Why Every Entrepreneur Must Understand the Pre and Post-Money Valuation
In the technology world, we like to ‘start high and end low.' It's a maxim that isn't always applicable in the business world, but it is often a good rule to follow when thinking of your business. The Pre-money valuation of a company tells you how much money you're getting at this moment, whereas the post-money valuation measures how much money you'd be likely to receive if left to its own devices.
It is used widely by venture capital investors, bankers, and financiers to determine the fair value of the company being purchased.
In the business world, a pre-money valuation is used to determine the value of a startup company. In other words, it's how much money you get for your shares before you start selling them on the open market. A post-money valuation considers how much money has been raised by using an initial public offering or an investor. The two terms are virtually identical, but they help you understand what's happening in your company while it's still private and what it'll be once it's public.
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What is pre-money valuation?
The pre-money valuation is the value of a company before a new investor invests. The pre-money valuation can be calculated as follows:
Initial investment amount x Share of equity/Outstanding equity
In this formula, “initial investment amount” refers to the total amount being raised by the company, and “share of equity” refers to the percentage ownership an investor will have in the company after his or her investment.
For example - If Bobby wants to invest $1 million into a company with 100 shares outstanding and he buys 1 share for $10 per share, then his ownership in this company would be 10%. This means that he will be entitled to 10% of any dividends paid out from this business at some point in time. In addition, if there were no other investors who made investments into this business beforehand (and therefore had no previous claim on profits), then Bobby would also receive 10% of any future profits generated by this business from now on until all 100 shares were purchased by someone else again later down their road toward success!
What is post-money valuation?
Post-money valuation is the value of a company after investment. This can also be called incremental value or added value since it reflects the difference between pre-money and post-money valuations.
For example: if I invest $5 million into your company, giving you $2 million in cash and $3 million in stock (i.e., ownership), then your post-money valuation would be $7 million ($2 + $2 + $3). However, this does not mean that my investment has increased your firm’s overall worth by 50%!
The key difference between pre-and post-money values lies in how much money was raised during each transaction—not unlike how mutual fund companies will tell you what percentage return they made for their clients on each investment.
How to calculate post-money valuation?
Once you know the pre-money valuation and investment amount, you can calculate the post-money valuation.
Post-money valuation = pre-money valuation + investment
Post-money valuation= Investment amount /Percent equity sold
To do this yourself, simply put the numbers in a calculator or spreadsheet.
Why do you need to understand pre-money valuation and post-money valuation?
Knowing your pre-money and post-money valuations will help you understand how much capital you are raising from investors. This information is important for both the entrepreneur and the investor.
The entrepreneur should be aware that he or she is receiving a certain number of shares at a specific price per share. If the entrepreneur wants to know how much capital he or she has raised, he or she must know what the valuation means and then calculate it based on his percentage ownership of the company (or shareholding).
The investor should understand that although an investment may look attractive on paper, it might not be as good when one accounts for dilution caused by future raises in capital or other factors such as warrants issued with stock purchases.
Examples of pre-money and post-money valuation
Pre-money valuations are the total value of a company before any investments are made. Post-money valuations are the total value after investments have been made.
As an example of a pre-money valuation, let's say you own a lemonade stand and you want to sell it for $10,000 but only have $5,000 in cash on hand. If someone offers to buy your business for $7,500 in cash and another $2,500 worth of supplies and equipment (the "post"), then they would buy your business for $9000:
Pre: 5k+2k = 7k
Post: 7200
In this example, we can see that the buyer paid less than what they would've paid in full upfront ($10k). They also didn't pay much more than what was owed ($9k vs 7200). Just like with stock options where there may be some uncertainty around whether they'll ever be exercised by employees who might leave before their vesting period ends, there could be some uncertainty around whether these investors will stay committed long enough to see all those shares fully vested.
Conclusion
If a potential investor was to offer you a post-money valuation of $3 million, it means that they will be investing $1 million in your business at the price of $2 per share. So, if you decide to go ahead with their offer, your startup's value will change from $2 million to $3 million. The important thing to note here is that these evaluations are relevant only when you're raising capital from external investors as opposed to getting funds from an internal source like friends, family, or bank loans.
Key Takeaways
The pre-money and post-money valuation give you an idea about the current value of your company, as well as how much each share owns.
Pre-money valuation is used by investors to determine the percentage of ownership they will have in the company after investing.
The pre-money valuation can be used as a way for founders and investors to agree on the value of the company before an investment is made.
Post-money valuation = Pre-money valuation +amount of new money offered by investors.