Pre-Money vs. Post-Money valuation is one of the weirdest terms you'll have to deal with
as you navigate your fundraising. It almost looks
deliberately designed to confuse you and screw you.
But it's not.
The reality is that both of these terms are important and used for different
critical calculations your business needs to run.
Let's get to it The first concept your
business needs to grasp is how shares get issued. We are accustomed to thinking of company ownership
as percentages. I'm giving 10% to this investor. The founders are keeping 30% each for themselves.
But what if a new investor comes in? Whose end does their 10% come from?
Understanding company ownership in percentages is simple,
but the reality is that's just not how things work in real life.
Splitting and distributing shares While LLCs operate on percentage ownership,
C-Corporations (the most traditional types of business structure, especially in the startup
world) work with shares of stock. When a company is founded,
it creates a bucket of shares. A share is a fraction of the company. So, yes,
you could have a company with one single share. Or three shares, which is simple but unpractical.
The problem with this approach is that it's tough to split the ownership of a company if the number
of shares is so tiny- so it's pretty standard when corporations get established that the number
of shares is set to 1,000,000 or 10,000,000. We incorporated Slidebean with 10 million shares.
Our cap table is a bit more complex than this, but for the sake of example,
let's assume that we split the company three ways: 3,333,333 shares for each one of the founders.
Well, we've found a problem here. There's a share that we can't split. Shares can't be fractional.
One solution would be just to give someone an extra share.
In the context of 10,000,000 shares- 1 share is pretty irrelevant and wouldn't be worth a lot.
Another alternative would be to establish
the company with a number of shares that's divisible by 3.
Like 9,000,000. That gives us around 3,000,000 shares for each, which is pretty good and round.
The percentage ownership is 3,000,000 divided by 9,000,000, which gives us that 33.33%.
Bringing an investor A key point to understand
here is that shares don't usually exchange hands, except if the company is getting sold.
In a typical scenario, the number of shares a partner owns will not change. Founders don't
give or sell shares to the investors. Instead, the company issues new shares when it needs to.
And that's where valuations come in. How many shares does this investor get
(and therefore, what percentage of the company do they get?).
In more traditional companies, this investment transaction is based on how much the company
is worth. The value of a company can be calculated by the assets they own, the revenue
they generate, or the EBITDA, which is earnings before taxes- or a combination of those three.
Then the term becomes very clear and straightforward:
pre-money valuation. How much is the company worth before the investor comes in?
So let's say a company is making $500,000/yr in revenue and that revenue is growing
at a steady 20% YoY, with a 25% margin, so about $125,000 in annual EBIDTA. An investor
could come in and say that the company is worth 1x or 2x revenue to them, so $1M.
If they wanted to invest, say, $250,000, based on that $1M pre-money valuation, the company's
post-money valuation would be $1,250,000. The pre-money valuation, plus the new capital.
Considering that scenario, since the investor provided $250,000 of the $1,250,000 worth of
the company, their corresponding share is 20%. That's the investment
divided by the post-money valuation. Not the pre-money valuation.
So once again, where does that 20% come from? The founders won't be selling their shares;
on the contrary, the company will be issuing new shares.
In this scenario, the company will need to issue new stock to this investor. Assuming
this company is Slidebean, with 9,000,000 shares of stock, then a basic rule of
three would tell us that if 9,000,000 should now represent 80% of the company,
then 20% of the company about 2,250,000 shares of stock.
So the company will issue 2,250,000 shares to this new investor.
After that, each of the founders will continue to hold 3,000,000 shares- but they will no longer
represent 33% of the company, since the company now has 11,250,000 issued shares of stock.
The 3,000,000 shares each founder owns now represent about 26.6% of the company. The
number of shares is the same; what changes is the percentage of equity they represent.
So once gain, pre-money valuation + investment = post-money valuation.
If you don't want to crack your head at this, our financial model has a little
funding estimation tool you can use to get this calculated. You can download it for free.
Startup Valuations In that particular example,
we used a valuation that was based on some tangible data: revenue, assets, growth.
On early and seed-stage startups, though, valuations can't be calculated based on anything,
so the whole investment and shares exchange becomes a negotiation game.
That's why you essentially see a large range of valuations that may sound unjustified.
In the end, the valuation is simply a reflection of how excited investors are about the company,
how much capital the company needs, and how much upside they expect.
If many investors want to come in, or if the company is in a very hot space,
founders might literally get competing term sheets between different investors,
pick the best valuation, or use the other term sheets to negotiate up.
Clubhouse reportedly raised a Series C round on a $4B valuation.
Pre-revenue. Their founders must be good at this.
When an investor considers what stake in the company they expect, in exchange for the risk
they are taking, they are asking themselves what will eventually happen with the company.
If this is a company that could become a unicorn and go public,
then investors might consider a smaller stake because the upside is still huge.
If on the other end, the expectation is that the company gets acquired for under $200M,
then investors need to be much more careful about these valuations.
I had a chat with Paul Silva the other day on how they value their investments at his Angel Group.
Either way, it's a negotiation on upside vs. risk,
just like the odds on your favorite gambling website.
Traditionally, a seed round will be in the range of $500K to $2M and should translate into a 10-20%
stake in the business.
Let's translate those ranges into pre-money and post-money valuations.
In the lower range, $500K for 20% of the business would mean that the entire company was valued
at $2,000,000 pre-money. Post-money, it's $2.5M, where $500K represents 20%.
On the higher range, $2M for 10% of the business would mean that the company was
valued at $18,000,000 pre-money. Post-money, it's $20,000,000- where $2M represents 10%.
As far as I've seen, investors will use either term on a term sheet,
and you just have to be careful and understand what this means.
On the $500K investment example- we saw a $2M pre-money valuation translated into a 20%
stake. If we use $2M as the post-money valuation, then the stake becomes 25% instead.
Share price The share price is not particularly relevant
at this stage- but as a reference, the share price is calculated on the pre-money valuation.
Let's go back to the Slidebean example. Again, 9,000,000 shares for the founders, $250,000
investment, and 2,250,000 shares were issued to the investors for a 20% stake in the business.
The share price for this company is estimated using the pre-money valuation, which was
$1,000,000. It's $1,000,000 divided by 9,000,000 shares, for an effective $0.11 price per share.
The investors bought 2,250,000 that were issued for them. So we can
also confirm that $250K divided by 2,250,000 holds up the same $0.11 price per share.
Share price becomes relevant when the company gets acquired
or when you are issuing stock options for your employees.
Other investment mechanisms
Valuing a company with no revenue can be too arbitrary, so other approaches to raising money,
such as convertible notes and SAFEs have been invented. We have some content around it.
On convertible notes:
Also, we did a 4-episode series on a startup story- from inception to
exit- including examples like a founder leaving to multiple rounds of funding.
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