We understand that the bedrock of any asset, physical or intangible, is its value. When startups are considering raising capital, it is essential that the economic value of the business is determined. During the valuation process for the startup, all areas of its business are usually analysed to determine its worth.
There are two kinds of valuations that are considered before the startup raises capital – pre-money valuation and post-money valuation. The pre-money valuation is the value of the company before funds are raised and the post-money valuation is the value of the company after funds are raised.
More than 50% of the negotiation between an investor and a startup is based on the agreed pre-money valuation and every side must come to an agreement on this before they proceed with the investment. Pre-money valuation also determines how much equity the investors will own in the startup based on the money they invest.
Many times, valuations are more of an art than a science. The figure is not a standard calculated amount but determined by factors like the market operated in/market size, competitors etc. As mentioned in the previous edition of this Newsletter, this is a negotiation and an interpretation determined by both parties in the room. For early-stage startups, factors like the team, the product market fit, the product, and strategic partnerships are taken into consideration and for growth-stage startups, the financial projection, market size, team, revenue and profitability stand out more.
One very standard economic technique used by founders to drive up their valuation at an early stage is demand. When a founder has more investors willing to take a deal, he can use this to his advantage. He would use this power to conclude the best deal, retain more ownership and ultimately increase the valuation of the startup.
Post-money valuations are easy to understand. They are the pre-money valuation of the company plus the equity received in the company following the funding round.
In practical terms, this leads to a situation where a startup is valued at $5M after raising $1M with a pre-money valuation of $4M. Consequently, as an early-stage startup moves into its growth phase, its valuation gets higher and previous capital raised plays a big role in valuation.
Pre-money valuation and Equity stakes
As mentioned earlier, an important part of pre-money valuations is the investor’s stake in the company.
When a company is founded, it creates a bucket of shares. with a share is a fraction of the company. The founders of the company, and any initial investors they may have, would be the initial shareholders of the company when it is set up. Subsequently, when the company decides to raise funds, the company would create new classes of shares of the incoming investors.
Take for example a situation where a company was issued 10M shares at incorporation with two founders, Founder A and B, having 5M shares each.
The pre-money valuation for the company is $6M and the investor is willing to invest $1,000,000 in the company.
Thus, it can be said that the startup is raising $1M at a $7M post-money valuation.
These investors are issued new shares whose factors depend on how much is raised and the equity it is raised for.
To determine the equity in this case, the founders have 10M shares and 100% equity. With the company has raised $1M at a $7M post-valuation, the percentage of the equity to be given to the investors would be computed as the investment divided by post-money valuation. In other words, the amount invested must equal post money x equity stake (%)
This would be reflected as $1,000,000 ÷ $7,000,000 x 100/1 = 14.28%
Now, the investors have 14.28% and the founders no longer have 100% equity but 85.72% equity among themselves.
Ideally post money valuation is pre-money plus investment raised but to determine every component of this calculation, there is another formula.
Post money valuation = Capital raised divided by equity stakes (%) x shares issued.
As a simple calculation, this formula can be used to determine each piece depending on what figures are known or unknown. It can be used to determine each chunk according to what is available.
For our above example, the new shares issued approximately 10,000 shares.
Conclusively, the investors and founders must be familiar with the factors that determine pre-money valuation according to the stage they are in and how to calculate their post-money valuation, equity stake or shares to be issued. This will ensure a clean cap table and an even more attractive investment negotiation round.