What is the difference between pre-money valuation and post-money valuation? How are they different for startups?
Valuations can already be a confusing and challenging element for startup founders. If you’ve started preparing for a fundraising campaign, you now also have to think about pre-money and post-money valuations.
In general, valuation can be a distraction from focusing on some of the most important parts of building and scaling a business. Yet, valuation can be a powerful tool for growing your company. They can make a big difference to you, your organization, and customers in some unexpected ways.
Here’s what you need to know…
Why Are Valuations So Important For Startup Founders?
In general, the valuation may feel like some form of validation of success to some entrepreneurs. Of course, this in itself, or the money isn’t a top priority for most hyper-successful founders. It may be an indicator you are doing other things well, but it can mean the opposite too.
When you are figuring out what is the difference between pre-money valuation and post-money valuation, keep in mind that valuation can have a variety of impacts. It can act as a theoretical benchmark against competitors. You don’t want to be far behind others in your space. One of the most overlooked is recruiting and hiring. Workers love to work for funded companies with big valuations. It is a badge of honor for them on their resumes. It can also be attractive to educated talent who you may be offering stock options to.
The same can apply to partners and vendors, manufacturers and distribution channels and well as remote service providers.
It’s important to know the difference between pre-money valuation and post-money valuation of your startup too. Note that this can be much different from how your company is valued for an acquisition or an initial public offering.
It’s important because this is what really determines the equity share that your investors will get after they close on your funding. When it comes down to fundraising keep in mind that it is all about storytelling. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
What Is Pre-Money Valuation?
When considering what is the difference between pre-money valuation and post-money valuation, note that pre-money valuation is the value an investor puts on your business prior to it receiving your next round of equity funding.
Put simply, your startup’s pre-money valuation should equal the post-money valuation, minus the amount of new capital invested in this round.
However, the math here is done in reverse. Investors calculate the post-funding valuation first, and then back out the amount of funding to determine the pre-money value to assign.
As a founding team, you and your experts may have some negotiating power here, though all basic math principles and traditional business valuation methods aside, the decision is going to rest with the investor. It is then up to you and your board to accept or reject the offer and term sheet.
You can bet there will also be more renegotiating during the deal after your initial acceptance of terms too. At least in most cases. Those tweaks and adjustments don’t go in your favor.
Traditionally businesses valuation centers on EBITDA. However, valuations and valuation methods change by round and stage of business, and often depending on the type of investor and broader economic conditions.
Common methods of valuing pre-revenue early-stage startups include:
- Berkus method
- Scorecard method
- Venture capital method
- First Chicago method
- Risk factor summation
In the video below I cover in detail pre-money valuation vs post-money valuation which may give you a better understanding of what I point out here.
What Is Post-Money Valuation?
The last important piece of what is the difference between pre-money valuation and post-money valuation, is to remember that post-money valuation is how much your startup is going to be worth immediately after the funding round is closed.
The simple calculation for post-money valuation is the amount of new money invested, divided by the percentage of ownership the investor receives.
So, if an angel investor is putting $2M into a Series A round in exchange for 25% of your company, your startup’s post-money value would be $2M divided by 25%, or $8M.
In this case, your pre-money valuation should be $6M.
Of course, common sense tells you that in the scenario of an early stage, no revenue startup, your company isn’t really worth this $6M, unless you get the funding. You are riding on an idea, and without actually getting the funding, you may have no real tangible value.
Debt & Valuations
Aside from understanding what is the difference between pre-money valuation and post-money valuation, how does debt and other traditional financing impact these valuations?
Pre-money valuations are calculated net of any debt, as when calculating net worth. However, any previous funding that was structured as debt with the ability to convert to equity during this funding round will not typically be counted as debt and taken out of your pre-money valuation.
Valuation Vs. Terms
Not that valuation isn’t important, but you’ll commonly find that experienced entrepreneurs will tell you that they would prefer to let the investor pick the price (valuation), if they can pick the terms.
The terms, details and fine print can make far more difference in the net effects, than either of your valuations.
The terms layout important factors like types of shares, clauses that come along with an investor’s preferred stock and the voting rights.
In fact, there may be some cases in which you may prefer a lower valuation over a higher one. You may not want the pressure of having to grow too fast. Such as clauses that continue to dilute your ownership the longer you wait to go public and provide an exit to investors. You may be looking at other conditions out there and want to avoid a down round when you need more capital.
Stock option pools can be another dangerous gotcha for inexperienced entrepreneurs. When investors want you to set aside a stock options pool for more hires, that is typically coming out of what is left of your share of the company. It will deplete your ownership and control even more. There can be good reasons for these pools, but make sure you are doing the full math and understand the impacts.
Hopefully this piece provided some perspective as you are looking into what is the difference between pre-money valuation and post-money valuation.