Before a company goes through any round of financing, receives any external funding, or goes public, it needs to be given a pre-money valuation or a figure determining how much money it is actually worth.
In this article, we will go through everything you need to know about a company’s pre-money valuation, how venture capitalists use it to determine whether they should be involved in it and what their investment amount will be. So, let’s get started.
Pre-money valuation refers to the valuation of a company before it has received any venture capital financing round or investment round. The purpose of this figure is to provide investors with a picture of what the current value of a specific business will be.
The pre-money valuation of a company is not a static figure. In fact, it will change before each funding round and also depend on the types of investments it is expected to receive. For example, you can do a pre-money valuation before there are any angel investors interested in it or right before a company begins trading on a public market.
How Do You Calculate a Pre-Money Valuation?
In some cases, the pre-money valuation of a company will be calculated by a potential investor. This is typically the case when someone interested in providing financing also wants to specify how much they would like in return. The company leadership can reject these pre-money valuations or investor offers, although they will usually be negotiated until all parties come to an agreement.
The most common way of calculating a pre-money valuation, though, is by using the post-money valuation. This might sound a little confusing as the terms refer to seemingly opposite ends of a process, so let’s look into it in some more detail.
Using Post-Money Valuations for Pre-Money Calculations
You can make the pre-money calculation by using the following formula:
Let’s first see how the pre and post-money valuations differ. As we mentioned, the pre-money value is the value of a company before it’s gone public or received any investments. A post-money valuation, on the other hand, is the value a company will be worth after receiving funding (though any form of capital, such as private or external sources or a public offering).
The post-money valuation will be the total of the pre-money plus the equity that will be injected into the company. Let’s see an example to illustrate this better.
A fictional shop, a restaurant, is considering going public. How would you go about calculating post-money valuation? The first thing you could do is estimate how much you think the company will be able to raise in an Initial Public Offering (IPO). If you think you could secure $10 million, then the shop would have $50 million in pre-money. If the restaurant then receives an extra $10 million from an investor, then the post-money valuation will probably be $20 million.
This figure is vital because it can help investors determine how much of the company’s equity they will receive when investing. For instance, if someone invests $250K in a company that has a pre-money valuation of $1 million, the equity will be 20%.
Metrics to Calculate Company Valuations
As we mentioned, there’s no straightforward way to determine a company’s pre-value as it’s often the result of a negotiation between the venture capitalist and the founder (based on performance, market forces, and several other important factors). However, there are some metrics that can help come up with a number; for example:
Founders and team: “Good” founders (a term coined by Paul Graham) are people who remain realistic while planning their businesses. If the founder is considered resourceful and has a successful track record of creating and launching companies, and they have a good team around them, this can help increase the pre-money valuation number considerably. After all, investgors know these people can probably back up their claims.
Comparable companies: Another good way of estimating the pre-money value is to look at other similar businesses available for the same marketplace. We often hear that a company is “the next…” (for example, the next Airbnb, the next Facebook, etc.) These other names could be used to compare revenue and evaluate a company’s potential.
Deal interest: If a deal is sought after by many investors, the founders will tend to have more leverage when determining a company’s valuation. This can drive the pre-money number up and/or, in many cases, allow the founding team to retain a more significant ownership stake.
Why Are Pre and Post-Money Valuations Important
Pre-money valuations are essential for negotiating venture capital. Mainly because all sides need to agree to it before moving any financing round forward. Angel investors need to interpret this value to separate good deals from bad deals. Other considerations will include benefits such as participation rights, liquidation preferences, and anti-dilution rights.
Both pre-money and post-money valuations will be used throughout the entire venture investment process. As we saw, they will also have an impact on which percentage of a company an investor will acquire after providing a round of funding (and what the existing stakeholders will retain).
This is why it’s essential to understand both what these terms represent and how they can be used to support a specific number. Founders will typically have optimistic expectations about this value, but there are some things you can do as a company owner to improve the figure. A common strategy is to offer venture capital firms preferred shares to bridge any valuation gaps. For example, VCs can be offered to get paid out first when a company is sold, get a better rate for their investment, or gain additional participation and anti-dilution rights.
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