The field of venture capital is replete with terminology that is detail orientated, and specific to individual business situations. Any venture capitalist worth their salt understands the basic differences between, a Bear and a Bull market. However, other more arcane verbiage must also be contended with to ensure that all parties in a deal are not only on the same page, but are also working from the same book. Pre-money and post-money valuation represent two such deal terms that must be understood prior to writing, or accepting, any cheque for investment purposes.
Understanding Pre-Money and Post-Money Valuation
Those remotely familiar with real estate are aware of the adage, “Location, location, location” when it comes to determining the ultimate value of a piece of property. For the venture capitalist, a proper understanding of the difference between pre-money and post-money valuation is based upon, “Timing, timing, timing.”
Simply stated, pre-money is the valuation of a company prior to any outside investment force, whereas post-money valuation looks at the equation after the firm has received an injection of outside capital. Is this a case of tomato vs. tomato? Not at all. The two terms have two distinctly different meanings that have have a huge impact on the bottom line of both the entrepreneur’s and investor’s ownership stake.
Simple Valuation Math
Imagine that an investor has some venture capital to invest in a business, and is looking to determine what type of ownership stake that their investment will buy. As such, an investor and the entrepreneur in a new start up determines that the actual value of the company is $100,000, and the investor is willing to invest $25,000 in the company. Whether the investor’s $25,000 investment is pre-money or post-money, the resultant ownership stake can vary widely.
If the total valuation of $100,000 represents pre-money, the addition of $25,000 would boost the company’s valuation to $125,000. Of that, 80% of that valuation would represent the entrepreneur’s ownership stake, while the venture capitalist would hold one fifth, or 20%.
Conversely, if the company’s valuation is $100,000 after the injection of outside financing, otherwise known as post-money, then one would see a larger ownership stake (percentage) for the investor. In this case, the venture capitalist’s $25,000 would result in a 25% ownership stake while the entrepreneur would retain three-quarters, or 75% of the valuation ownership.
Does 5% matter? Absolutely. It may not seem like much at first, but depending on the share rights attached, it can make a huge difference. We’ll get to the rights in future parts of this series, but of key immediate interest should be participation rights, and preferences.