Pre-money valuation

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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.[1] 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.[2] 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.

Basic formula[edit]

There are many different methods for valuing a business, but basic formulae include:[citation needed]

Round A[edit]

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 post-money valuation of the company will be $60 million. ($10 million * (120 shares / 20 shares) = $60 million).

The pre-money valuation in this case will be $50 million ($60 million - $10 million). To calculate the value of the shares, we can divide the Post-Money Valuation by the total number of shares after the financing round. $60 million / 120 shares = $500,000 per share.

The initial shareholders dilute their ownership from 100% to 83.33%, where equity stake is calculated by dividing the number of shares owned by the total number of shares (100 shares/120 total shares).

Series A Cap table

Pre-Financing Post-Financing
# of Shares Ownership Stake (%) # of Shares Ownership Stake (%)
Owner 100 100% 100 83.33%
Series A - - 20 16.66%
Total 100 100% 120 100%

Round B[edit]

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, with 30 newly issued shares. The total of shares after Round B financing will be 150. The Post-money valuation is $20 million * (150 / 30) = $100 million.

The Pre-money valuation is equal to the Post-money valuation minus the investment amount – in this case, $80 million ( $100 million - $20 million).

Using this, we can calculate how much each share is worth by dividing the Post-money valuation by the total number of shares. $100 million / 150 shares = $666,66.66 / share

The initial shareholders further dilute their ownership to 100/150 = 66.67%.

Series B Cap table

Pre-financing Post-financing
# of Shares Ownership Stake (%) # of Shares Ownership Stake (%)
Owner 100 83.33% 100 66.67%
Series A Investor 20 16.66% 20 13.33%
Series B Investor - - 30 20%
Total 120 100% 150 100%

Note that for every financing round, this dilutes the ownership of the entrepreneur and any previous investors.

Up round and down round[edit]

Financing rounds can be categorized into three types: Up round, down round, or flat round. A financing round will be considered an up round when the share price of the round is higher than the share price before the financing round. In an up round, the post-money value will be higher than the pre-money value. If the share price of the round is lower than the share price before the financing round, this is considered a down round. In down rounds, the post-money valuation is lower than the pre-money valuation. A flat round is when the pre-money valuation and the post-money valuation do not change.

In the examples above, the Series B funding was an up- round investment because the post-money valuation ($80 million) was higher than the pre-money valuation ($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. Down rounds were common during the dot-com crash of 2000–2001.

See also[edit]

References[edit]

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