a certain point after the fundraising, the company will adopt an option pool that will dilute them. Sometimes, the company already has an option pool, and investors fear that the pool will not be sufficient and will need to be expanded. In such a case, the investor can be assured that the company will grant them anti-dilution protection if the option pool is expanded before the next round. This way, the investor will not be diluted in such a case, and on the other hand, there will be no necessity to expand the option pool due to investors’ concerns.
Determining the share price in an investment round (Price Per Share) is done by dividing the company’s total valuation by the total number of shares. However, the question arises—does this include only the total issued shares or also rights to shares (i.e., a person’s right to a future allocation of shares in the company)? In other words, is the calculation based on full dilution?
Market practice shows that in investment rounds, the company's valuation is almost always determined on a fully diluted basis. Fully diluted basis means counting all shares in the company and any future rights to share allocation. This includes unconverted convertible loans, unexercised options, commitments to grant options or company shares to third parties, etc.
For example, here is a definition of full dilution from one of the recent investment agreements we drafted:
“Fully Diluted Basis” means all issued and outstanding shares of the Company, with all securities convertible into share capital and other rights (or promises or undertakings to grant such rights, orally or written) to acquire shares or exchangeable for shares deemed converted, exchanged or exercised, as the case may be, at their existing conversion or exercise prices (including, to the extent applicable, the effect of any anti-dilution adjustments or protections resulting from the transactions contemplated herein) but excluding any shares to be issued in accordance with this Agreement.”
The example above shows that the dilution basis includes all issued shares, any security convertible into shares, any commitment or future promise to grant company shares or a security convertible into shares, and even any share issued due to anti-dilution protections attached to such shares. This is a very broad definition. The key point is to account for the maximum possible dilution the investor may face at the time of investment and to calculate accordingly (even though, in practice, this is theoretical dilution that may not necessarily materialize).
In contrast, Issued and Outstanding Basis refers only to the share capital issued by the company and actually realized (i.e., options that have not been exercised or convertible loans that have not been converted are not counted). This basis is widely used in determining preferred shareholder rights in the company (such as the right to appoint a director). It is often determined that a certain percentage of holdings grants a shareholder a specific right, and here, the dilution basis is critical. A 5% stake on an issued and outstanding basis can sometimes represent twice the proportional ownership of a 5% stake on a fully diluted basis. Therefore, defining rights based on an issued and outstanding basis preserves the investor’s rights for a longer period.
