I recently had an e-mail correspondence with a first-time entrepreneur about valuation. They requested pre-money of north of $100m, and I fell out of my seat. Luckily, our floors are carpeted, so it didnâ€™t hurt much. But after many e-mails (note to self, I should have just picked up the phone) it became apparent that we werenâ€™t on the same page, and the entrepreneur didnâ€™t understand what I meant about valuation for investing purposes.
So what is valuation? Itâ€™s simply what a company is worth before and after financing.
Why is it important? Well, it impacts the cap table, which impacts what everyone involved owns, impacting how much one could potentially make one day, impacting oneâ€™s returns, impacting oneâ€™s motivation. I think you get the point – its impacts a heck of a lot.
So now to define some important terms and provide some color into the mechanics.
Pre-Money: This is the value of the company at the current moment, ahead of the close of a funding round.
The math formulas we were taught (i.e. the science) in school donâ€™t work here, as generally there is no revenue or substantial assets to base them on. Using financial formulas would lead to a valuation of $0 or close to it, so that doesnâ€™t work for anyone.
So if we cant determine a pre-money based on science, we need art. The bad news is that art is abstract, and in this case, a balancing act of the needs of the many parties involved. Here are some of them:
- Ensuring the founders / team have enough ownership now and in the future to be incentivized correctly; if not, the likelihood for success reduces dramatically.
- Ensuring the investors have the ownership level they need to properly generate the returns to support their investment thesis (there will be a future blog post on this).
- Setting it to the correct level, which will help facilitate a future financing round that doesnâ€™t set the company up for a downround.
- What the ownership will look like for all parties after future rounds.
As a rule of thumb, you generally should expect to give up between 20% – 45% of the company in each round of early financing, regardless of the amount raised. Now, there are outliers to the rule (i.e. Twitter/Facebook/your company) but these are exceptions, not the norm. Further, there are always other terms (i.e. liquidation preference) that also have impacts on returns, ownership, etc.
Post-Money: This is the value of the company after the financing. This is equal to the pre-money valuation + total amount raised or the total number of shares in the company times the purchase price per share.
So why does this matter? Well, it determines how much everyone owns. To figure out dilution to the current owners (founders and any existing shareholders), divide the amount invested by the post money valuation and multiply by 100.
Amount Raising $2m
Pre-Money Valuation: $4m
Post-Money Valuation: $4m + $2m = $6m
Ownership to Investors: ($2m / $6m) * 100 = 33.3% (this is the dilution to current owners)
Ownership to Founders / Existing Owners: 100% – 33.3% = 66.6%
An Important Note about Convertible Debt
In a future post, I will explore more about convertible debt (both the pros and cons), but I wanted to quickly explain how it impacts the cap table. If you have convertible debt that is converting as part of this round, it needs to be included in the money raised and the post-money valuation, even though it’s not new money. Using the above example, lets say the company had $1m in convertible debt, here is what the thing looks like.
Amount Raising $2m
Convertible Debt $1m
Pre-Money Valuation: $4m
Post-Money Valuation: $4m + $3m = $7m
Ownership to Investors: ($3m / $7m) * 100 = 42.8% (this is also the dilution to existing owners
Ownership to Founders / Existing Owners: 100% – 42.8% = 57.2%
The important thing to look at here is where the breakout of the 42.8% goes. New money receives 28.5% of the company and convertible holders receive 14.3% of the company. (To make things easy, I have left out interest / discounts on convertible; though this only exacerbates the situation). Now, the new money $2m receives significantly less of the company due to the convertible debt (28.5% vs. 33.3%). The takeaway lesson here is to be careful about convertible debt and donâ€™t take so much of it in that it impacts your ability to do a future round of financing. My rule of thumb is that existing convertible debt shouldnâ€™t exceed 25% of the new money coming in so that it doesnâ€™t have a huge impact on new money.
We’re looking forward to comments / questions / criticisms about this and all posts.