Let’s look at the example shown on the right. First, let’s take the initial exit amount at $15M. In this example, everyone walks away with some money. Now, change the exit amount from $15M to $5M (just enter and hit return). First off, you may notice is that the Convertible Preferred stock is no longer converting to common. Instead, it is staying as preferred during the exit. Also the liquidation stack takes over, and you see that the last investor (VC2) walks away with all $2M of their initial investment as this was a 1x liquidation preference. The first investor (VC1) only receives $3M of their original $4M investment. Last, you’ll notice that the founders receive $0.

In this example, the seniority of the liquidation stack was on the last money-in. You can edit the exit amount and see various scenarios for what happens with the liquidation stack.

Illustrated on the right is the difference for methods used to create an option pool. In both pie charts, you’ll notice that the option pool size is 10%, as this is computed on a post-money basis (after the investment). On the top is the option pool created from the pre-money side. As the Investor bought 40% the company ($2M investment on a $3M pre-money valuation), that leaves 60% for the founder and option pool. Since the option pool accounts for 10%, logically the founder own’s 50% of the company. In the bottom the option pool is created from the post-money side, which dilutes both the founder and investor. Before the option pool, the founder owned 60% while the investor owned 40%. Dilution to both sides is based on the 60/40 ratio. Therefore, the founder goes from 60% ownership to 54%. The investor goes from 40% to 36%.

The equations are shown for these two situations. Please note that you can update the values and watch the equations solve for other values as you desire.

The example to the right illustrates how each type of preferred stock behaves given the same exit event. Participating will always give a higher return to the investor than convertible. Try some different exit values to see how each type of stock behaves.

Let’s take an example. The increased number of fields with our illustration reflects how timing now enters into the equation. With dividends, how long they have been accumulating interest is critical, so we’ve added the dates to the right. The impact in this example with only two years of non cumulative dividends is an additional 8% of the proceeds ($2M x 10% x 2 years = $400k) going to the investors.

Even more dramatic is when the liquidation preference is increased from 1x to 2x. In this case, the liquidation preference is $4M with the dividends accumulating on this $4M amount ($4M x 10% x 2 years = $800k).

We see on the right the two scenarios.  The top chart shows the proceeds for the investor and founders if the investors put their money into common stock (where no liquidation preference exists).  The chart below shows if the stock was Convertible Preferred Stock with a liquidation preference of 2x.  With an exit amount of $5M, the 2x liquidation preference means that the investors receive 2x their initial investment of $2M for a total of $4M, before any money is provided to common shareholders.  Therefore, the founders only receive $1M (the remaining money) of the $5M exit amount (thus 20%). 

It is possible to try out different scenarios with the example to the right. Keep in mind, that the behavior of Convertible Preferred Stock is:

1. to not convert to common, which means the liquidation preference is taken or
2. convert to common and ignore the liquidation preference.

To see a scenario where the investor converts to common, set the Exit Amount to $12,100,000.  At this point, the investor converts to common to receive 33.33% of the $12,100,000 exit instead of the 2x liquidation preference yielding $4,000,000.  Up until $12,000,000, the investor will stay as preferred and utilize their liquidation preference.  This is an illustration of down-side protection for the investor, which is the reason that liquidation preference exists.

To the right, we have an example of this price per share calculation. There are 3,000,000 founding shares. With a pre-money valuation of $3M, this results in a $1.00/share price. The key aspect is that new shares are then created with this price per share ($1.00/share). If the investors put in $2M of new money, then 2,000,000 new shares are created.

Another method exists to calculate the price per share if an option pool is created in an alternate method. Please refer to the post on Option Pool Creation, which shows both methods used to evaluate the price per share.

Let’s take an example, illustrated to the right. An entrepreneur needs $2M given their current cash flow projections. However, the entrepreneur wants a very high valuation to avoid dilution. If the investors require the entrepreneur to take more money (due to the size of the fund, e.g. they have a $500M fund and need to put roughly $30-50M in each company over its lifetime), the investor is willing to be flexible about pre-money valuation. The amount of invested cash spent by the company makes no difference to the ownership percentages (although investors are usually very interested in their portfolio companies’ cashflows). In a competitive environment, this is easy to justify. Simply put, a higher amount of money yields a higher pre-money valuation because the percentage ownership enters into the rationale on both sides.

The simplest way to understand pre-money valuation is to look at the percentage ownership the investor would receive for their investment.

The example begins with a $2M investment on a $3M pre-money valuation. This means that prior to the investment, the company is evaluated by the investors to be worth $3M. Why? Because the investors expect to own 40% of the company. The post-money valuation is the pre-money valuation plus the amount invested. Therefore, if the company is raising $2M and the investor intends to own 40% of the company after the investment the pre-money valuation must be $3M. A common misunderstanding is that the pre-money valuation is derived from a complicated evaluation of the company’s potential earnings, with a discounted cash flow analysis (DCF) of the unleveraged cash flows. The problem is that these projections are almost always wrong. In addition this would put the valuation of the company in the hands of the financial projections rather than in the hands of investors.

So, the “magic” of the pre-money valuation is based not on projections, but a combination of three factors:

1. The percentage ownership described above. 
2. The investor’s experience with previous investments of similarly staged companies (this is the “black-box” aspect of valuations).
3. The competitiveness of the deal, usually reflected in the experience of the entrepreneurs. This is where “serial entrepreneurs” have a marked advantage over new entrepreneurs as they command a higher pre-money valuation.