The venture capital valuation of a company is critical to the success or failure of any venture capital financing round. A company’s venture capital valuation is frequently the subject of a difficult negotiation between its founders and potential investors. These figures are significant because a startup’s pre-money valuation and post-money valuation can have a significant impact on the overall success of the financing round, and capital is essential for startups and emerging companies. The terms ”pre-money value” and ”post-money value” regularly arise throughout venture investment. Let’s read more about how pre-money valuation your way to success.
What is pre-money valuation?
A pre-money valuation is the estimated value of a startup before raising a round of funding. The value of a company before any new outside investment or financing is known as the pre-money valuation. Pre-money valuations are subjective and can be based on a company’s financials, comparable market exits, and the founders’ and team’s makeup. The pre-money valuation of a startup generally determines the share price and the ownership stake an investor will receive based on the amount of capital invested.
All VC negotiations are based on pre-money valuations. They are the critical number on which all parties must agree for a funding round to proceed. Being able to interpret the pre-money valuation can help angels distinguish between good and bad deals at the seed stage and also interpret how to pick a winning startup for investment
The value of a company before a fresh outside investment is called a pre-money valuation. Pre-money valuations are used to determine how much a VC’s portion of the firm is worth based on how much they spend.
The pre-money valuation will most likely alter over time because it is set before each round of funding. There is no hard-and-fast rule for determining the pre-money valuation. It’s often up to interpretation by both the VC and the entrepreneur, depending on the company’s performance, the market they operate in, the space’s rivals, and a variety of other criteria.
How to determine pre-money valuation?
The financial indicators available to seed-stage enterprises are often limited. They haven’t even put a product on the market in certain circumstances. Pre-money value can be thought of as a negotiated figure that represents the company’s enterprise worth at a specific point in time. It’s worth noting, though, that the figure isn’t always derived from accounting metrics like sales, or free cash flow, especially in the case of early-stage companies that are pre-revenue, where this would be impossible, for more clarity on this read startup stages and investment options. Instead, it is frequently heavily negotiated, influenced by market factors, and essentially speculative. For startups, it’s important to evaluate as pre-money valuation your way to success.
So as an angel investor, there are a few metrics investors use when proposing a pre-money valuation when financials are not readily available. They are as follows:
1. Founders and team. People who make things happen the way they want them to happen, have a healthy respect for reality, and are endlessly resourceful are good founders. VCs are interested in founders that have a strong track record of launching new businesses and have put together a team of clever, efficient people to help them.
2. Deal interest. If a large number of investors are interested in a deal, the founders have power and can raise the company’s valuation, allowing them to keep greater control. However, if a sale is undersubscribed (low demand), the investors can set the company’s worth.
Difference between pre-money and post-money valuation
The distinction between a pre-money and a post-money valuation of a business boils down to timing. A company’s agreed-upon worth before it receives the next round of financing is referred to as a pre-money valuation, but its value immediately after obtaining the capital is referred to as a post-money valuation.
Importance of 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 several 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 later funding round when determining a valuation is easier.
The extent of the investors’ ownership stake in the company from their investment is also influenced by pre-money and, as a result, what percentage of the company the existing stockholders will retain.
The value of the cash obtained from a round of financing can have a significant impact on the stock value of a company at an early stage. It is for this reason that it is said so widely that a company’s value could be about to shift dramatically.
How to calculate pre-money valuation?
Remember that a company’s pre-money value occurs before it obtains any funding. However, this figure gives investors an idea of how much the company is worth at the present moment. It’s not difficult to figure out the pre-money value. It does, however, necessitate an additional step—and that is only after you’ve determined the post-money worth.
Depending on the stage of investment and how much information you have about the terms of the investment, you can calculate the pre-money valuation in several ways.
If you know how much was invested and the post-money valuation, you can easily work in reverse to determine the pre-money valuation. Here’s how it’s done:
Pre-money valuation = post-money valuation – investment amount
Let’s implement the above illustration with examples and identify pre-money valuation. In this case, the pre-money valuation is $55 million. That’s because we subtract the investment amount from the post-money valuation. Using the formula above we calculate it as:
- $60 million – $5 million = $55 million
Calculating the pre-money valuation of a company makes it easier to determine its per-share value. Check the illustration below:
Per-share value = Pre-money valuation ÷ total number of outstanding shares
Alternatively, if you know you want to raise a certain amount of money and are willing to part with a certain percentage of equity, you can easily work out the pre-money valuation:
Pre-money valuation = investment amount / percent equity sold – investment amount
- Discount Cash Flow (DCF): The discounting approach for calculating valuations uses future cash flow predictions to discount them using the present value of money. Essentially, you’re determining if a particular investment will earn you more money in the long run than keeping your money in a safe, interest-bearing savings account. If your DCF calculation yields a result higher than the suggested original investment, it will almost certainly be a good investment, provided your estimates are correct and the company’s cash flows remain stable.
- Enterprise Value to Revenue Multiple: By adding the equity value to the debts and deducting the cash, the enterprise value (EV) is derived. At first look, this seems contradictory as we are adding debt while subtracting cash. Consider how much a company would cost if you bought it fully; you’d have to buy the existing owners out of their equity and take on all obligations. These expenses would be offset by any cash on the balance sheet. The enterprise value to revenue multiple is computed by dividing the annual revenues by the enterprise value.
- Market Comparable: Investors and entrepreneurs would go to the market to indicate a fair value in the case of a pre-revenue firm where estimating revenue or cash-flow-based values is impractical.
These data can help investors and entrepreneurs arrive at a fair valuation if a competitor has recently been bought or secured funding or if several publicly-traded incumbents are trading at similar market capitalizations.
It’s vital to remember that pre-money valuation relates to the company’s overall equity value, not the share price. While acquiring additional cash will affect the equity value, the share price will remain unchanged.
Throughout the venture investment process, the term “pre-money value” is utilized. It also has the most influence on determining how much of a company an investor will get for a given investment, as well as how much of a company current stockholders will keep. As a result, investors and founders must consider what they’re saying when they use these terms, what they mean to them, and how the times might support a specific number.