One of the most common factors considered when raising capital is valuation. While there are a variety of ways to calculate it, ultimately there are two just forms: pre money valuation and post money valuation. In this guide, we cover the basics: what, why and how its used, as well as the benefits and drawbacks of using pre money valuation when raising capital.
What is pre money valuation?
Pre money valuation describes the value of a startup, not including the capital that is being raised as part of the current round. The pre money valuation of a startup is used by angel investors, angel groups, angel syndicates and venture capitalists alike. While there are no hard and fast rules surrounding the use of pre or post valuation, generally speaking, as a founder you should push for pre money valuation. This is because the associated dilution with a pre money valuation is lower, so your outcome from a liquidation event would be higher.
How to calculate pre money valuation?
The basic formula for calculating pre money valuation is as follows: pre-money valuation = post-money valuation - investment amount. This is calculated on a fully diluted basis, and as such, all warrants and options issued are taken into account.
To calculate the post money valuation, take the investment amount ($) divided by the percentage of ownership that the investor receives. Alternatively, if new shares are being issued as part of the current raise, then the post money valuation = investment amount x (total outstanding shares / newly issued shares).
For example, lets say the company is raising $1M for 10% of the business. The post money valuation is $10 million = $1M / 10%.
The pre money valuation would then be $9M, or $10M - $1M.
How to determine the benchmark valuation?
Most early stage startups are pre-revenue, as such there are no applicable financial-based valuation methods. Instead, investors typically rely on the following to determine the value of the business:
- Comparable businesses. One of the easiest ways to determine how much your company is worth, is to look at other businesses that service different verticals or mature companies in your space.
- Addressable market. Rather than looking at who’s currently in the market, VCs will sometimes try to understand how big the market for your product or service really is. Typically, they’re looking for markets that are large and relatively unpenetrated.
- Founders and team. Sometimes VCs will back a company simply because it has a dynamic team. They realize that the idea might not work, but those leading the company will pivot, push through, and figure it out.
- Deal interest. If there are a ton of investors who want in on a deal, the founders have leverage and can drive up the valuation of the company.
Pre money vs post money valuation?
Whereas pre money valuation refers to the value of the company prior to the capital being invested into it, post money valuation refers to the value of the company after it receives all of the capital. While the outcome from both scenarios might seem similar, the reality is that they’re quite different. If you are fundraising and are in a position to negotiate, seek terms that leverage your pre money valuation because you’ll receive less dilution and a better outcome as a result.
To show just how drastically different the outcomes can be, let’s say company x is raising $5M at a $25M valuation. Using the post money valuation, the startup receives $5M and the venture capitalist receives 25% of the company in exchange for their investment. Using the pre money valuation, the startup receives the same $5M, but now they only have to give up 20% of the company to investors in exchange.
Assuming no new investments, that same company goes public at $100M. Using the post money valuation, the founders receive $75M. Using the pre money valuation, the founders receive $80M—a difference of nearly $5M!
Use of pre money valuation in venture capital?
Venture capitalists, like other forms of investors, want to generate returns on their capital. But unlike other types of investors, venture capitalists seek to generate 50-100x returns on one or two investments because the risk of them going to zero is high. To ensure that they receive the highest returns, VCs typically push for post money valuation, but occasionally they’ll agree to pre money valuation during competitive deals. If you are raising capital from VCs, consider pursuing term sheets that use your pre money valuation to minimize your dilution!
Pre money valuation in up rounds, flat rounds and down rounds?
While both pre money valuation and post money valuation can be used in up rounds, flat rounds and down rounds, typically investors will only agree pre money valuation in an up round. In flat or down rounds, where investors have more leverage, they’ll typically push for a post money valuation.
What other terms can pre money valuation affect?
There are a variety of other contractual provisions (terms) that pre money valuation can affect. A few of the more common are the most favored nations clause, pro rata rights, and anti-dilution protection. This is because all of these terms can be triggered based on a new round of fundraising and the current valuation cap.
How does pre-money valuation impact the financing overall?
Pre money valuation impacts financing in several ways. First, it can impact the quality and quantity of investors that you are able to attract. Second, it can impact the amount of capital that investors are willing to provide. Third, it can impact other contractual provisions from prior rounds. Lastly, it can impact the value of subsequent financing rounds, which may impact future decisions about growth.
Benefits of using pre money valuation?
- Minimizes dilution. As shown in the example above, using the pre money valuation results in less dilution to the founders and other investors in the company.
- Provides a sense of market value for your company. Having a pre money valuation can help establish a target price for future funding rounds.
- Better negotiating power. Leveraging a pre money valuation indicates that the company has a high perceived value in the market.
- Alignment of incentives. Typically investors will agree to use the pre money valuation, in exchange for other contractual provisions which align both interests long term.
Drawbacks of using pre money valuation?
- Detractant to Investors. An excessively high pre-money valuation can make it difficult to attract investors. They likely won't move forward with an investment in a startup if they feel that the risk profile is too high or that their share will end up being heavily diluted.
- Can lead to down rounds. Raising too much money, too quickly, at too high of a valuation is a recipe for disaster. Miss growth targets one quarter and you might be forced to take a down round.
- Can trigger other provisions. As mentioned above, using the pre money valuation may trigger the most favored nations clause, pro rata rights, participation rights, and anti-dilution protection among other things.
Common pitfalls to avoid when using pre money valuation?
Determining your valuation is a bit like walking on a tightrope—raising capital at too high of a valuation will detract investors and potentially set you up for a down round, while raising capital at too low of a valuation will result in excessive dilution. So how do you balance the two? Simple, avoid these common pitfalls when using pre money valuation.
- Prioritizing valuation over everything else. While your valuation is important, it isn’t the only thing you should consider. Sometimes other contractual provisions such as the most favored nations clause or anti dilution protection take precedence.
- Not being flexible w/ other terms. If investors agree to using your pre money valuation, in exchange for other contractual provisions such as a liquidation preference or pro rata rights, consider agreeing to them.