A pre-seed investors cap table is used to show the effect on the percentage ownership of a business following the introduction of pre-seed equity capital.
In its early stages a business might have an idea which the founders have started to develop using their own funds. At some point, before the business even has a working product, traction or revenue, it may need additional funding from external sources.
This type of investment, referred to as pre-seed investment, usually comes in small amounts from friends and family or other outside investors and requires the founders to relinquish part of their ownership in return for the funding provided.
Pre-Seed Investors Cap Table Example
Suppose a business has issued shares to its founders and a few other key personnel and currently has the following cap table.
| Holder | Shares | % |
|---|---|---|
| Founders | 950,000 | 95.00 |
| Team | 50,000 | 5.00 |
| Total | 1,000,000 | 100.00 |
Together the founders have 950,000 shares representing 95% of the issued capital. In addition another 50,000 shares have been issued to members of the team such as key employees and advisors. The creation of the cap table prior to any investment is more fully discussed in our post on pre-investment cap tables for startups.
Creation of a Stock Options Pool
Suppose now that the business is seeking an investment of 70,000 to fund initial development work on the product. The business has located pre-seed investors who in addition to providing the funding, require 100,000 stock options to be set aside to reward employees, advisers and other team members.
The stock options are not shares they are simply the right to buy shares, and are used to recruit, incentivize and retain the necessary key personnel to develop the business into the future.
The business has an agreed pre-money valuation of 550,000 and to avoid dilution the investors require the options pool to be created prior to their investment.
The share price is calculated as follows.
Shares in issue = 1,000,000 Stock options = 100,000 Total = 1,100,000 Pre-money valuation = 550,000 Share price = Pre-money valuation / Shares and Options in issue Share price = 550,000 / (1,000,000 + 100,000) = 0.50
The share price prior to investment is 0.50.
The effect of the granting of stock options is more fully discussed in our post on stock option pools.
Pre-Seed Funding
Without the creation of the options pool the share price would have been 0.55 (550,000/1,000,000). The effect of the options pool is to reduce the share price prior to investment to 0.50 thereby increasing the number of shares the investors receive for their investment of 70,000.
The number of shares due to the investors in return for their investment is calculated as follows.
Share price = 0.50 Pre-seed investment = 70,000 Number of shares = Investment / Share price Number of shares = 70,000 / 0.50 = 140,000
Pre and Post Money Valuation
The post-money valuation for the business is simply the pre-money valuation plus the new investment.
The table below summarizes the effect of the inclusion of the option pool and the issue of shares to the pre-seed investors and shows the relationship between the pre-money and post-money valuations.
| Shares/Options | Value | |
|---|---|---|
| Founders | 950,000 | |
| Team | 50,000 | |
| Options pool | 100,000 | |
| Pre-money valuation | 1,100,000 | 550,000 |
| Investment | 140,000 | 70,000 |
| Post-money valuation | 1,240,000 | 620,000 |
In this example the pre-money valuation is 550,000 which together with the investment of 70,000 gives a post-money valuation of 620,000. The total number of shares in issue is now 1,240,000 and the pre-seed investors cap table is set out as follows.
| Holder | Shares/Options | % |
|---|---|---|
| Pre-seed investors | 140,000 | 11.29 |
| Founders | 950,000 | 76.61 |
| Team | 50,000 | 4.03 |
| Options pool | 100,000 | 8.07 |
| Total | 1,240,000 | 100.00 |
The pre-seed investors cap table shows that for their 70,000 investment the investors receive 140,000 shares representing 11.29% of the total shares and options in issue. In addition the options pool contains 100,000 stock options equivalent to 8.07% of the total.
Dilution and the Effect on the Founders
The effect of obtaining pre-seed funding and creating the options pool is to dilute the percentage ownership of the founders.
Although the number of shares held by the founders has not changed, the total number of shares including the stock options is now 1,240,000 and therefore the percentage ownership of each shareholder reduces as shown in the table below.
| Holder | % Before | % After |
|---|---|---|
| Founders shareholding | 950,000 | 950,000 |
| Total shares and options | 1,000,000 | 1,240,000 |
| % Ownership | 95.00% | 76.61% |
The founders who previously held 95.00% of the business are diluted and now hold only 76.61%.
Likewise the team of key personnel previously held 5.00% of the business and are diluted down to 4.03%.
| Holder | % Before | % After |
|---|---|---|
| Team shareholding | 50,000 | 50,000 |
| Total shares and options | 1,000,000 | 1,240,000 |
| % Ownership | 5.00% | 4.03% |
Pre-Seed Investors Cap Table and Financial Projections
In the above example the pre-seed investment was 70,000. The amount represents new equity capital for the business and needs to be entered in the financial projections template as either startup capital in the opening balance sheet or alternatively as new capital in the cash flow.
In practice it is recommended that the plan is developed first using the financial projections template to determine the amount of equity capital needed to fund the business. These amounts can then be referenced back to the pre-seed investors cap table to determine how the necessary capital will be provided. In any event, the capital required by the financial projections template should always agree to the capital shown in the pre-seed investors cap table.
The granting of stock options to key personnel is a method of compensating them for providing their services and usually creates an expense for the business. The expense is the number of options granted multiplied by the fair value of each option at the date of grant, and is included in the financial projections template income statement as an expense allocated over the vesting period of the options.
Summary
It is important to understand the effect of obtaining outside investment and the creation of a stock option pool on the fully diluted pre-seed investors cap table.
Investors usually require the options pool to be created prior to their investment in order to ensure there are sufficient options available to recruit, incentivize and retain the necessary key personnel without being diluted. The effect of the options pool is to reduce the share price prior to investment resulting in a larger number of shares being issued to the pre-seed investors.
Each time the business seeks outside investment or increases the size of the options pool the founders are diluted and the percentage of the business they own reduced.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.