Pre-Money & Post-Money Valuations

One of the many important concepts to learn when it comes to startups and raising capital in general, is the difference between pre-money and post-money valuations. You probably often read news articles talking about how a certain company raised X amount of money at a Y valuation. The easiest way to understand the difference between pre and post money valuations is through a simple example.

Let’s say I have a small clothing company that I have built from the ground up. I have been fairly successful at it and now I want to capitalize on the initial traction that I have gained and grow my business more. I decide to raise 500,000 from an investor, and use the money to hire more staff and invest in better equipment. I decide to value my current business at 1 million. This 1 million valuation is the PRE-money valuation that I have set for my company. It’s the amount that the company is worth, BEFORE successfully raising money. If say I do convince an investor to give me 500K at this valuation, my company is now worth 1M + 500K = 1.5M. As a result the investor would now own approx 33% of my company (500K/1.5M). 1.5 million will now be the POST-money valuation of my company.

In the same context, if say I decided to raise money at a 1 million POST-money valuation, the investor would now get 50% of my company. Typically when companies say they are looking to raise a certain amount of money at a certain valuation, they are talking about a pre-money valuation unless specified.

Let’s go forward with our initial example. Let’s say after successfully raising 500K at a 1M pre-money valuation (which now makes my company worth 1.5M), I was able to put the money to good use and grow my business considerably. I decide to open another office across the country and ramp up sales there. I would need 1 million for this expansion. Since the last round of funding and the growth that followed, I now decide to value my company at 3 million pre-money. So I am trying to raise 1 million at a 3 million pre-money valuation. If I am successful at this, after raising the money, my company will now have a 4 million post-money valuation. The second investor would now get a 25% share of the company (1M/4M). 25% of my share and 25% of the first investor’s share will be given to this second investor.

Let’s look at how the equity shares break down:

Before raising money, I had 100% ownership.

After 1st round:

I own 66.66%

1st investor owns 33.33%

After 2nd round:

I own approx 50% (75% of 66.66%)

1st investor owns 25% (75% of 33.33%)

2nd investor owns 25%

As you can see with every round of funding the shares of the founders and previous investors keep getting smaller. However the value of their investment keeps increasing. At first I owned 100% of a $1Million company, but after 2 rounds of funding I own 50% of a $4M company which is $2M. The first investor owned 33.33% of a $1.5M company after the first round, and owned 25% of a $4M company after the second round (His investment is now worth $1M).

There is a lot that goes into coming up with a valuation for a company. You need to be able to justify to the investor you’re trying to raise money from, why exactly your company is worth the value you are placing on it. If it is too high, you might have to negotiate and come to a valuation that works for both parties. Ideally an investor wants to see the post-money valuation of the company they invested in, to be higher after every round. There are circumstances where a company might have difficulty growing and have to raise money at a lower valuation than before in order to stay in business, in which case the value of the equity shares would be lower than before.

Keep in mind that these are not strict rules. Companies and investors work out deals that have more details attached to them, which are custom to those specific deals. Some may involve rules with regard to voting rights of investors, paying earlier investors when new money is raised, and so on. Every deal is unique, although this is a general template followed.

#Business #Entrepreneurship