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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 ask for 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.
There are many different methods for valuing a business, but basic formulae include:
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 new price per share will be:
- $60 million / 120 shares = $500,000 per share
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%.
Up round and down round
Up round and down round are two terms associated with pre- and post-money valuations. If the pre-money valuation of the upcoming round is higher than the post-money valuation of the last round, the investment is called an up round. If the pre-money valuation is lower than the post-money valuation of the previous round, then the investment is called a down round. In the above example, Round B was an up round investment, because pre-money B ($80 million) was higher than was post-money A ($60 million).
A successful growing company usually receives a series of up rounds until it is launched on the stock market, sold, or merged. Down rounds are painful events for initial shareholders and founders, as they cause substantial ownership dilution and may damage the company's reputation. Downrounds were common during the dot-com crash of 2000–2001.