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.
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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.
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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.
FULL TRANSCRIPTION OF THE VIDEO:
Hello, everyone. This is Alejandro Cremades, and today we’re going to be talking about what is the difference between pre-money valuation and post-money valuation. There’s a lot out there in terms of what is pre-money valuation, and what is post-money valuation? But here’s the thing. The valuation itself is supercritical, especially as you’re thinking about the business itself as a founder or as an investor. In today’s video, we’re going to break it down. We’re going to give you all the insights so that by the end of the video, you’re going to have a clear understanding of what is the pre-money valuation and what is the post-money valuation, and then why the valuation itself is so important for you? So with that being said, let’s get into it.
Why are the valuations so important? The valuation is super important because it’s really that price tag. It is a way to signal to the market – obviously, the more that the business grows, the more the valuation is going to be. But, essentially, the valuation is going to send a signal to the market so that people understand what is ultimately the value of the business.
That happens again during the multiple fundraising rounds that you’re going to do. Ideally, you go from Seed to Series A to Series B to Series C and beyond. We’ve heard the different types of financing cycles, and from financing cycle to financing cycle, the valuation grows.
What that means is that the people that hold the shares of the business may hold a less amount of equity as you continue to scale up, and as you continue to mature the business. But, obviously, the more that you scale, the hope is that the valuation increases in parallel. Also, on the acquisitions is the price tag that they’re going to be giving. That is going to be buying everyone out and providing the returns and the cash for you, or the stock, and for the investors that have invested in your business.
What is the pre-money valuation? The pre-money valuation, in essence, is the value of the business before the money is injected, either from investments or perhaps from an acquisition. It is the value of that company that has been established via one of the multiple methods to establish a valuation, and that is pricing it for the next course of action to happen.
Some of those methods – traditionally, you were calculating the EBITA. There were certain multiples to it. But when you’re a hypergrowth business, or you’re looking at other things that are not as specifically related to the EBITA, you can find some of these options:
- The Berkus Method
- The Scorecard Method
- The Venture Capital Method
- The First Chicago Method
- The Risk Factor Summation
What is the post-money valuation? The post-money valuation, as the name says it, is the value of the business after that investment has come in. Basically, if we were to put it into an example, let’s say that the pre-money valuation of your business is $10 million, and you’re asking for a $2 million investment. The post-money valuation is the $10 million from the pre-money valuation with that $2 million that is being invested, and as that is resolved, you’re looking at $12 million, and that $12 million is the post-money valuation.
In terms of debt and valuation, you need to understand that typically the debt is going to be taken outside of what the valuation is. There are certain cases, for example, if you have convertible notes that are converting into equity, that could affect the post-money valuation because if we take a look at the post-money valuation example, where you have a $10 million dollar value, $2 million dollars of money that is actually invested.
If you had convertible notes, that $2 million is going to trigger those notes to convert into equity. What’s going to happen is, for example, if you have $1 million in convertible notes that had been invested before this $2 million investment, what’s going to happen is that your post-money valuation is not going to be the $12 million that we were talking about before. It’s going to be $13 million because you’re adding that $1 million as well. So, in this case, that convertible note is going to impact the post-money valuation that you’re going to have in the end.
When it comes to valuation and terms, ultimately, you want to make sure that you are not the first one talking because investors are going to ask you, “What is the value of your business? The minute that you’re talking and you are disclosing the valuation remember that they’re going to negotiate you down. They’re going to always negotiate a price under.
That’s why, even if you have a valuation that you’ve done on your business, maybe with a company that has helped you to do this like a service provider. You want to keep that number, that valuation, very tight to your vest because what you want to do is, you want to turn it around. You want to give it back to the investor, and you want to let them do the talking first because what you would do then is negotiate them up. Not the other way around. Otherwise, you’re putting yourself in a really difficult situation.
The other thing is that you need to also keep in consideration the fact that having an equity incentive pool or an equity incentive plan to pay in stock to some of your employees, via stock options, that is going to be required by the investor before you actually do the financing round. Typically, what I’m seeing now in the market – and obviously, you want to consult about this with your corporate lawyer – are equity incentive plans that go between 15% to 20%, and that’s going to be of the equity. Now, again, remember to have this in place before you go into the round of financing; otherwise, you’re going to be the bottleneck, and the last thing that you want is to really hold up on the process of getting that money in or whatever that is.
I would love to hear on the comment section below how you’re thinking about the valuation process. Again, Like this video and subscribe to the channel so that you don’t miss out on all the videos that we’re rolling out every week. And, as well, take a look at the fundraising training, which is the program where we help from A to Z with everything related to fundraising. And I find that you will really see a tremendous amount of value in it. So, thank you so much for watching.