What are the best practices for modeling the dilution and exit scenarios of preferred stock in VC?

1 Understand the terms

The first step is to understand the terms and conditions of the preferred stock in the term sheet. This includes the valuation, the amount invested, the share price, the percentage ownership, the liquidation preference, the dividend rate, the anti-dilution protection, and the conversion option. You should also know the capitalization table, which shows the number and type of shares outstanding for each shareholder. You can use a spreadsheet or a software tool to keep track of these details and update them as the deal progresses.

2 Calculate the pre- and post-money valuation

The next step is to calculate the pre- and post-money valuation of the company based on the preferred stock terms. The pre-money valuation is the value of the company before the investment, while the post-money valuation is the value of the company after the investment. The post-money valuation is equal to the pre-money valuation plus the amount invested. The share price is equal to the post-money valuation divided by the number of shares outstanding after the investment. The percentage ownership is equal to the number of shares owned by each shareholder divided by the total number of shares outstanding.

3 Model the dilution

The third step is to model the dilution of each shareholder's ownership and value as the company raises more capital. Dilution occurs when new shares are issued to new investors, reducing the relative stake and share price of existing shareholders. To model the dilution, you need to estimate the future rounds of funding, the valuation, the amount invested, and the share price for each round. You also need to account for any anti-dilution provisions that protect the preferred shareholders from losing value if the share price drops in later rounds. You can use a spreadsheet or a software tool to calculate the dilution impact for each shareholder and round.

4 Model the exit scenarios

The fourth step is to model the exit scenarios of the company and how much each shareholder gets paid. Exit scenarios are the possible outcomes of selling or going public. To model the exit scenarios, you need to estimate the exit valuation, the exit multiple, and the exit date for each scenario. You also need to apply the liquidation preference and the conversion option of the preferred stock to determine the payout order and amount for each shareholder. You can use a spreadsheet or a software tool to calculate the exit returns for each shareholder and scenario.

5 Compare the scenarios

The fifth step is to compare the different scenarios and evaluate the trade-offs and risks for each shareholder. You can use metrics such as internal rate of return (IRR), cash-on-cash return, and multiples to measure the performance of each scenario. You can also use charts and graphs to visualize the distribution of returns and the sensitivity to changes in assumptions. You should consider the probability and timing of each scenario and how they affect the value and risk of the preferred stock.

6 Communicate the results

The final step is to communicate the results of your modeling to the relevant stakeholders, such as investors, entrepreneurs, and board members. You should present your findings in a clear and concise way, highlighting the key assumptions, inputs, outputs, and insights. You should also explain the logic and rationale behind your modeling and how you accounted for the preferred stock features. You should be prepared to answer questions and address feedback from your audience.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?