Pre-Money vs Post-Money: What Founders Get Wrong

Valuation: Pre-Money vs. Post-Money

Understanding your startup’s valuation is essential when engaging with investors. The terms “pre-money” and “post-money” valuation are fundamental to any term sheet and they directly impact your ownership stake. This guide aims to simplify these concepts, offer clear explanations, practical examples, and provide advice for founders.

Definition

Valuation refers to the agreed-upon worth of your company. It’s the figure that determines how much equity investors receive for their capital.

Pre-Money Valuation: This is the value of your company before any new investment is made. It forms the basis for negotiating the price per share for new investment. It is basically how much your company is “worth” today, before the new money comes in. It not only provides the idea of how much the business is currently worth but also determines the value of each share that has been issued.

Formula: Pre-Money Valuation = Post-Money Valuation – New Investment Amount

Post-Money Valuation: This is the value of your company after the new investment has been added. It reflects the company’s updated total value, including the fresh capital. It is basically how much your company is “worth” after the new money is in the bank.

Formula: Post-Money Valuation = Investment Amount ÷ Percentage Ownership Stake the Investor Receives

So, if an investor receives 10% stake by investing $500,000, the post- money valuation simply would be $5,000,000 ($500,000/10%)

These valuations are often agreed upon during negotiations and are not necessarily a strict accounting measure of assets but rather a reflection of what investors are willing to pay for a stake in your company’s future potential.

Let’s Understand it with an Example:

Suppose an investor is investing in a tech startup. Both the investor and the founder agree at a valuation of $2 million and the investor puts in $500,000. Now, whether this valuation of $2 million is pre- money or post- money plays a very important part to determine the ownership stake of both the investor and the founder.

Now, if the $2 million valuation was pre-money, the investor’s ownership stake would be 20% ($500,000/$2,500,000) and the founder’s stake would be 80% ($2,000,000/$2,500,000).

However, if the agreed upon $2 million valuation was post money, the Investor’s ownership stake would be 25% ($500,000/$2,000,000) and the founder’s stake would be 75% ($1,500,000/$2,000,000).

Why it Matters

The distinction between pre-money and post-money valuation is crucial for several reasons:

Ownership Percentage: These valuations directly determine the percentage of your company that new investors will own. A higher pre-money valuation means you give away less equity for the same investment amount, thus diluting your ownership less.
Founder Dilution: When new capital comes in, new shares are issued, which inherently dilutes the ownership percentage of existing shareholders, including founders. Understanding pre- and post-money helps you calculate and anticipate this dilution.
Investor’s Stake: Investors often focus on the post-money valuation because it directly clarifies their exact equity stake in the company after their investment.
Future Funding Rounds: Your current valuation sets a benchmark for future funding rounds. An “up round” occurs when your pre-money valuation for a new round is higher than the previous round’s post-money valuation, signalling growth. Conversely, a “down round” (where the pre-money valuation is lower) can be challenging and further dilute existing shareholders.

Common Variations

While the core definitions remain consistent, how valuations are presented and influenced can vary:

Option Pool Creation/Refresh: Investors often require a certain percentage of the company to be set aside for future employee stock options (the “option pool”). This pool is typically “carved out” from the pre-money valuation, effectively diluting existing shareholders (including founders) before the new money comes in. Founders should negotiate whether the option pool is included in the pre-money or calculated post-money, as this significantly impacts their effective ownership.
Convertible Notes and SAFEs: In early-stage funding (pre-seed and seed), companies often raise money through convertible notes or Simple Agreements for Future Equity (SAFEs) instead of setting a precise valuation upfront. These defer the valuation decision until a future round. Investors don’t get equity immediately, but convert into equity at a later, priced funding round (when the company’s valuation is set before investment) , usually at a discount to that round’s valuation, sometimes with a valuation cap (a maximum valuation at which the convertible instrument will convert).
Negotiated vs. Formulaic: For younger companies, the pre-money valuation can be highly negotiated and somewhat arbitrary, often based on market interest, team, and idea rather than the focus on the companies’ assets. For more established companies, it might be derived from financial models or comparable company analyses.
“X on Y”: You might hear investors say “$X on $Y,” which means they are investing $X on a pre-money valuation of $Y. This implies a post-money valuation of $X + $Y.

Evolv’s Recommendations

Don’t Obsess Solely on Valuation: While a higher valuation sounds appealing, it’s just one piece of the puzzle. Overvaluing your company can deter investors or set unrealistic expectations for future performance. Focus on the overall deal terms and the long-term partnership with investors.
Understand Dilution: Always calculate your post-investment ownership percentage. A seemingly small difference in valuation can lead to significant dilution over multiple funding rounds as well as public funding rounds (for example, IPOs).
Negotiate the Option Pool: Pay close attention to how the option pool is treated. If it’s included in the pre-money valuation, it will dilute existing shareholders more. Aim to negotiate terms that minimize upfront dilution if possible.
Know Your Market: Research typical valuations for companies at your stage and in your industry. This provides a realistic benchmark for negotiations.
Focus on “Effective” Ownership: Consider factors like liquidation preferences (which determine who gets paid first in an exit event) as they can significantly impact your actual payout even with a seemingly high valuation.
Seek Experienced Counsel: Term sheets are complex. Always work with experienced legal and financial advisors who specialize in startup investments. They can help you navigate the nuances, protect your interests, and ensure you understand all implications before signing.
Balance Price and Partner: Sometimes, accepting a slightly lower valuation for a strategic investor who brings significant value (e.g., industry expertise, network, mentorship) can be more beneficial for your company’s long-term success than a higher valuation with less supportive investors.
Transparency in Assumptions: Be clear and realistic about the assumptions behind your valuation. Strategic transparency builds trust with investors.

Understanding pre-money and post-money valuations is a cornerstone of successful fundraising. By grasping these concepts and their implications, founders can negotiate more effectively and make informed decisions that shape the future of their companies.