2018 Startup GUIDE - 10th Edition

COVER STORIES 67
Kellerhals Carrard
Term Sheet Basics: Do you really
know what “fully diluted” means ?
When it comes to term sheets, there will be one key term that
you will have to negotiate: the pre-money valuation. It defines the
price per share and, therefore, serves as a basis to calculate the
shareholding the investors will receive as a result of their investment,
hence also the dilution of the existing shareholders. The
higher the pre-money valuation, the higher the share price, the
lower the percentage of the investors‘ shareholding and the lower
the dilution of the existing shareholders.
Venture capital investors typically calculate the share price on a
“fully diluted basis”. The formula to obtain the price per share is
as follows: pre-money valuation / fully diluted number of shares.
The important detail is that investors will not only consider the
current number of shares but add on top the number of shares
that are or will be issuable under existing and/or future options.
Like that, investors simulate their future dilution and shift the
economic effect thereof to the founders. The dilutive effect may
come from employee incentive plans (based on stock options,
treasury shares or other share plans), convertible loans or other
options to subscribe for shares of the company in the future at
pre-set conditions.
E.g., if your startup has issued 1,000,000 shares and implemented
(or undertakes to implement post-closing) an employee
stock option plan (ESOP) under which 200,000 options may
be granted to employees, the relevant number of shares for
the calculation of the share price would be 1,200,000. If you
assume a pre-money valuation of CHF 4 million, the share
price on a non-fully diluted basis would be CHF 4.00, whereas
on a fully diluted basis it would be CHF 3.33. So the impact
is obvious: except if the exercise price of the options is
higher than the pre-money valuation, the higher the size of
the actual or agreed upon ESOP, the higher the overall number
of shares, the lower the price per share and the higher
the dilution of the existing shareholders. However, the concept
of “fully diluted” is not carved in stone. For instance, the
founders could agree with the investors that only 10% of the
ESOP will be relevant for the calculation of the fully diluted
share price, although the total amount of the ESOP will be
actually 20%. A typical argument of the founders in favor of
this approach is that the ESOP constitutes an incentive to the
good-performing employees which benefits all shareholders
(founders and investors).
The concept of “fully diluted” gets more complex when you
have convertible loans outstanding that convert into equity
as part of the financing round. The issue is, again, to determine
who should support the dilution caused by the conversion of the
loan, especially if the conversion price includes discount from the
share price in the financing round.
How to calculate the share price if you have convertible loans:
1. Pre-money Method (founder-friendly): Here the share price
for the new investors and the convertible loan investors (reflecting
the applicable discount) would both be derived from
the agreed pre-money valuation with the new investors. Accordingly,
both the existing shareholders as well as the new investors
will be diluted pro rata by the shares that will be issued
to the convertible loan investors.
2. Percentage-Ownership Method (investor friendly): With
this approach, the new investors will not be diluted from the
shares that are issued to the convertible loan investors. In other
words, it is assumed that the shares for convertible loan investors
are already issued when you calculate the share price
for the new investors.
3. Dollars-Invested Method (compromise): The bridge between
the two mentioned methods is to shift the dilutive effects
of the convertible loans to the founders only with regard
to the extra shares that are issued due to the discount that is
typically granted on the share price and otherwise share the
dilutive effect of the remaining shares pro rata among the existing
shareholders and the new investors.
Bottom line is that you should be mindful of the above when negotiating
the valuation of your startup with investors as both, ES-
OPs and convertible loans, can have significant effects on your
share price.
KARIM MAIZAR NICOLAS MOSIMANN FRÉDÉRIC ROCHAT
+41 58 200 39 00 +41 58 200 30 00 +41 58 200 33 00
Facts and Figures
Organization
Foundation 1885
Mission Statement
Kellerhals Carrard
Employees More than 200
Postal Address
Webpage
You focus on translating your idea into
economic value – we support you with
our best legal solutions on your way to
the top.
Rämistrasse 5, CH-8024 Zurich
+41 58 200 39 00
www.kellerhals-carrard.ch
SWISS STARTUP GUIDE 2018