Understanding your pre-money valuation
Pre-money valuations are:
The pre-money valuation is a company’s value prior to any outside investment or financing.
Pre-money valuations are subjective and may be based on a company’s financials, comparable market exits, and the founders’ and team’s composition.
In general, the pre-money valuation determines the share price of a business and the ownership stake an investor will receive in proportion to the amount of cash invested.
Your pre-money valuation is what you believe your startup to be worth prior to raising funds.
Pre-money valuations are the key to successful VC negotiations. They form the basis for all funding rounds, and all sides must agree on the pre-money valuation for a round to move forward. For angels investing at the seed stage, understanding how VCs determine pre-money valuations can help you identify good deals from bad ones.
This guide will examine how VCs determine pre-money valuations, the math behind a pre-money valuation, and how a pre-money valuation influences an investment round.
What is a Pre-Money Valuation?
A pre-money valuation is the value of a company before a new outside investment. Pre-money valuations generally form the basis of what a VC’s share in the company is determined to be worth, based on how much they invest.
For example, if I invest £250k in a company that has a pre-money valuation of £1M, it means I own 20% of the company after the investment: £250k / 1.25m = 20%.
Because the pre-money valuation is determined before each round of financing, it will likely change over time. The pre-money valuation of a company can vary greatly depending on a number of factors, including the company’s performance, the market they operate in, and their competitors. As such, there is no one-size-fits-all rule for determining a pre-money valuation. Instead, it is often open to interpretation by both the VC and the founder.
Determining the Pre-Money Valuation
Some of the metrics investors use when proposing a pre-money valuation when financials are not readily available are as follows:
VCs are attracted to founders who have a successful track record of launching new companies and have assembled a team of smart people around them. These founders are seen as people who are able to make things happen the way they want, have a healthy respect for reality, and are relentlessly resourceful.
You’ll often hear VCs refer to a company as “the next big thing.” This is based on a comparison of the company to other more established companies in the marketplace. They’ll measure the revenue and market value of more mature companies as a gauge of a startup’s potential.
If there is high demand from investors for a particular deal, the founders can use this to their advantage to drive up the valuation of the company — thus retaining more ownership. However, if there is low demand (undersubscribed), then the investors have more power to dictate the valuation.
Pre-Money vs. Post-Money Valuations
It’s common to hear pre-money and post-money valuations used interchangeably, so it’s important to know the difference. The post-money valuation, fortunately, is simple to comprehend: it’s the pre-money valuation plus the additional capital pumped into the company during the fundraise.
Pre-Money Valuation = Investment Amount — Post-Money Valuation
So, if I had a £1m pre-money valuation and raised an extra £500k, my post-money valuation is £1.5m. Simple.
When a founder says they’re raising £500k at a £1.5 million post-money valuation, what they’re really saying is that their startup is worth £1million right now.
The post-money valuation is used to help investors understand their ownership position in a firm after they have made an investment. For example, if you invest £500k in a company with a pre-money valuation of £1 m, your equity ownership in the company is 33% (since £500k is 33% of £1.5 m).
If you invest £500k at a post-money valuation of £2 million, your ownership stake is 25% (25 percent = £500k of £2 m). Pay attention to whether the founders employ pre-money or post-money valuations, as this indicates two very different approaches to determining the value of their company, and consequently your possible ownership position.
Head over here to dive into understanding post-money valuations.
Deal Terms and Pre-Money Valuation
Many additional deal terms are influenced by pre-money valuations.
Investors generally request preferred shares in the company as a precaution against overvaluation because the pre-money valuation is open to interpretation. Preferred shares provide investors with a number of potentially valuable advantages, including a liquidation preference, participation rights, and anti-dilution protection.
Preferred shares are often more valuable than common stock held by founders and employees because of these rights.
If the founders and investors cannot agree on a pre-money valuation and there is still interest in investing, the founders may issue convertible notes to the investors. Convertible notes are a type of debt given by investors that can be converted into preferred shares during a later funding round when determining a valuation is easier.
Early-stage investors are also fond of SAFEs. When investing in a SAFE, investors usually convert at a discount or at a valuation cap when the next equity offering comes around. Read our SAFEs guide for more information.
How to Work Out the Pre-Money Value
Let’s say I want to establish a SaaS business. I decide to raise a seed round to scale the company after a year of growth. With 1 million shares outstanding, my co-founder and I own 100% of the company.
We’re looking for £1m at a £3m post-money valuation. To put it another way, the pre-money value is £2 million. As a result, each individual share of the corporation is worth £2 (£2 x 1,000,000 = 2,000,000). I’ll need to issue another 500k shares to raise another £1 million (£2 x £500k = £1 million).
This means that in exchange for an additional £1 million in funding, I’m giving up a 33% equity position in the company.
You decide to invest £500k in my company after conducting your due diligence, garnering you 250k shares. This provides you a 16.67% share in my SaaS company (£500k x £3M = 16.67%).
The Art of Pre-Money Appraisals
Because pre-money appraisals are subjective, the bargaining phase is crucial. If you negotiate well, you could find up owning a significant piece of a company with a lot of promise.
Of course, you don’t want to force founders into an unjust valuation, as this might set the tone for the rest of the relationship.
Keep in mind that when the pre-money valuation grows and larger VCs get involved, you’ll likely be diluted in subsequent funding rounds as an angel investor. This isn’t always a negative thing. The price per share rises as a company’s pre-money valuation rises.
Assume my SaaS company goes on to raise a Series A at a £9 million pre-money valuation. Assuming no further shares are issued, this means each of your 250k outstanding shares is now worth £6. To put it another way, your £500K investment is now worth £1.5 million.
Click here to get under the hood of post-money valuations.