If you’ve ever seen the movie “The Social Network,” there’s this kind of famous moment at the end when Eduardo realizes that his percentage of the company was basically reduced down to nothing. It’s a really dramatic scene, but what happens in it, while admittedly it’s kind of an extreme version, is a real thing. It’s called dilution. And typically it’ll happen when a company raises money.
And the reason that it matters for you, the employee, is because it affects the percentage of the company that you ultimately have. This is all wrapped up in the company’s valuation or how the company is being valued at a specific point in time. In this lesson, I’m going to take you through how valuations work, so that when your company receives a valuation, you have an understanding of what it means for you.
When a company raises money, the investor will typically give them a legal document called a term sheet. And what this document does is lay out all the terms and conditions under which the investor will give money to the company. One of those terms is the valuation. This is where the investor says, in plain English, here’s how much money I believe the company is worth right now. The reason this matters is because it affects the fair market value of the shares of the company.
So let’s say a company has 10 million shares in total. An investor comes in who wants to give the company money at a $10 million valuation. So that means the entirety of the whole company’s issued stock is being valued at 10 million, in total. And since there are 10 million shares, this means the value of each share is $1. So let’s say this investor wants to give the company a million bucks. That means they’re buying one million shares, which is 10% of the company. Easy enough, right?
But now let’s switch it up. Let’s say that instead of $10 million, the valuation lands somewhere higher, like $20 million. So the company’s total shares are now worth $20 million divided by the number of shares, which is 10 million shares. Meaning, in this second scenario, the value of each share is actually $2. Again, the investor is putting in a million bucks. At $2 per share, they’re getting 500,000 shares, which is 5% of the company.
So in scenario one, it was 10% of the company, but in scenario two it’s 5%. The only thing that changed was the valuation, but it affected how many shares were being given, how much each share was worth, and what percentage of the company the recipient ultimately owned.
The big thing to know here is: If you own shares, the valuation of your company affects how much each of your shares is actually worth.
The scenario that we just went over is really simple. There’s actually more than one type of valuation. But for you, the employee, there’s one other important thing to know here. So I want to quickly touch on that before we move into the types of valuations.
So like we were talking about before, if you’re joining a startup, especially at that really early stage, like Iris, it’s likely that you’re receiving stock options. Meaning once your shares vest, you’ll still have to purchase or exercise them with your own money. At this point, the valuation of the company is typically pretty low. Meaning that the fair market value at which you receive your options is also pretty low. This makes it less financially difficult for you to actually exercise your options or purchase them.
Hopefully, though, as the company grows over time, the valuation will also grow along with it. That doesn’t always happen, but we hope that it happens. The company grows and becomes more valuable. And as a result of that, the shares will also become more valuable. So employees who join the company at a later stage might receive their shares at a really high strike price that reflects the fair market value of those shares at that time. And sometimes that fair market value is so high that they can’t afford to actually exercise their options into shares.
If you remember, in the earlier lesson, we talked about more mature companies using RSUs instead of options. And this is exactly why. Like we talked about, RSUs don’t need to be bought. They’re just given to the employee once they vest. The advantage of RSUs is that you don’t have to spend your hard-earned money to actually buy the shares. The disadvantage, kind of naturally, is that since you’re joining the company at a much later stage, you’re likely getting the opportunity to acquire a lot fewer shares than those earlier employees did.
Long story short: As an employee, you want to make sure that you always have an eye on your company’s valuation because it directly affects how much your shares are theoretically worth.
When a company raises money, their valuation is typically broken up into distinct phases. There’s the amount of money that the company is worth before the investment comes in. This is called the pre-money valuation. Then there’s the actual investment itself. And finally, there’s the amount of money that the company is worth after the investment. This is called the post-money valuation.
So obviously, you’re probably wondering: Why does this matter? Like a lot of things, it can affect the fair market value of the shares that you hold. Remember earlier when we talked about the employee stock option pool—that percentage of the company that gets carved out for new hires and new employees? Well, if you think about how dilution works, when an option pool gets carved out, it reduces the ownership percentage of all of the other shareholders. So that’s why a lot of the time, when an investor puts money into a company, they’ll require that this option pool gets sliced out of the company on a pre-money basis. Or in other words, the option pool will only affect the people who owned shares before the investment came through the door.
And I know that can sound like a lot to wrap your head around, but the big thing for you to know is this. The post-money valuation matters to you because that affects how much your shares are valued at tomorrow—after the money comes through the door.
Ultimately in the end, more information is always better. So when your company raises money, it can be helpful to know what the pre-money valuation was and what the post-money valuation is.
So before we wrap up, let’s quickly talk about how valuations are calculated. One question we get asked a lot is: How do valuations even work? Who decides the value of a company? The short answer is, valuations for startups are complex. With a mature company, like a public company, there’s typically a lot of data that you can look at. For example, the company has revenue, profits, taxes, et cetera. And because of this, it’s easier to just kind of do the math and figure out what the value of the company is.
For startups, though, especially companies that don’t have revenue yet, finding a valuation is a lot more challenging. You’re looking at things like growth rate, the number of users, the company’s industry, and sometimes even the experience level of the founding team.
There was this big scandal with a company called Enron that you’ve probably heard of. And the fallout from the Enron scandal led the government to step in and create a brand-new IRS code called section 409A. One of the things that this code says is that if you’re a private company, you now have the option to bring in a neutral third party to analyze your books and set your valuation for you.
So this valuation—the 409A valuation—should be done every 12 months or whenever the company has a material event, like a fundraise. Think of it kind of like renewing the registration on your car. It just has to happen every 12 months or whenever you get a new car.
So for you, the employee, the thing to know is, after your company raises the first priced round, like a Series A, your company is likely going to get a 409A valuation done at least once a year. And every time they get a new 409A valuation, it’s going to have an impact on the fair market value of your shares. Now, what we obviously hope for is that with every new 409A valuation, the value of the company grows and your shares are valued higher. (Again, it doesn’t always happen that way, but we hope that it does happen that way. And when it does, that’s what creates the spread that we learned about a couple of lessons ago.)
I remember the first time that I was at a company when we saw a 409A valuation happen, and just seeing this kind of moment where I was like, “Wow, when I exercised my options, the strike price was one thing. But now that we did the 409A valuation, the shares are valued more.”
And I think what it did was it just made it feel really real for me. It made me realize that equity isn’t just a lottery ticket. If I paid attention and I made smart choices, equity could be a real way for me to build my financial future. With that being said, this is a complex set of decisions that you should always discuss with your tax, accounting, and legal advisors.