Earlier this year, Magic Leap announced the completion of its Series D equity funding with an investment from AT&T. This followed the initial $502m and $461m Series D tranches led by Temasek and the Kingdom of Saudi Arabia's sovereign wealth fund in October 2017 and March 2018, respectively; the $793.5m Series C led by Alibaba in February 2016; the $542m Series B led by Google in October 2014; and the $50m Seed & Series A announced in February 2014. To date, the privately-held, the augmented & mixed reality start-up has raised over $2.4b in equity financing.

In October of last year, as Magic Leap was initially preparing its Series D, a Delaware regulatory filing surfaced that shed light on the company’s financing history. Flux decided to analyze the filing information to better understand Magic Leap’s capital structure. Equipped with the data, we were able to create the pro forma cap table following the Series D. In this analysis, we detail our process in creating Magic Leap’s cap table and offer some perspective on the implied results.

The first step in the analysis is to determine the fully-diluted share count across common and preferred stock, respectively. In the document, this information is presented explicitly:

The total number of shares of all classes of stock which the Corporation shall have authority to issue is (i) 254,817,996 shares of Common Stock, $0.001 par value per share (“Common Stock”) and (ii) 167,521,802 shares of Preferred Stock, $0.001 par value per share (“Preferred Stock”)

The distinction between common stock and preferred stock is an important one. Fred Wilson explains:

Almost all venture capital firms and many angel and seed investors will require the company they are investing in to issue them preferred stock. The vast majority of equity dollars invested in startups are securitized with preferred stock. So if you are an entrepreneur, it makes sense to understand preferred stock and what it means for you and your company.
Preferred stock is a class of stock that provides certain rights, privileges, and preferences to investors. Compared to common stock, which is normally held by the founders, it is a superior security.

For the purposes of this analysis, we will reasonably assume that all investors in the company hold preferred stock, whereas founders (and employees) hold common stock.

An important step here is to understand the right of preferred stock to convert its stake into common stock. Brad Feld explains:

In all the VC deals we’ve ever seen, the preferred has the right – at any time – to convert its stake into common…This allows the buyer of preferred to convert to common should he determine on a liquidation that he is better off getting paid on a pro rata common basis rather than accepting the liquidation preference and participating amount.

Thus, we will assume that of the 254,817,996 common shares authorized for issuance, exactly 167,521,802 have been reserved for the conversion of preferred stock into common stock at a 1:1 conversion ratio. This leaves 87,296,194 common shares reserved for Magic Leap’s founders, employees, and stock option pools (i.e., 254,817,996 - 167,521,802).

The next step is to understand the taxonomy of preferred stock across the various financings. Again, the document designates the various classes of preferred stock explicitly, revealing the number of shares in each series:

21,140,264 shares of the authorized Preferred Stock of the Corporation are hereby designated “Series Seed Preferred Stock”, 26,234,180 shares of the authorized Preferred Stock of the Corporation are hereby designated “Series A Preferred Stock”, 47,750,855 shares of the authorized Preferred Stock of the Corporation are hereby designated “Series B Preferred Stock”, 35,359,353 shares of the authorized Preferred Stock of the Corporation are hereby designated “Series C Preferred Stock”, and 37,037,150 shares of the authorized Preferred Stock of the Corporation are hereby designated “Series D Preferred Stock”

as well as the respective issuance prices:

The “Series Seed Original Issue Price” shall mean $0.9661 per share… The “Series A Original Issue Price” shall mean $1.1931 per share… The “Series B Original Issue Price” shall mean $11.560 per share… The “Series C Original Issue Price” shall mean $23.0330 per share… The “Series D Original Issue Price” shall mean $27.0000 per share

An important formula underpinning this analysis is the following:

capital invested = # of shares issued * price per share

Consequently:

# of shares issued = capital invested ÷ price per share

Official press releases from the company pegs the size of the Seed & Series A capital at “more than $50m”; the Series B at $542m; and the Series C at $793.5m. For the Series D, Magic Leap notes its “completion”, suggesting the entire round was filled. Recall that Temasek led the initial Series D investment in October 2017 with a $502m investment. Then, in March 2018, Magic Leap received a second Series D tranche of $461m from the sovereign wealth fund of the Kingdom of Saudi Arabia. This implies that Magic Leap's completion of its Series D with an investment from AT&T sums to $37m (i.e., $1b - $502m - $461m).

We interpret these results as follows:

Another piece of venture math underpinning this analysis is the following:

ownership acquired = shares acquired ÷ fully-diluted share count

Accordingly:

fully-diluted share count = shares acquired ÷ ownership acquired

Pitchbook places the pro forma Series A ownership at 11.05%. Assuming the Series A investor group own 26,234,180 shares, this implies the fully-diluted share count is 237,413,394 shares. This places the common share count at ~71,665,415 shares. With that, the pro forma cap table is solved:

We calculate post-money valuation with the following:

post-money valuation = capital invested ÷ ownership acquired

Hence, Magic Leap’s post-money valuation following the Series D is ~$6.4b ($1b invested ÷ 15.6% ownership acquired).

In order to fully understand Magic Leap and its position & potential in the market, it is important we define what “augmented reality” means. Benedict Evans provides a crisp overview:

What, exactly, does 'augmented reality' mean? The term often gets used for things like Pokemon Go or Snapchat lenses (or even things like location-based museum audio guides), but here I'm talking about wearing a device over your eyes, that you look through, that places things into the real world - glasses, in effect. The term mixed reality also floats around here as well, but AR will do.

So what makes augmented reality interesting and potentially lucrative? Ben Thompson sums up the opportunity neatly:

[I]t’s worth remembering that smartphones were originally conceived of as a spoke around the PC hub; it turned out, though, that by virtue of their mobility — by being useful in more places, and thus capable of augmenting more experiences — smartphones displaced the PC as the hub. Thus, when thinking about the question of what might displace the smartphone, I suspect what we today think of a “spoke” will be a good place to start. And, I’d add, it’s why platform companies like Microsoft and Google have focused on augmented, not virtual, reality, and why the mysterious Magic Leap has raised well over a billion dollars to-date; always in your vision is even more compelling than always in your pocket

It is worth acknowledging that in his analysis, Thompson is commenting specifically on the attractiveness of augmented reality relative to virtual reality. This is a salient point and one that is re-emphasized by Evans:

Where VR seems to me to be a branch off the main strand of computing, a little like games consoles were a branch off the PC, mostly, AR (augmented reality, sometimes called mixed reality) can be your main screen. It can be the next multitouch.

Evans’ allusion to “the next multitouch” suggests that AR has the potential to be a paradigm-shifting technology. He notes:

AR has the potential to be a new computing platform in a way that VR cannot - AR can be with you everywhere whereas VR needs a room, and so AR could be the next universal computing platform after mobile.

It is through this lens that we can offer some perspective on the company and its valuation. While a $6.4b valuation for a company that has yet to deliver a mainstream product to consumers may seem high on an absolute basis, this is likely balanced by the company’s audacious (and, frankly, time-consuming) goal of creating a paradigm shift in personal computing. Remember, it is because of augmented reality’s ability to – forgive the literal translation – augment current experiences that it has the potential to displace the mobile phone as the primary personal computing device. From that perspective, coupled with the belief that Magic Leap has in fact made substantial progress on its mission, perhaps the seemingly-outsized valuation is justified. And, to be fair, the personal computing company currently operating at the intersection of hardware & software in today’s dominant platform – mobile – is only the most valuable company in the world.

The incumbent technology giants have made its interests in augmented reality – whether explicit or implicit – clear. In fact, it is this allure that has likely contributed to the market’s validation and created opportunities for investors. Fred Wilson offered this perspective in light of Facebook’s $2b acquisition of Oculus in 2014. He suggested:

[T]he roadmap has been clear for the past seven years (maybe longer). The next thing was mobile. Mobile is now the last thing. And all of these big tech companies are looking for the next thing to make sure they don’t miss it..[sic] And they will pay real money (to you and me) for a call option on the next thing.
It isn’t clear if the next thing is virtual reality, the internet of things, drones, machine learning, or something else. Larry doesn’t know. Zuck doesn’t know. I don’t know. But the race is on to figure it out. Trillions of dollars of collective market capitalizations are on the line. So a couple billion here or there is chump change. Except for the people who collect that chump change for selling them an option on the next thing. It’s real money to us.
So for the next few years (I have no idea how long this search for what’s next will go on), a game to be playing is building a platform that can plausibly be the next big thing. It’s a risky game. But the payoff can be large.

Hence, Magic Leap’s valuation at each round might be justified based on a potential acquirer’s willingness to pay up for the “next big thing”. After all, if the technology is real, Magic Leap could be a valuable strategic asset to one of these companies, in which case its value may be a function of the market cap of its potential acquirer. That said, absent market leadership and millions of customers, this argument is unlikely for Magic Leap specifically.

At a more micro level, another factor to consider is the potential of a “dirty” term sheet. Bill Gurley explains:

“Dirty” or structured term sheets are proposed investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document… Examples of dirty terms include guaranteed IPO returns, ratchets, PIK Dividends, series-based M&A vetoes, and superior preferences or liquidity rights.

While we cannot be sure with the information on-hand, these financings may have been accompanied by term sheets that guaranteed certain return profiles.

Also noteworthy is the implied ownership of the common shareholders: over 30%, pro forma for the Series D. While the common remains the largest shareholder group, it is unclear whether the voting structure allows founder & CEO [and likely majority common shareholder] Rony Abovitz to maintain control of the company. Regardless, the common is sitting under a massive & growing liquidation preference stack. Brad Feld explains:

The liquidation preference determines how the pie is shared on a liquidity event.
Liquidation preferences are usually easy to understand and assess when dealing with a series A term sheet. It gets much more complicated to understand what is going on as a company matures and sells additional series of equity as understanding how liquidation preferences work between the series is often mathematically (and structurally) challenging. As with many VC-related issues, the approach to liquidation preferences among multiple series of stock varies (and is often overly complex for no apparent reason.) There are two primary approaches: (1) The follow-on investors will stack their preferences on top of each other: series B gets its preference first, then series A or (2) The series are equivalent in status (called pari passu – one of the few latin terms lawyers understand) so that series A and B share pro-ratably until the preferences are returned. Determining which approach to use is a black art which is influenced by the relative negotiating power of the investors involved, ability of the company to go elsewhere for additional financing, economic dynamics of the existing capital structure, and the phase of the moon.

The filing clearly highlights the former approach: follow-on investors stacking their preferences on top of each other. In the scenario that Magic Leap is much more valuable than it is today, these preferences are rendered irrelevant as preferred stockholders convert into common shares. On the other hand, in the case where Magic Leap fails to achieve enough success to support its current valuation, then the liquidation preferences play a critical role as the company is sold for parts (e.g., its intellectual property and other assets).

Ultimately, it is likely that Magic Leap will either be worth a lot or not very much at all. And the best venture investors are not only cognizant of this, but they actively embrace it. Chris Dixon observes:

The best VCs [sic] funds truly do exemplify the Babe Ruth effect: they swing hard, and either hit big or miss big. You can’t have grand slams without a lot of strikeouts.

Time will tell if Magic Leap can live up to its valuation. Benedict Evans offers some optimism, but notes that it is too early to say in a cogent, thought exercise:

Is AR going to be an accessory that a subset of mobile phone users have (like, say, smart watches)? Or will every small town in Brazil and Indonesia have shops selling dozens of different $50 Chinese AR glasses where today they sell Androids? (What would bandwidth cost by then?) Again, it's very early to say. But the other useful argument from the late 1990s and early 2000s was around whether everyone would have the same kind of mobile data devices, or whether some people would have what we now call smartphones but most people would have what we now call 'feature phones', on a spectrum all the way down to simple devices with no camera or colour screen. In hindsight, that was like arguing about whether everyone would have PCs or some people would stick with word processors. The logic of scale and general purpose computing meant that first the PC and then the smartphone became the single universal device - of 5bn people with a mobile phone today, 2.5-3bn have a smartphone and it is clear that the overwhelming majority of the rest will follow. So do most people stick with smartphones and some (100m? 500m? 1bn?) move on to glasses as an accessory, or is this the new universal product? Any answer to that is a leap of imagination, not analysis. But then, so was saying in 1995 that everyone on earth would have a phone.

A leap of imagination, indeed. A magic leap, if you will.

The goal in this analysis was to provide a framework in understanding the components of a capitalization structure, specifically through the lens of a company that appears to be widely misreported on & misunderstood in this regard, and subsequently offer some context through which to better comprehend the results. Hopefully, this helps demystify the mechanics of cap table math and adds some perspective on the investments supporting Magic Leap. If there are any questions, feel free to reach out.