Reading: From Value to Issue Price

Especially in early rounds of financing, investors are often confronted with investment decisions for which the (implied) valuation of the company might not directly observable. For example, such an offering could be:

• We offer 75'000 shares at a price of 100 each
• The firm currently has 1 million shares outstanding (before the financing round).

What valuation does this information imply?

With the tools that we have discussed in the previous sections, the answer is rather simple. The numbers imply that, after the transaction, there will be 1'075'000 shares outstanding that are valued at 100 each. Consequently, the implied post-money valuation is 107.5:

Implied post-money valuation = Number of shares × issue price = 1'075'000 × 100 = 107.5 million.

Since the company issues 75'000 shares, the value of the total offering is 7.5 million [= 75'000 × 100]. Consequently, the firm's pre-money valuation is 100 million:

Implied pre-money valuation = Post-money valuation - Capital investment = 107.5 - 7.5 = 100.0

Finally, we can see that the new round of financing will give an ownership stake of 6.98% [= 75'000/1'075'000] to the investors who participate in this round of financing.  

Arguably, such valuations are easier to understand and verify for many investors than stock prices and number of shares issued.

Another interesting constellation that can sometimes be observed among less professional investors is that such investors might be willing to invest a certain amount of capital in an exciting growth case without caring too much about how many shares they get in exchange for this amount of capital. It is easy to show that this is a rather dangerous investment approach.

To do so, let us slightly modify the case from above:

• Suppose the firm's exit value is 500 million in 5 years. From its current situation with small revenues and negative earnings, this therefore promises to be an exciting growth case.
• To participate in this venture, a private investor is willing to invest 100'000. The company informs him that is entitled to 200 shares in return for this investment. 
• At the time of the exit, the value of the firm is 500 million. Assuming 1 million shares outstanding (just to keep the computations simple), the stock price at the time of exit is 500.

Obviously, this investment would not be very attractive for the private investor. At the time of his investment (today) he pays a price of 500 per share [= 100'000 / 200] just to receive the same amount at the expected time of exit in 5 years. Consequently, despite the fact that the company's business case promises penomenal growth, the investor earns a return of 0%. Why is that the case? Simply because he overpays for his shares today:

• Today's post-money valuation is 1'000'000 × 500 = 500 million
• The exit value in 5 years is also 500 million.

The expected return, therefore, is 0%.

In sum, the relations between valuation, number of shares issued, issue price, dilutive effect of future rounds of financing, etc. are extremely important to understand in the context of young ventures. The reason is that equity investments in young firms typically go from the investor to the target firm, and thereby alter the ownership structure, etc. In contrast, equity investments into more mature firms, especially listed firms, often involve transactions among individual shareholders. These transactions bypass the balance sheet of the underlying firm. If you buy Apple shares today, you typically buy them from another shareholder and not from Apple directly.