A great place to start is to watch the TV series “Silicon Valley”. Trust us.
First up, the terms ‘pre-money’ and ‘post-money’.
Whether it’s your VC, or within your term sheet, cap table or with peers on your accelerator, everyone will be asking how these terms will directly affect your bottom line. You need to be up to scratch on what they mean, what they represent and how much impact they have on the financing of your company.
Why you need to know about these terms
‘Valuation’ will be the negotiation point between your team and your potential investors, as these chats are speculative and largely emotive and subjective. Investors will have different (usually lower) estimates of valuation than entrepreneurs. Cofounders always want a higher valuation so that they don’t ‘lose’ much once dilution kicks in. Investors want low valuations, so they ‘win’ a bigger share from their investment. Valuations impact both of these, so think carefully about what you mean by pre- and post-money, and how each phrase impacts which number…
Both terms are valuation measures of a company, but at different times.
Pre-money is the valuation of your business before an investment round. They are more common.
Post-money is the valuation of your business after an investment round. They are simpler for investors to get.
Let’s throw in an equation:
Post-money = pre-money + money received during investment
Why is post-money simpler?
In a word? It’s fixed. Post-money valuations stay the same, whereas pre-money scenarios can fluctuate due to variables such as employee share options planning (ESOP) expansion.
You and your co-founder incorporate a company, and issue 100,000 shares 50:50 between yourselves. You run a successful company and now you need more capital. An investor offers you £25,000 for shares in the company on a valuation of £100,000. Depending on whether the valuation is pre- or post-money, will influence the ownership percentages. If the £100,000 is a pre-money valuation, the company is valued at £100,000 before the investment and £125,000 afterwards. If it is a post-money valuation, the £100,00 valuation includes the £25,000 investment. In this examples, the difference in the founders’ ownership is only 5% (or 2.5% per co-founder), but this could easily escalate with the success of the business.
Following our example, the price per share (PPS) that an investor pays is determined using the following formula: PPS = pre-money valuation / fully diluted capitalisation. PPS and pre-money valuation are directly proportional, so the higher the valuation, the more an investor pays, but receives less shares for the same investment amount. With each round, this dilutes further. Investors may take part in further rounds to maintain a good percentage. Pre-money valuation and dilution of your ownership are key concerns as a founder, but remember that owning 10% of a huge pie may be more lucrative than 25% of a small pie!
Post-Money valuations rarity
Sales psychology (ooooh!) means that ‘anchoring’ is a tactic to make investors focus on the lower number, even if the end result is the same. For example, a rent for an apartment quoted as “£200 per night plus 15% taxes, 5% service fee and £20 per night government fee,” compared to “£260 per night,” at first the initial quote seems more appealing due to the lower number, but it ends up being the same total as the all-inclusive rate. Apply that to a £5m Series A round at £10m (pre-money valuation) or £15, (post-money valuation), the first is more appealing for an investor to take back to their partners. A pre-money valuation lets the post-money valuation float, and the founders could negotiate more favourable terms as part of the investment round.
I’m Pre-Revenue, Do I Need to Care?
The valuation approach is important if you have a good idea but few assets. It might not be possible to use accounting measures such as revenue or cash flow. Ask your angel community and compare your startup to other startups with similar pre-money valuations. Look for those who have successfully closed any investment rounds.
A Worthwhile Expense?
Some founders ignore any form of valuation process, and just place a pre-money valuation on their company after deciding how much of the company they’re willing to give up for the investment that they need. However, this is risky and may give potential investors an unrealistic valuation and form an opinion that you are unprepared. Investors will also consider other factors such as your target market and scalability, as well as your team!
If you want to know more, please contact us and we can point you in the right direction.