Pre-money and post-money are frequently used terms to describe the valuation of a company when raising capital. In this post, we provide an introduction to the concepts as well as explore the impact multiple rounds of funding have on the entrepreneur’s ownership stake.
The pre-money valuation of a company is simply the value of the company before an equity investment is made. The post-money valuation is the pre-money valuation plus the equity investment.
Although it might seem like a quick equation, the difference of pre-money and post-money valuations can prove critical as a business scales and receives new investors. For example, suppose you and a partner start a company. You initially issue 1,000,000 shares of stock and divide them equally between you and your partner. After some initial success, you decide you need additional capital. An investor states they are willing to invest $5 million at a post-money valuation of $15 million, giving an implied pre-money valuation of $10 million. So before you receive the investment, the original shares were worth:
To complete the transaction, you have to issue new shares to the investor. For the $5 million investment, the investor receives:
So now there are 1,500,000 shares outstanding, with you and your partner owning the original 1,000,000 shares, representing 67% of the company.
Suppose the company continues to grow and show promise. It is not long before you need additional capital. A new investor now is willing to invest $10 million at a post-money valuation of $30 million, giving an implied pre-money valuation of $20 million. Notice that the investor is willing to give a premium to the previous round — nice work! Using the same calculations, each share is worth $13.33 before the investment ($20,000,000 / 1,500,000) and the company will issue 750,000 new shares ($10,000,000 / $13.33) to this latest investor. Following this transaction, there are 2,250,000 shares outstanding with the 1,000,000 owned by you and your partner representing 44% of the company.
As you can see, each round of capital that you raise, reduces you and your partners ownership stake in the company (i.e. “dilutes”). However, each time you raise capital, the value of each of your shares is getting higher and higher (from a couple bucks to $10 per share to $13.33 per share). The outside investors from early rounds are also subjected to dilution at each subsequent round of funding. Investors can mitigate the amount of dilution they incur by participating or “playing” in each funding round. In other words, the investors who have invested previously may exercise the option to invest in subsequent rounds to maintain their equity stake.
When raising capital, pre-money valuation and the dilution of your ownership is an important issue as a business owner. Remember though, owning 10% of a huge pie can often be more lucrative than owning 50% of a small pie, and you often need outside capital to build a large pie! While this post is focused only on valuation, there are other key terms to review when raising growth capital, which will be the subject of future posts. In the meantime, great resources from around the web on these issues are FeldThoughts and Venture Hacks.