You’ve probably read this a dozen times: X Startup raised $XM at A $XM Valuation. But what does that actually mean?
This is called pre-money valuation. According to Wikipedia, 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.
Investment / Post-Money Valuation = Ownership
So if 10M is invested into a company that is at a 95M Valuation, that means that the company (without the funds) is considered to be a 95M value alone, and the funding brings up the value to 105M – with the investors getting (10M/105M)=9.5% of the company, leaving the remainder for the existing founders, employee pools, etc.
So basically when you read articles like that, it means that the company is worth X+Y. For example, if we would say, Gjirafa.com announced a $2m investment at a $10m valuation, that means that Gjirafa is considered valued $10m and the funding raises the value of the company to 12m, with the investors getting (2m/12m)=16.7% of the company. (we don’t have the exact details on how much has the company been valued in the Series A funding).
Basic terms that will help you understand this:
Pre-Money Valuation + Capital Invested by Investor = Post-Money Valuation
Capital Invested by Investor / Post-Money Valuation = Ownership
Taking ownership into account
When you start your company you own 100% of that. If you have co-founders, you may split that pie. As you add employees, you may issue stock options. Those can represent a certain percentage of the company. While that percentage is often between 10% and 20%, it is at the discretion of the founder.
Bringing on board investors is very similar. All these terms are just various ways of determining ownership in a company.
Why does it matter?
If you sell your company for $100M and you own 100% you get $100M, at 50% you get $50M, and at 10% you get $10M. Investors play by the same math.
When an investor makes an investment they are projecting the future value of a company, calculating the desired return, and determine the required ownership for that return.
If an investor thinks a business will be sold for $500M and they are making a $10M investment with a desire for a $50M return, they need to own 10% of the company (10% times $500M). Therefore they will invest at a price that allows them to purchase 10% of the company today (a $10M investment at a $40M post-money valuation would equal 10% of the company).
Accelerators vs investment funds
Accelerators usually take between 6-9% and offer between $15,000 to $35,000. So if TechStars takes a 6% equity stake for $18,000, it’s fair to say that the quality idea/prototype is worth $300,000 when raising seed money. In accelerators by definition, you value the mentorship, access to investors, office space, legal, hosting, PR and other services.
Suppose that an investor is looking to invest in a startup. The entrepreneur and the investor both agree that the company is worth $1 million and the investor will put in $250,000.
The ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation. If the $1 million valuation is pre-money, the company is valued at $1 million before the investment and after investment will be valued at $1.25 million. If the $1 million valuation takes into consideration the $250,000 investment, it is referred to as post-money.
If a company is valued at $1 million, it is worth more if the valuation is pre-money compared to post-money because the pre-money valuation does not include the $250,000 invested. While this ends up affecting the entrepreneur’s ownership by a small percentage of 5%, it can represent millions of dollars if the company goes public.
The post-money valuation refers to a company’s valuation post-investment. For example, if a company has a pre-money valuation of $10 million and raises $2 million from new investors (for simplicity, ignoring any convertible notes or convertible securities), the post-money valuation is $12 million.
An investor who invests $2 million in that particular round of funding will measure their percentage ownership of the company as $2 million/ $12 million, or 16.67% of the company.