Arithmetic of Deals (B)

By Frank Demmler

It is essential for an entrepreneur to know how to build a capitalization table and look at any deal in the context of the number of shares of stock that are involved under what circumstance.

Deals are negotiated with percentages, but they are structured with shares.

This article discusses the impact of stock options on the arithmetic of deals.

Stock Options

In the world of private equity investments, stock options are like motherhood and apple pie. Everybody agrees that they’re a good thing.

Stock options are rights to buy shares of common stock of the company at some time in the future at a price determined at the time of option grant. For example, let’s look at the case of someone being granted options to purchase100,000 shares of common stock with an exercise price of $0.10 per share. If that company were to go public at $15 per share, that person would be able to acquire $1,500,000 worth of common stock for $10,000! Is this a great country, or what?

Stock options are a necessary portion of the compensation for individuals who join early stage companies. Investors understand that. Entrepreneurs understand that. There’s no argument there. Usually, an early stage business does not have all of the management talent that it will need to be successful. Stock options will be used to entice individuals to join the team.

The Arithmetic of Deals (part 2)

Let’s look at the situation where a founder owned 400,000 shares of common stock and was offered the following deal:

A person invests $600,000 for 60% of the company. The founder’s equity would be 40%. Since 400,000 shares represent 40% of the company, we can use division to determine that the company has a total of 1,000,000 shares.

With that information we can fill in the blanks, determining that the investor will buy 600,000 shares (1,000,000 – 400,000) for $1.00 per share ($600,000 invested divided by 600,000 shares purchased).

On a post-financing basis, the company would be worth $1,000,000 (1,000,000 shares outstanding multiplied by the transaction share price of $1.00).

Let’s look at the impact of including stock options in the deal.

So, we have an investor who is willing to invest $600,000 for 60% of the company. This investor has also let it be known that he believes that there needs to be a stock option pool of 15%. When these statements are translated into a structured deal, the following capitalization table results:

This is not what the entrepreneur expected. He thought that he would own 40% of the company, or at worst, slightly less than 40% after a modest adjustment for the stock option pool.

What happened? The tyranny of the arithmetic of deals happened. Do you remember?

Deals are negotiated with percentages, but they are structured with shares

From the investor’s perspective, his offer was such that he would own 60% and there would be an option pool of 15% after the financing. That leaves the entrepreneur with 25%. If his 400,000 shares represent 25%, then the total shares would be 1,600,000 and all the numbers can be calculated using multiplication and division. Simple arithmetic.

Most likely the entrepreneur had anticipated that the investment of $600,000 would have happened first and then the 15% option pool would be set up. If he had run the numbers, he was expecting to receive something like the following:

What has been the real impact of these differing interpretations? Since both sides agree that stock options are necessary, that’s not the real issue. Whether the initial pool is 240,000 options or 176,471, while not inconsequential, is beside the point because as the options are granted and the team is built, if additional options are needed, they will be approved at that time.

So, when are stock options not stock options? When they’re used to mask the actual pre-financing value of an investment. In this example, the apparent pre-financing value was reduced from $400,000 to $250,000 by including the stock option pool in the calculation.

While the preceding casts the investor in a negative light, that is not the case. An entrepreneur must be well versed in deal making (and the arithmetic of deals) when conducting discussions with potential investors. Otherwise, entrepreneurial disappointment is highly likely.

Advice to the entrepreneur

Learning how to do the Arithmetic of Deals is critical for all entrepreneurs.

· Remember: Deals are negotiated with percentages, but they are structured with shares.

· Ask questions and make sure you understand what a potential investor is saying.

· Do not agree verbally to any individual deal elements.

· Ask for a written term sheet so that you can evaluate the entire proposed investment before commenting to any of its individual features.

Frank Demmler (fd0n@andrew.cmu.edu) is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (http://web.gsia.cmu.edu/display_faculty.aspx?id=168)