How valuation works: pre-money vs. post-money valuation

If you’ve ever watched CNBC’s Shark Tank, you’re probably familiar with the word “valuation.” One of the most entertaining parts of the show is when one of the sharks flips their lid after hearing an outlandish valuation pitched by one of the show’s entrepreneurs.

There’s a good reason the sharks get so worked up about all this: the higher a company’s valuation is, the more expensive it gets to buy a stake in the business.

Let’s dig into what this important metric is and how it affects an angel investor’s upside potential.

Where do valuations come from?

Entrepreneurs and investors each use their own unique methods to value a startup.  

When entrepreneurs assess their startup’s worth, they typically start by taking inventory of their assets, including the value of what they would be worth if they had to liquidate. While this approach is a solid one, it isn’t a reliable indication of profitability.

The most common way entrepreneurs arrive at a valuation is by comparing their business to competitors. This “market-value approach” works best for companies with limited assets.

In comparison, venture capitalists take a more pragmatic approach to valuing startups. Many VCs live by the saying that valuing startups is “more art than science.” What they mean by this is that it is hard to value something that hasn’t yet proven itself through concrete numbers (i.e., revenue; profits). 

Without this critical information, VCs may rely on other, less-precise methods to arrive at a number they are comfortable with. Such methods include:

• Cost-to-duplicate; 

• Market multiple;

• Discounted cash flow (“DCF”), and

• Valuation by stage

Now that we have discussed the genesis of valuations, the next step is to learn the difference between the two types one frequently encounters when building a portfolio:: pre-money and post-money. 

Knowledge of the two is important because their values will potentially impact an investor’s price per share.

Here’s what you need to know…

What is pre-money valuation?

The pre-money valuation is what the investor is valuing the company at today, prior to the investment.

The price per share and pre-money valuation run in the same direction (i.e., if one goes up, so does the other). The higher the pre-money valuation, the more an investor will potentially pay per share.

Example:

XYZ Venture Capital plans to invest $2.5 million into ABC & Co. based on a pre-money valuation of $10 million.

In this example, the pre-money valuation is $10 million. This represents what XYZ and ABC & Co. have agreed the company is worth right before XYZ’s new investment.

It’s important to note that the number is not necessarily derived from precise accounting methods that involve balance sheet items like revenue, free cash flow, or EBITDA. 

We’re talking about private companies here—not public—so specific information like the aforementioned is largely inaccessible (especially for early-stage companies that are pre-revenue). In most cases, the valuation is often arrived at through negotiations between the investors and founders.

What is post-money valuation?

The post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount.

Here’s a hypothetical example to illustrate how it works:

Let’s say venture capital firm “XYZ” invests $2.5 million into an early-stage company, “ABC & Co.”, with a pre-money valuation of $10 million. 

In this example, the pre-money valuation ($10M) is combined with the VC investment ($2.5 million) to arrive at the post-money valuation of $12.5M.

Calculating ownership percentages by valuation 

The ownership percentages will depend on whether the valuation is pre-money or post-money. If the $10 million valuation is pre-money, the company is valued at $10 million before the investment. After (post) the investment, the company will be valued at $12.5 million.

Pre-money valuation

Post-money valuation

As the tables demonstrate, the valuation method used can affect the ownership percentages greatly. If a company is valued at $10 million, it is worth more to the business owner (entrepreneur) in the pre-money stage than in the post-money stage. The reason for this is that the pre-money valuation does not include the $2.5 million contemplated investment.

The second table conveys the difference in potential ownership for an investment made at the pre-money versus post-money stage. By subtracting the $2.5M investment from the valuation, the investor gains 5% ownership, while the entrepreneur gives up the same.

While this may not seem like a big deal at first, it could mean millions of dollars down the road if the company goes public.

Which type of valuation is used more often?

Most term sheets tend to employ pre-money valuations more than post-money valuations (sometimes both). The usage of the two words might occasionally conflict with one another, so it may be worthwhile to keep in mind both valuations when evaluating an early-stage company.

You will frequently come across both pre-money and post-money valuations while you research and build your startup portfolio. It’s important to learn their differences because they will determine the percentage of a company you will own.

Luckily for you, you won’t have to worry about negotiating (or even calculating) any offerings on Republic. Our diligence team vets all deals for you. 

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