Last Updated on
February 3, 2023
By
Excedr
Most startup founders have similar goals even if their companies are wildly different. The typical founder wants to create a profitable business around a product or service that adds value to their customers’, clients’, or patients’ lives. Some founders want a business that grows over the long-term and can even eventually be taken public through an IPO or acquired by another company. However, to build for long-term growth and profitability, founders often need to seek out external funding.
Some founders will use personal wealth, bank loans, government assistance, and grants to build the startup business. All of these methods have an element in common; they do not result in the founder sharing ownership of the company with another party. But some founders will turn to external investors to obtain the cash needed to build the business.
There are numerous reasons why a company might need external funding. But, whatever the reason, founders have historically turned to angel and venture capital (VC) investors to secure business capital. Investors help the business get up and running or significantly scale and prepare for an IPO. For this reason, equity-based funding plays an essential role in many startups’ lives.
If you’re a startup founder looking to raise external funding from an angel or venture capital investor, understanding the language of valuation is essential. What does it mean when a potential VC investor is willing to make an investment based on a “pre-money valuation of $5 million” or a “post-money valuation of $8 million”?
In VC funding, pre-money and post-money valuation each represent the valuation of a company’s equity, with the difference being the timing of when the equity value is estimated. Each valuation refers to a different point in the funding timeline.
You’ll hear these two terms many times during an investment round involving a VC investor, whether it be in your term sheet, capitalization table, or during negotiations between the company founders and potential investors.
In this article, we’ll review three topics founders should understand:
We’ll start by reviewing a valuation and why it’s important, followed by a review of pre- and post-money valuations, what their differences are, and what that means for you.
Generally speaking, valuation determines the current or projected worth of an asset or company. When it comes to startup valuation, it is the process of calculating that business’s total worth at a particular point in time. Businesses change value as the technology matures, the public increases demand for the products, or as investors take equity positions in the company.
When raising an equity round, investors will provide capital in exchange for equity in the business and an influential role in the business leadership. To determine the fair amount of equity founders have to give up to an investor in exchange for funds, the startup needs to have a value. In most cases, when external funding is involved, a startup will have a pre- and post-money valuation.
Whether it’s pre- or post-money valuation, it is an essential part of any VC term sheet you will receive and is a key negotiation point during the investment round. It determines how much ownership the founder will retain, how much ownership the investor will gain, the price-per-share of the startup, and sets rules for sharing control of the company.
Founders and investors don’t always agree on valuation though. For many reasons, founders will often ask for a higher valuation. One reason is so they suffer less dilution after the investment round. In contrast, investors—particularly new investors—may want a lower valuation. What each party wants, in the end, can heavily depend on the stage of the startup. For example, existing investors, like founders, may want to see a higher valuation. This means their investment is worth more. However, if they plan to add more money, they may want the lower valuation instead. The concept follows the general advice of “buy low, sell high.”
The goal here, for both an investor or founder, is to land on an agreed valuation that will maximize the ownership percentage both parties receive or retain. However, the goals are slightly divergent, in that the founder wants to maximize the amount of funding they can get without too much dilution, and the investor wants to maximize their ownership. Valuations directly impact the percentage of the company a founder retains and what ownership percentage an investor receives.
If you want to get an idea of how angel investors think, read How to Be An Angel Investor by Paul Graham. The article covers a number of very important aspects of investing, and is an excellent source of information that I’ve relied on to deepen my own understanding of early-stage investing and its nuances and unusualness.
A pre-money valuation is the estimated value of a company before it takes on any investors. Startups that began with the founder’s own savings, or the financial support of friends and family, usually do not treat the founder or the family members as official investors. When a company raises its first round of formal financing, the founders and investors will have to determine the startup’s value using various valuation methods, taking into account various business factors and metrics.
Valuing an early-stage business can be rather difficult, especially when it’s pre-revenue. In these situations, traditional approaches that use accounting measures such as revenue, cash flow, or EBITDA (earnings before interest, taxes, depreciation, and amortization) to assign a valuation might not be relevant. Young startups don’t usually have complete financial reports or data to evaluate. Relying on metrics commonly used to evaluate established businesses might be impossible.
For example, the EBITDA formula requires you to add-up net profit, interest, taxes, depreciation, and amortization to determine a company’s EBITDA, which shows the true value of the business. Without complete figures on hand, traditional accounting or financial-based valuation methods are not reliable. We recommend at least two years of normal business operations before the EBITDA method is considered, although some companies will measure EBITDA quarterly as a standard practice.
Without hard numbers, it can feel extremely speculative valuing a pre-revenue startup. You’ll find that a combination of market forces, risk assessment, comparisons, and speculation is more commonly used to value early-stage, pre-revenue startups rather than methods that rely on revenue streams and financial records.
Approaches like the Scorecard Method, Berkus Method, Venture Capital Method, Risk-Factor Summation Method and, in some cases the Discounted Cash Flow (DCF) Analysis and Risk-Adjusted Net Present Value (NPV) Method are often cited as go-to formulas. These methods are commonly used because they rely on comparisons, future projections, product and team strength, and other factors as substitutes for hard numbers.
Startup valuation methods provide investors and founders with a numeric way to value a business that lacks traditional metrics. Understanding these methods can give you more influence when negotiating with potential investors, so make sure to study up.
Pre-money is determined before each round of financing. However, it will likely change over time. Many successful companies will grow in value as they move through each financing round, from seed to Series, A, B, C, and so on.
While a startup might be valued at a pre-money of $2MM during their seed round, that pre-money value may grow by several million when the founders decide to raise a Series A. The increase (or, possibly, decrease) depends on the performance of the startup as well as the investors’ belief in future growth of the company.
Pre-money valuation determines the ownership percentage an investor will receive for their investment and at which share price they will invest. For example, if I invest $500K in a company that has a pre-money valuation of $2MM, it means that, after the investment is included in the valuation, I’ll own 20% of the company. Some VC investors would call this a “half-on-two” investment because it is a half million dollar purchase into a two million dollar company.
[amount invested] / [pre-money] + [amount invested] = ownership %
Using the example above, my ownership percentage would look like this:
$500K / $2.5MM = 20%
Another method of calculating your startup’s pre-money valuation is based on an investor’s offer for a specific percentage of your business. It looks something like this:
This technique is useful when an investor or group of investors offer you a price for a specific equity percentage in the business.
The pre-money also establishes the startup’s price-per-share (PPS) before any investment is accepted. PPS is equal to the pre-money valuation divided by the total amount of outstanding shares, or fully diluted capitalization. That formula looks like this:
[pre-money valuation] / [fully diluted capitalization] = PPS
Let’s use the same numbers above for this next example.
Your company has a pre-money valuation of $2MM and has issued 1M outstanding shares. This means your current price-per-share is $2, or:
$2MM / 1M = $2
Recall that a corporation can authorize shares but issue them at a later time. When you receive investment funds from an investor (me, in this example), you need to issue new shares. The number of shares you issue will be determined by the investment amount and the pre-money PPS.
[investment amount] / [price-per-share] = number of new shares issued
In other words, you will issue 250,000 new shares for my investment of $500K.
$500K / $2 = 250K new shares issued
Now, your company has a total of 1.25M shares. I own 250,000 of those shares, or 20% of the company, and you own 1,000,000 shares, or 80%.
In later rounds, determining the number of shares can look complicated from a founder’s perspective. The total number of shares outstanding is calculated on a fully-diluted basis. Most of the time, this means that the total number of shares will include all outstanding common stock as well as all outstanding stock options, stock warrants, and other convertible securities (including any previously issued convertible preferred stock) as if fully converted into common stock.
Furthermore, PPS and pre-money valuation are proportional to one another.I If one goes up, so does the other. This means that the higher the pre-money valuation is, the more I, the investor, will have to pay per share, thus decreasing the amount of shares I receive for my investment as well as my ownership percentage.
The connection between price-per-share and pre-money valuation has a major impact on financing. Although the lead investor will generally have the final say, it’s important for founders to try and negotiate a desirable pre-money valuation by showing the company’s top-line revenue in the best context possible. Doing so secures a higher share price for the founder and existing shareholders, helping retain as much ownership percentage as possible while bringing in new investors.
Negotiating can be tricky. Set a pre-money valuation too high, and you may experience the consequences of a down round in the next stage of funding. A down round is a fundraising campaign that sells shares at a lower price than the previous funding round. Down rounds sometimes occur when the company is not meeting expectations or reaching specific milestones that were tied into the previous funding stage.
A post-money valuation—or post-money, as it’s often simply referred to—is a startup’s estimated value after receiving its currently-contemplated round of outside investment.
[pre-money valuation] + [amount invested] = post-money valuation
Using the previous example, if a company has a pre-money of $2M and I invest $500K in the business, then its post-money valuation is $2.5M.
$2M + $500K = $2.5M post-money valuation
This post-money valuation signals the amount of money that investors believe the company is worth at its current trajectory. In the example above, the investors believe the company is worth $2.5M when the latest investment round is included.
Just like a pre-money, one of the primary functions of a post-money is to determine the amount of ownership an investor will receive in exchange for their investment.
[amount invested] / [post-money valuation] = Ownership %
Using our example above, the ownership percentage works out to 20%, the same as our pre-money example.
$500K / $2.5M = 20%
However, if the pre-money is $1.5M instead of $2M, and my additional $500K investment brings the post-money valuation to $2M, then my equity percentage increases.
$500K / $2M = 25%
This example demonstrates how pre-money and post-money can affect the amount of equity an investor receives, and, subsequently, how much equity founders retain.
A startup’s post-money valuation will remain influential after a financing round is completed, regardless of which round it is. Each post-money valuation acts as a key indicator of the company’s performance from round to round. If the post-money valuation increases after a financing round, the startup will generally have a higher chance of attracting investors and employees in the future.
In contrast, if the post-money valuation in a new round falls below that of the previous round, it could signal to outside investors that the startup’s performance has stalled.. When this reduction in post-money valuation happens, the round is referred to as a down round. The implications of a down road are sobering. Founder and employee morale can take a serious blow and anti-dilution protection can be triggered. Investors may even “write down” the value of their holdings, which can negatively affect the startup’s ability to fundraise in the future.
If the value neither increases or decreases, and remains similar to the last round, then the round is referred to as a flat round. Whichever outcome occurs, a company’s post-money valuation can have a significant impact on its ability to raise money in the future.
You’ll often hear the terms pre- and post-money valuation used together in equity financing. But, as a founder, it helps to understand the differences between the two terms and how each idea may impact your ownership in the company.
Firstly, both terms are valuation measures of companies that differ in the timing of the valuation. Pre-money is the valuation of your business prior to an investment round, while post-money is the value of your business after an investment round. Because post-money is the value of the company after every factor has been considered, agreed upon, and added up, it is simpler for investors.
On the other hand, pre-money can be based on any number of predictions, projections, or presumptions. Various methods are used to prescribe some order to the art and chaos that is pre-revenue startup valuation. However, this doesn’t always help to demystify the process. Nonetheless, pre-money valuations are more commonly used.
The valuation of the business is mathematically fixed in a post-money calculation, compared to a system of estimates and predictions in a pre-money calculation. For example, something like an employee stock ownership plan (ESOP) expansion may affect how much equity is available making the pre-money valuation more variable.
Convertible instruments like convertible notes, Simple Agreements for Future Equity (SAFEs), and Keep It Simple Security (KISS) notes have become more and more common for seed investment. While investors often prefer straight equity, you may find yourself becoming familiar with these terms as you begin to raise a seed round. Comparing convertible notes, SAFE, and KISS is critical when you are considering your options for providing investors with equity.
Here’s an example of how these convertible instruments affect the post-money:
You are part of a founding team that has recently incorporated your business. You issue 1,000,000 shares, which are divided equally between the founding members. Let’s assume there are two founders and you split the shares equally, meaning you hold 50% of the shares and your co-founder owns the other 50%.
You’re seeing early success with the science and have strong preclinical data to support your business idea. You and your co-founder want to raise additional capital. After a number of meetings and pitches, an investor offers you $1MM for shares in the company on a valuation of $5M.
The ownership percentages of you, your co-founder, and the investor will depend on whether this $5MM valuation is pre-money or post-money. If the valuation is a pre-money valuation, then your business is valued at $5MM before the investment. If the valuation is post-money, then your business is worth $6MM.
If it is a pre-money valuation, then the investor’s ownership equals their investment divided by the post-money valuation, or $6MM:
$1MM invested / $6MM post-money = 16.7% ownership
However, if that $5MM is a post-money valuation, then the investor’s ownership percentage is 20%, or:
$1MM invested / $5MM post-money = 20% ownership
All that is to say, the amount of ownership an investor receives depends on the timing of the valuation.
Initially, the difference doesn’t look too bad to a founder. They either end up with 80% or 83.3% of the company after taking on the investment, and are able to use the funds to grow the company. However, while the difference is small now, it could represent a large sum of money later on if the company continues to be successful.
Although either valuation approach can be derived from the other, term sheets typically use pre-money value more often than post-money value. On occasion, you may see a term sheet that uses both pre- and post-money. However, it is often recommended to stick with the pre-money, as it reduces the issues that can arise when an investment amount fluctuates.
Pre- and post-money valuations are important terms used in equity financing to determine the value of a business before or after an investing round. While pre-money is the value of a startup before it receives any investment, post-money is the value after it does.
Both terms differ in timing, and this timing can alter your ownership dilution as a founder. It’s important to understand the differences between the two terms when working with angel and venture capital investors.
Having a strong understanding of your startup company value will help you negotiate your pre-money valuation. Knowing the differences between pre- and post-money will help you understand how much dilution you will experience as a founder in each equity-based financing you raise.
This article is informative and does not represent legal advice. Before raising capital through equity financing, it is best practice to speak with a lawyer experienced in startup and venture capital deals.
