All VC agreements are based on pre-money values. They are the critical number on which all parties must agree in order for a funding round to proceed. Being able to evaluate the pre-money valuation can assist angels in distinguishing between good and bad acquisitions at the seed stage. This post will explain what a pre-money valuation is and how to calculate it. We’ll also discuss the pre vs post money valuation.
What Is Pre-Money Valuation?
A pre-money valuation is a company’s value before it goes public or receives other investments such as external financing. Simply put, a company’s pre-money valuation is the amount of money it is worth before any investment is made in it. The word, sometimes known as “pre-money,” is frequently used by venture capitalists and other investors who aren’t immediately involved in a company. This statistic enables them to calculate their share in the company based on how much they invest.
Understanding Pre-Money Valuation
A company’s pre-money valuation is its value prior to any rounds of financing, and it provides investors with an idea of the company’s existing value. However, it is not a fixed figure and can change. This is because the valuation is decided before each round of financing, whether private or public. Pre-money can be calculated shortly before a firm goes public. You can also utilize this valuation before investing in a firm with seed, angel, or venture capital.
The pre-money valuation could be a figure given by a possible investor. The figure might then be used to determine how much funding they will supply and how much ownership they expect in return. The company’s leadership may reject pre-valuations proposed by others until they achieve a value that matches the company’s ambitions.
It is relatively simple to calculate a company’s pre-money valuation. You do, however, need to understand the post-money valuation, which we’ll explain later. The basic formula to calculate pre-money valuation is as follows:
Pre-Money Valuation = Post-Money Valuation – Investment Amount
So, a company with a post-money valuation of $20 million after receiving a $3 million investment has a pre-money valuation of $17 million.
Important Notes
Early-stage prices may also correspond to the company’s being pre-revenue, which means it has yet to make any sales. This could be because it does not yet have a product on the market. Investors can still assess the company’s worth based on a range of different variables. Comparable firms could be one such measure. The revenue and market value of more established, mature companies with a comparable focus and operational approach can be used to determine the potential of pre-money companies.
Even if pre-money enterprises claim to be inventing an altogether new market with wholly new business strategies, their prospects will almost certainly be cast in the mold of a previous business. For example, if a new firm intends to manufacture a new type of automated vacuum cleaner, its pre-money valuation may be determined in part by analyzing the success of other manufacturers of robot vacuums. Other elements that may contribute to this valuation include the founders’ and leaders’ experience and track record, the feasibility of delivering on promised services, and any potential competition.
When discussing pre-money, venture capitalists and entrepreneurs must be careful not to fall into the trap of counting their chickens before the eggs hatch, or, in other words, spending money they don’t have.
When discussing pre-money valuations, investors should take care not to spend money they don’t have.
How to Calculate the Pre-Money Valuation
Assume I establish a business selling widgets. After a year of expansion, I decided to raise a seed round to scale the company. With 1 million shares outstanding, my co-founder and I own 100% of the company.
We’re looking for $1 million at a $3 million post-money valuation. To put it another way, the pre-money valuation is $2 million. As a result, each individual share of the corporation is worth $2 ($2 x 1,000,000 = 2,000,000). To raise another $1 million, I’ll need to issue an extra 500k shares ($2 x $500k = $1 million).
This means I’m giving up a 33 percent stake in the company in exchange for an extra $1 million in funding.
You decide to invest $500k in my company after conducting your due diligence, earning you 250k shares. This provides you with a 16.67% ownership stake in my widget company ($500k $3M = 16.67%).
Pre-Money vs Post-Money Valuation
Both pre-money and post-money valuation measures of companies are important in assessing how much a company is worth.
Post-money valuation differs from pre-money valuation in that it reveals how much a firm is worth after it receives an investment. This includes any amount of funds raised, whether through a public offering or through private, external sources. The post-money valuation is the sum of the pre-money valuation and the additional stock injected into the company. So, if a company’s pre-money valuation is $25 million and it receives $5 million from an investor, the post-money valuation is $30 million. This is an essential metric since it allows investors to determine how much stock they own after investing in a company.
Pre Money vs Post Money Valuation: The Difference
We’ll use an example to demonstrate the distinction. Assume an investor wants to invest in a tech startup. Both the entrepreneur and the investor agree that the company is worth a million dollars, and the investor will contribute $250,000.
The ownership percentages will differ depending on whether this is a $1 million pre-money or post-money valuation. If the $1 million valuations are pre-money, the company is valued at $1 million before the investment and $1.25 million after the investment. If the $1 million valuation includes the $250,000 investment, it is referred to as post-money.
As you can see, the valuation method used has a significant impact on ownership percentages. This is related to the amount of value assigned to the company prior to investment. If a company is valued at $1 million, the pre-money valuation is greater than the post-money valuation because it does not include the $250,000 invested. While this only affects the entrepreneur’s ownership by a fraction of a percent, it can amount to millions of dollars if the firm goes public.
In such circumstances, determining the true value of the company is extremely difficult, and valuation becomes a point of contention between the entrepreneur and the venture capitalist.
Post vs. Pre Money Valuation: How to Calculate Them
Calculating Post-Money Valuation
The post-money valuation is relatively simple to calculate. To accomplish so, use the following formula:
Post-money valuation = Investment dollar amount % investor receives
So, if a $3 million investment returns 10%, the post-money valuation is $30 million:
30% of $3 million = $30 million
But remember one thing. This does not imply that the company is worth $30 million before receiving a $3 million investment. Why? That’s simple. This is because the balance sheet only reflects a $3 million cash increase, enhancing its value by the same amount.
When an entrepreneur has a good idea but little assets, the distinction between pre-money and post-money becomes critical.
Calculating Pre-Money Valuation
Remember, a company’s pre-money valuation occurs before it obtains any funding. However, this amount provides investors with an idea of how much the company would be worth today. It is not difficult to compute the pre-money valuation. However, one further step must be completed after determining the post-money valuation. This is how you do it:
Pre-money valuation = post-money valuation – investment amount
Let’s utilize the previous example to demonstrate this. In this example, the pre-money valuation is $27 million. This is because we deduct the investment amount from the post-money valuation. Using the given formula, we get:
$30 million minus $3 million equals $27 million.
Knowing a company’s pre-money valuation makes determining its per-share value easier. You’ll need to do the following to accomplish this:
Per-share value = pre-money valuation total number of outstanding shares
Example of Pre-Money Valuation
Assume Sam’s Coffee Shop is considering going public. The owner presents the company proposal with the intention of recruiting potential investors. If management and venture capitalists believe the firm will raise $100 million in its initial public offering (IPO), the company is said to have $100 million in pre-money.
Pre-Money Valuation and Transaction Terms
Pre-money valuations influence many additional deal terms.
Because this valuation is open to interpretation, investors often desire preferred shares in the company as a hedge against overvaluation. Preferred shares provide investors with a number of potentially valuable advantages, including a liquidation preference, participation rights, and anti-dilution rights.
Preferred shares are often more valuable than common stock held by founders and employees because of these rights.
If the founders and investors cannot agree on a pre-money valuation and there is still investment interest, the founders may offer convertible notes to investors. Convertible notes are essentially loans given by investors that can be converted to preferred shares at subsequent funding round when a valuation may be easier to determine.
Early-stage investors like SAFEs as well. With a SAFE, investors typically convert at a discount or valuation cap at the next equity financing.
The Art of Pre-Money Valuation
Because pre-money appraisals are subjective, the bargaining phase is critical. If you negotiate properly, you could find up controlling a significant share of a company with huge potential.
Of course, you don’t want to force founders into an unjust valuation, as this might set the tone for the rest of the relationship.
As an angel investor, keep in mind that your stake is likely to be eroded in subsequent investment rounds as the pre-money valuation rises and larger VCs become involved. This isn’t always a terrible thing. As a company’s pre-money valuation rises, so does its share price.
Assume my widget company raised a Series A round at a pre-money valuation of $9 million. Assuming no additional shares are created, your 250k outstanding shares are now worth $6 each. In other words, your $500K investment is now worth $1.5M.
In Conclusion,
The value of a company before any fresh outside investment or financing is known as its “pre-money valuation.” They are subjective and might be based on a company’s financials, comparable market exits, and the founders’ and team’s makeup. Furthermore, this valuation often sets the share price of a firm as well as the ownership stake an investor would receive based on the amount of capital invested.
Frequently Asked Questions
How is pre money valuation calculated?
Pre-money valuation is calculated by removing the investment amount from the post-money valuation.
Pre-money valuation=post money valuation – investment amount
Is debt included in pre money valuation?
Debt is usually not included in the pre-money valuation
