Funding rounds bring with them a complete new vocabulary and terms that business founders have to get familiar with, often in a rush. You’ll probably hear the terms “pre-money” and “post-money” often throughout a VC investment round, whether in your term sheet, capitalization table, and even during negotiations between your company and its own potential investors. As a founder, these terms are central to your important thing, so you should comprehend what they mean, what they represent, and how they impact the financing of your company.
First up, why should you find out about these terms? Valuation is a big negotiation point between you as well as your VC investor: valuation discussions are speculative, and you will be driven by market forces. Entrepreneurs and investors will often have differing estimates of valuation. Existing shareholders want a higher valuation, so they suffer less dilution following the investment round. Investors prefer a minimal valuation, to allow them to maximize the ownership percentage they receive because of their investment. Valuations directly impact the percentage of the business which existing shareholders will retain and what percentage an investor will receive for that investment. Be cautious in what you mean by using the terms pre-money and post-money, and how each phrase may support a specific number.
SO, WHAT’S THE DIFFERENCE BETWEEN PRE-MONEY AND POST-MONEY?
Both are valuation measures of companies, however they differ in the timing of the valuation. Pre-money may be the valuation of your business ahead of an investment round. Post-money may be the value of your business after an investment round. Post-money is very simple for investors, but pre-money valuations are additionally used. So, the bottom line is: post-money = pre-money + money received through the investment round.
Why are post-money valuations simpler? As the valuation of the business enterprise is fixed, whereas in a pre-money scenario, the worthiness of the business enterprise can float with variables, like, for instance, ESOP (employee Share Open plan) expansion, debt-to-equity conversions and pro-rata participation rights. Pro-rata participation rights will be the right, however, not the obligation, to purchase future rounds to keep the same ownership proportion. Convertibles -i.e. convertible loan notes, SAFE (Simple Agreement for Future Equity), KISS (Keep It Simple Security)- have become more prevalent for seed investment, and the facial skin value of the instruments are put into the postmoney valuation during investment.
Here’s a good example to illustrate this better. You as well as your co-founder add a company. The business issues 1,000,000 shares which are divided equally between your two shareholders (you possess 50% of the shares, your co-founder owns the other 50%). The business is successful and today you will need additional capital. An investor gives you US$250,000 for shares in the business on a valuation of $1,000,000. The ownership percentages of the founders and the investor depends on whether this $1,000,000 valuation is pre-money or post-money. If the $1,000,000 valuation is a pre-money valuation, the business is valued at $1,000,000 prior to the investment, and, following the investment, it’ll be valued at $1,250,000. But if this is a post-money valuation, the $1,000,000 valuation includes the $250,000 investment. In this example, the difference in the founders’ ownership is 5% (2.5% per founder), but this may represent a vast sum if the business is still successful and reaches the idea of an IPO.
Image credit: Support Legal.
HOW DOES PRE-MONEY VALUATION INFLUENCE THE INVESTMENT ROUND?
The purchase price per share (PPS) an investor can pay for shares in your company is set using the next formula: PPS = pre-money valuation / fully diluted capitalization. The PPS and pre-money valuation are directly proportional (i.e. as you rises, the other rises). So, the higher the pre-money valuation, the more an investor can pay for each share, however the investor will receive less shares for the same investment amount. Here’s an illustration again. Continuing the example above of a $1,000,000 pre-money valuation, let’s say the founders together hold 1,000,000 shares (500,000 each). You’ll then have to issue some shares to the investor. Before you obtain the investment funds, the worthiness of the shares in your company was: $1,250,000 / $1,000,000 = $1.25 per share. Upon receiving the investment funds, your company will issue new shares to the investor. The quantity of shares = investment amount / pre-money PPS.
And in this specific scenario, for the $250,000 investment, the investor will receive: $250,000 / $1.25 = 200,000 shares. The business now has 1,200,000 shares, with the founders owning 1,000,000 shares or 83.33% of the business, and the brand new investor holding 200,000 shares or 16.66% of the business. Now, if things continue steadily to go well, then, in a short time, you’ll need more capital. A fresh investor really wants to invest $750,000 at a post-money valuation of $2,500,000 (which implies a premoney valuation of $1,750,000). Using the calculations above, the PPS is currently $1.46 ($1,750,000 / 1,200,000) prior to the investment, and the business will issue 513,699 new shares to the investor ($750,000 / $1.46).
Following the investment, the business could have 1,713,699 shares, which the founders continue steadily to own 1,000,000 shares that now represent 58.35% of the company’s shares. Each capital raise reduces the founders’ ownership (i.e. it dilutes their ownership). But, the PPS is increasing every time. Investors from earlier rounds may also experience dilution with each subsequent funding round. They are able to lessen the number of dilution by taking part in each of these rounds. Pre-money valuation and dilution of your ownership are fundamental concerns as a founder. But remember, owning 10% of a big pizza could be more profitable than owning 25% of a little pizza- and frequently, you can’t build that big pizza without investors.
WHY ARE POST-MONEY VALUATIONS RARE?
Short answer: sales psychology. “Anchoring” is a tactic often found in marketing. Consumers concentrate on the low number, even if the outcome is the same. For instance, compare a hotel rate quoted as “$200 per night plus 15% taxes, 5% service fee, and $20 per night government fee,” with another quoted as “$260 per night.” The high quality, with the low number, seems more desirable, but the total is equivalent to the next all-inclusive rate. When you are trying to negotiate a $5 million Series A round at $10 million (pre-money valuation) or $15 million (post-money valuation), the pre-money number might seem more desirable for the investor to get back with their partners. Using the pre-money valuation as the anchor lets the post-money valuation float, and the founders might be able to negotiate more favorable terms within the investment round.
‘MY COMPANY IS IN THE PRE-REVENUE STAGE. WHY DO I HAVE TO KNOW THESE THINGS?’
Well, the valuation approach is specially important once you have an excellent idea but few assets. It could not be possible to use accounting measures such as for example revenue, cashflow, or EBITDA (earnings before interest, taxes, depreciation, and amortization) to aid with a valuation exercise, particularly regarding startups which are in the pre-revenue stage. We suggest seeking to the angel community, which includes developed methods that are generally utilized by early-stage companies to determine valuations. Angel investors will most likely recommend using a mixture of methods rather than counting on just one single. Where possible, discover what companies with pre-money valuations similar to your business have completed investment rounds. In the centre East, a source like MAGNiTT offers a wealth of useful market data and information to startups.
VALUATIONS COST MONEY. YOU DON’T NEED ONE?
We’ve seen some founders opting to ignore any type of valuation process, and place a premoney valuation on the company after deciding just how much of the business they are prepared to give up in trade for the investment they want. The downside to the approach is you offer an unrealistic valuation, as well as your potential investors think you are unprepared. Understand that investors may also be considering other factors associated with your company, like, for instance, your marketplace, sustainable competitive advantage over competitors, scalability etc.
SETTING UP Right: Three (Legal) Tips For Entreprene