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A pre-money valuation is a term widely used in private equity or venture capital industries, referring to the valuation of a company or asset prior to an investment or financing. If an investment adds cash to a company, the company will have different valuations before and after the investment. The pre-money valuation refers to the company's valuation before the investment.
External investors, such as venture capitalists and angel investors will use a pre-money valuation to determine how much equity to demand in return for their cash injection to an entrepreneur and his or her startup company. This is calculated on a fully diluted basis.
Usually, a company receives many rounds of financing (conventionally named Round A, Round B, Round C, etc.) rather than a big lump sum in order to decrease the risk for investors and to motivate entrepreneurs. Pre- and post-money valuation concepts apply to each round.
Shareholders of Widgets, Inc. own 100 shares, which is 100% of equity. If an investor makes a $10 million investment (Round A) into Widgets, Inc. in return for 20 newly issued shares, the implied post-money valuation is:
- $10 million * (120 / 20) = $60 million
This implies a pre-money valuation equal to the post-money valuation minus the amount of the investment. In this case, it is:
- $60 million – $10 million = $50 million
The initial shareholders dilute their ownership to 100/120 = 83.33%.
Let's assume that the same Widgets, Inc. gets the second round of financing, Round B. A new investor agrees to make a $20 million investment for 30 newly issued shares. If you follow the example above, it has 120 shares outstanding. Post-money valuation is:
- $20 million * (150 / 30) = $100 million
The pre-money valuation is:
- $100 million – $20 million = $80 million
The initial shareholders further dilute their ownership to 100/150 = 66.67%.
Upround and downround
Upround and downround are two terms associated with pre- and post-money valuations. If pre-money valuation of the upcoming round is higher than the post-money valuation of the last round, the investment is called an upround. If the reverse is the case, then the investment is called a downround. In the above example, Round B was an upround investment, for pre-money B ($80 million) was higher than was post-money A ($60 million).
A successful company usually has a series of uprounds until it is IPO-ed, sold, or merged. Downrounds are painful events for initial shareholders and founders, for they cause substantial ownership dilution and may damage the company's reputation. However, downrounds were common during the dot-com crash of 2000–2001.
- Forbes Investopedia: What's the difference between pre-money and post-money?
- Ryan Roberts: What is a Pre-money and Post-money Valuation?
- Samuel Wu: Venture Capital 101 for Startups — Valuation