This article is educational and not investment advice. Startup investing is highly risky and illiquid. Only invest money you can afford to lose.
1) What you'll learn
How venture capital funding rounds, valuations, and ownership work
The difference between pre-money and post-money valuation and how dilution happens
How convertible notes and SAFEs convert with discounts and valuation caps
How liquidation preferences impact exit proceeds to investors and founders
Portfolio math: power law, expected value, and reserves for follow-on rounds
How to read fund-level metrics like TVPI, DPI, and IRR
Practical steps to evaluate deals and construct an angel or syndicate portfolio
2) Concept explanation
Venture capital finances young, high-growth startups that need capital to build products and win markets. In exchange for cash, investors receive equity or the right to convert into equity later. Because most startups fail, VC relies on a few big winners offsetting many losses.
Each funding round sets a price for the company. Before new money arrives, the company has a pre-money valuation. After the investment, the post-money valuation equals pre-money plus new cash. Your ownership is the dollars you invest divided by the post-money value. Over time, issuing more shares for future rounds and employee option pools dilutes everyone who does not add more capital.
Investments can be priced equity rounds or convertibles. Priced rounds sell preferred shares with terms like liquidation preferences and protective provisions. Convertibles, such as notes or SAFEs, delay pricing until a future round, often using a discount or valuation cap to reward early risk.
Returns flow to investors according to the cap table and the terms in the term sheet. Liquidation preferences determine who gets paid first at an exit. The result is that exit outcomes can diverge sharply from headline valuations. Professional investors also plan follow-on reserves to maintain their ownership in winners and manage dilution.
3) Why it matters
Understanding these mechanics helps you avoid common pitfalls, like overpaying in early rounds, ignoring the option pool expansion, or underestimating the impact of liquidation preferences. It also helps you compare different opportunities on an apples-to-apples basis.
At the portfolio level, startup outcomes follow a power law: a small number of investments often drive the majority of returns. That means your process must be designed to identify and double down on potential outliers, while being comfortable that many checks may go to zero. Knowing how to model expected value, cash flow timing, and reserves equips you to decide how many investments to make and how much to allocate per deal.
4) Calculation method
Pre-money and post-money valuation
Post-money valuation = pre-money valuation + new cash invested.
Investor ownership at close = investment amount ÷ post-money valuation.
Example: Pre-money 8 million dollars, raise 2 million dollars. Post-money = 10 million dollars. A 500 thousand dollar investment buys 500 thousand divided by 10 million = 5 percent ownership.
Dilution and option pools
If a new round issues additional shares, existing holders are diluted unless they invest pro rata to maintain their percentage.
Option pool expansion is often required pre-financing. Expanding the pool before pricing effectively comes out of founders and existing holders.
Example: You own 5 percent. The company expands the option pool by 10 percent pre-money and raises a new round that issues 25 percent new shares. New ownership without pro rata becomes 5 percent multiplied by 0.9 multiplied by 0.75 = 3.375 percent.
Convertibles: discount and valuation cap
Discount method: If the next round price per share is P, the convertible converts at P times one minus discount rate.
Valuation cap method: The effective price is the lower of price based on the cap and the next round price after discount.
Example with cap and discount
Note principal 100 thousand dollars, no interest for simplicity.
Next round: pre-money 12 million dollars, company has 12 million shares outstanding, so price per share P = 1 dollar.
Terms: 20 percent discount, 8 million dollar cap on a pre-money basis.
Cap price per share = cap pre-money divided by fully diluted shares at conversion. If 12 million shares count, cap price = 8 million divided by 12 million = 0.6667 dollars.
Discount price per share = P times 0.8 = 0.80 dollars.
The note converts at the lower price, 0.6667 dollars, receiving 100 thousand divided by 0.6667 approximately equals 150 thousand shares.
Liquidation preferences
A 1x non-participating preference means preferred investors can take their money back first or convert to common if that yields more.
Participating preferred with 1x lets investors take their money back and then also share pro rata in the remainder. This can materially reduce founder and common proceeds in middling exits.
Post-money = Pre-money + New cash
Ownership = Investment / Post-money
Diluted ownership = Prior ownership × (1 - new issuance %) × (1 - pool expansion %)
Discount price = Next round price × (1 - discount)
Cap price = Cap pre-money / Fully diluted shares at conversion
Expected multiple = Σ [Probability_i × Multiple_i]
TVPI = (NAV + Distributions) / Paid-in capital
IRR: r such that Σ [Cash flow_t / (1 + r)^t] = 0
5) Case study
Suppose you join an angel syndicate for a seed deal.
Seed round
Pre-money 10 million dollars, raise 2 million dollars.
You invest 20 thousand dollars via a SAFE with 20 percent discount and 12 million dollar post-money cap.
Series A one year later
New money: 8 million dollars at a pre-money 24 million dollars for 25 percent new shares.
The company increases the option pool by 10 percent pre-money as a Series A condition.
Step 1: Seed SAFE conversion
Post-money cap applies. Your conversion price uses post-money cap divided by post-money share count at conversion.
If there are 10 million pre-money shares and pool expansion to 20 percent fully diluted is required before the round, then fully diluted shares become 12.5 million before new money.
Cap-based price per share = 12 million divided by 12.5 million equals 0.96 dollars.
A-round price P_A = pre-money 24 million divided by 12.5 million equals 1.92 dollars.
Discounted price = 1.92 times 0.8 = 1.536 dollars.
The SAFE chooses the lower price, 0.96 dollars.
Shares on conversion = 20 thousand divided by 0.96 approximately equals 20,833 shares.
Step 2: New issuance and ownership after A
New A shares issued = 25 percent of post-A fully diluted.
Post-A fully diluted shares = prior 12.5 million divided by 0.75 equals 16.667 million.
Your post-A ownership percentage = 20,833 divided by 16.667 million approximately equals 0.125 percent.
Step 3: Exit scenarios and liquidation preferences
Series A investors have 1x non-participating on 8 million.
Exit at 20 million dollars
A as preferred: 8 million back first, remainder 12 million to common. If A converts to common at 25 percent, they would get 5 million, which is lower. They take 8 million.
You participate only as common through your converted SAFE. Your proceeds = 0.125 percent of 12 million equals 15,000 dollars, below your 20 thousand investment.
Exit at 200 million dollars
A converts to common to take 25 percent of 200 million equals 50 million.
This demonstrates how option pool expansions, pricing mechanics, and preferences influence outcomes, and why large exits dominate returns.
6) Practical applications
Sizing your portfolio
Expect many zeros. If your target is at least 10 to 20 independent positions, spread checks evenly to reduce idiosyncratic risk.
Use a reserves policy: for each initial dollar, keep 0.5 to 1 dollar for follow-ons in your best performers.
Valuation discipline
Model ownership at entry and after likely dilution. Ask what exit price is needed to reach a 10x multiple on your check. If that exit seems unrealistic for the market size and margins, reconsider.
Term sheet sensitivity
Simulate outcomes across exit values with different liquidation preferences and participation. Small wording changes can shift millions at middling exits.
Convertible modeling
Build a simple sheet with inputs: discount, cap, shares outstanding, option pool target, and next round size. Show resulting conversion price and shares.
Power-law strategy
Track leading indicators of outliers: rapid revenue growth, strong retention, network effects, founder-market fit. Concentrate follow-ons where traction compounds.
Cash flow planning
Assume holding periods of 7 to 12 years. Budget illiquidity and taxes. Expect DPI to lag TVPI until exits occur.
Diversifying access
Use reputable syndicates or platforms. Seek deals where you can add value to improve information flow and follow-on rights.
7) Common misconceptions
よくある誤解
- Thinking post-money equals exit value. A funding valuation is a pricing reference, not a guarantee of worth or liquidity.
- Believing pro rata is optional without cost. Maintaining ownership requires writing new checks during future rounds.
- Ignoring the option pool. Pool expansions often dilute existing holders and should be modeled explicitly.
- Assuming all preferences are the same. Participating preferred can materially reduce common proceeds at modest exits.
- Overfitting to a single success story. Portfolio outcomes typically follow a power law; one winner may drive most returns.
8) Summary
まとめ
- Ownership is investment divided by post-money, and it dilutes with new issuances and pool expansions.
- Convertibles convert at the lower of discount price or cap price; model both.
- Liquidation preferences decide who gets paid first and can dominate mid-range exits.
- Portfolio math is power-law driven; plan for many losses and a few big winners.
- Keep follow-on reserves to defend or increase stakes in outliers.
- Evaluate fund metrics with TVPI, DPI, and IRR, noting timing effects.
- Build simple models to test round mechanics, dilution, and exit proceeds before investing.
Glossary
Pre-money valuation: The value of a company immediately before new investment in a funding round.
Post-money valuation: Pre-money valuation plus the new capital invested in the round.
Dilution: Reduction in ownership percentage due to the issuance of new shares or option pool expansions.
Pro rata rights: Investor rights to buy enough shares in future rounds to maintain their ownership percentage.
SAFE: Simple Agreement for Future Equity; a convertible security that converts to equity at a future round based on agreed terms.
Convertible note: Debt that converts into equity at a later financing, often with a discount and or valuation cap.
Valuation cap: A ceiling on the company valuation used to determine the conversion price for a convertible.
Liquidation preference: Contractual priority that dictates payout order in an exit or liquidation event.
Participating preferred: Preferred shares that receive their liquidation preference and then also participate with common in remaining proceeds.
TVPI: Total Value to Paid-In; fund multiple including both realized and unrealized value.
DPI: Distributed to Paid-In; cash returned to investors divided by capital invested.
IRR: Internal rate of return; the discount rate that makes the net present value of investment cash flows equal zero.
Example
Series A invests 5 million dollars for 25 percent ownership with 1x non-participating.
Exit at 12 million dollars.
As preferred: take 5 million. As common: 25 percent of 12 million equals 3 million. The investor chooses 5 million. The remainder 7 million goes to other shareholders.
Expected value and power law
You can approximate deal expected value as probability-weighted outcomes.
Example probability tree
60 percent probability of total loss, 0x.
30 percent probability of 1x to 3x outcome, use 2x midpoint.
9 percent probability of a 5x outcome.
1 percent probability of a 50x outcome.
Expected multiple = 0.6 times 0 + 0.3 times 2 + 0.09 times 5 + 0.01 times 50 = 0 + 0.6 + 0.45 + 0.5 = 1.55x gross.
Adjust for dilution and fees to estimate net.
Fund-level metrics
TVPI: total value to paid-in = net asset value plus distributed capital divided by paid-in capital.
DPI: distributed to paid-in = cash returned divided by paid-in capital.
IRR: discount rate that makes the net present value of cash flows equal zero.
Quick IRR intuition: front-loaded losses with back-loaded wins make IRR sensitive to timing. Faster distributions lift IRR even if multiples are the same.
Your proceeds = 0.125 percent of 200 million equals 250 thousand dollars, a 12.5x gross multiple on your 20 thousand check.
