Pre-money Valuation

Posted on 07. Jul, 2008 by in Graphical Examples

The first lever to understand is the pre-money valuation set on the company. Where does it come from? It is negotiated between the entrepreneur and investor (angel or venture capitalist). What is it based on? It depends on the stage the company is in, as well as the industry the company is entering.

The simplest way to understand pre-money valuation is to look at the percentage ownership the investor would receive for their investment.

The example begins with a $2M investment on a $3M pre-money valuation. This means that prior to the investment, the company is evaluated by the investors to be worth $3M. Why? Because the investors expect to own 40% of the company. The post-money valuation is the pre-money valuation plus the amount invested. Therefore, if the company is raising $2M and the investor intends to own 40% of the company after the investment the pre-money valuation must be $3M. A common misunderstanding is that the pre-money valuation is derived from a complicated evaluation of the company’s potential earnings, with a discounted cash flow analysis (DCF) of the unleveraged cash flows. The problem is that these projections are almost always wrong. In addition this would put the valuation of the company in the hands of the financial projections rather than in the hands of investors.

So, the “magic” of the pre-money valuation is based not on projections, but a combination of three factors:

  1. The percentage ownership described above. 
  2. The investor’s experience with previous investments of similarly staged companies (this is the “black-box” aspect of valuations).
  3. The competitiveness of the deal, usually reflected in the experience of the entrepreneurs. This is where “serial entrepreneurs” have a marked advantage over new entrepreneurs as they command a higher pre-money valuation.

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  • Marschnerc

    The ownership stake changes depending on how the option pool is allocated.  This model assumes no option pool

    • http://www.learnvc.com Jeff Boardman

      That is correct. We introduce pre-money by itself. If you want to see when option pools are added, check out http://learnvc.com/2008/08/option-pool-creation/ which has a similar miniature version of our product to demonstrate how this works.

  • http://www.paulbsilverman.com/blog Paul B. Silverman

    Good article. I always suggest doing multiple calculations to support investment discussions. Before even starting investor discussions I recommend doing a DCF analysis – I also like to show sensitivity so if your plan shows a 40 % CAGR do a 20% scenario – you develop an NPV range- that sends good signal to investors. I also like comparables- if possible show other deal multiples. Finally there are many business models where valuation based on number of users attracted ( think mint.com here). Sometimes you can defend this metric- I’ve done this in the analytics market. Bottom line- recommend entrepreneurs do this homework upfront to improve position, send positive signal to investors and maximize equity position

    Paul B. Silverman. Blog. moc.namrevlisbluapnull@luaP/blog.
    Follow. @globalbizmentor