Let’s explore this deeper.
Pre-Money Valuation + Financing Proceeds = Post-Money Valuation
Often, “pre-money” and “post-money” are written in shorthand as “pre-$” and “post-$.” This means the shorthand for the above equation is:
Pre-$ Valuation + Financing Proceeds = Post-$ Valuation
Rearranging the equation to solve for Pre-$ valuation gives the following:
Pre-$ Valuation = Post-$ Valuation – Financing Proceeds
Another equation that’s important to know is:
Post-$ Valuation = Financing Proceeds / Post-Financing Ownership Percentage
This equation tells you that if you invest $200,000 in a company in exchange for 10% ownership, then the post-$ valuation of the company is $2,000,000 (= $200,000 / 10%).
Let’s walk through an example to understand this better.
Wilma and Betty, two brilliant coders, form a company FlintRubble.com which will develop software to enable businesses to seamlessly integrate different back-office software programs. They plan to offer this as Software-as-a-Service (SaaS) with a monthly user fee.
Before the company is formed and stock is issued, the company basically has no value. So in our case we’ll assume the pre-$ valuation for the company is zero. When they form FlintRubble.com they contribute $10,000 to the company in exchange for shares of common stock. Immediately after this financing (meaning post-$), the company is valued at $10,000.
Pre-$ Valuation ($0) + Financing Proceeds ($10,000) = Post-$ Valuation ($10,000)
Wilma and Betty start developing their software, and three months later they have a basic working beta version. They now need to raise money to bring on a part-time coder to help further develop the software. They approach Fred Stone, a respected angel investor, and Fred invests $100,000 for 10% of the company.
Because Fred is investing $100,000 for 10% of the company, the company post-$ valuation is $1,000,000.
Post-$ Valuation ($1 million) = Financing Proceeds ($100,000) / Post-Financing Ownership Percentage (10%)
What is the pre-$ valuation? The answer is $900,000:
Pre-$ Valuation ($900,000) = Post-$ Valuation ($1,000,000) – Financing Proceeds ($100,000)
But wait, shouldn’t the pre-$ valuation be the same as the post-$ valuation from the prior round? In other words, the company had a post-$ valuation of $10,000 immediately after the founder financing round. Shouldn’t the company’s pre-$ valuation for the angel round still be $10,000? Why is it now $900,000? The answer lies in the work the founders have done since the founder round to develop the beta version of the software. Their work has created value, and Fred Stone, the angel investor, is recognizing this value and the company’s potential by valuing the company at $1 million post-$. Fred is investing because he believes that the company has great potential which will lead to Fred receiving a strong return on his investment in the future.
So the post-$ valuation of the prior round won’t usually be the same as the pre-$ valuation of the next round. One case where the post-$ valuation of the prior round may be the same as the pre-$ valuation of the next round is when the company doesn’t grow or show progress in the time from the last round to the next round. In this case, the company may not be able to convince new investors to an increase in valuation, and the post-$ valuation of the prior round could be equal to the pre-$ valuation of the next round.
Another scenario is when the company suffers a setback. In this case, the new investors may require that the company be valued lower in this new round than in the prior round, to reflect the impact of the setback on the company’s valuation. In this situation, the post-$ valuation of the prior round may be higher than the pre-$ valuation of the next round.
Let’s do one more financing round to complete the example.
After the angel financing round, Wilma and Betty finalize the software and get their first clients. The clients are thrilled with the results, and sales start growing quickly. Wilma and Betty now need money (capital) to build out a sales and marketing team, build the back-office functions (accounting, human resources, etc.) and to grow the business. Wilma and Betty approach UtterlyAmazing Capital, a venture capital firm, and UtterlyAmazing thinks that FlintRubble.com will be a smash success. They invest $10 million in the company in exchange for 10% of the company post-financing.
Post-$ valuation is $100 million:
Post-$ Valuation ($100,000,000) = Financing Proceeds ($10,000,000) / Post-Financing Ownership Percentage (10%)
Now that we know the post-$ valuation, the pre-money valuation is $90 million:
Pre-$ Valuation ($90,000,000) = Post-$ Valuation ($100,000,000) – Financing Proceeds ($10,000,000)
Note: there are some more complex situations where the above rules may be modified. One involves refreshing of stock option plans. An investor coming in may require the company to increase the size of its option pool prior to the financing. In this situation, the above equations must be modified to account for these option pool refreshes. That’s an advanced topic and the subject for a future post.
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