Understanding the difference between pre-money and post-money valuation is important if your business is raising money from investors. When going through the valuation process the terms pre-money and post-money valuation will often be used. This post will explain what these terms mean and provide an example of the impact multiple rounds of funding will have on your ownership stake.
Previous blog posts including Is Your Business Investment Ready? have touched on business valuations. Before you begin negotiations with investors interested in buying into your business it is vital you are across the concept of pre-money and post-money valuation.
What is pre-money and post-money valuation?
“Pre-money valuation” is the agreed-upon value of your company before an equity investment is accepted. “Post-money valuation” is the pre-money valuation and the new equity investment combined.
While these concepts are very simple to understand, they have a significant impact on how your business scales and receives additional investment.
As an example, let’s say your company issues 1,000 shares between yourself and your business partner. The business is a huge success, so the decision is made to obtain additional investment so it can be scaled up.
An investor says that they are willing to invest $500,000 in your company at a post-money valuation of $1.5 million. This means your agreed-upon pre-money valuation is $1 million. If your business has a valuation of $1 million and there are already 1,000 shares distributed, then each share is now worth $1,000 (before investment).
However, to receive more investment, your business will have to issue more shares. If they are investing $500,000 at a price of $1,000 per share they will receive 500 shares. After investment has been received, there will be 1,500 shares outstanding, with you and your partner holding two-thirds of those shares.
Let’s say the company continues to grow rapidly over the next year and you require even more investment to expand into new markets. Another venture capital firm is interested in investing in your company. They are willing to give you an addition $1 million at a post-money valuation of $3 million. Notice that the pre-money valuation has now increased to $2 million, presumably because the business is more profitable and has more assets.
The shares held by you, your partner, and the first investor before the second round of investment are now worth $1,333 each (a $2 million pre-money valuation divided by 1,500 outstanding shares).
When the second investor contributes their $1 million, they will receive 750 shares at a value of $1,333 per share. There will now be 2,250 shares allocated with the founding partners holding 44.44% of the company.
You will have noticed that each additional round of capital raising will further dilute your ownership of the company. However, the value of your shares will also continue to rise as long as the business’s valuation rises. The proportion of shares that are held by the first round investor has also been diluted, which is one of the reasons why first round investors often participate in subsequent rounds of capital raising.
Although raising funds will dilute your ownership of the company, having 20% of a $50 million company is more profitable than owning 100% of a $5 million one. Smart businesses can leverage capital to grow their successful business rapidly and take it to the next level.
Valuing and selling your business is both exciting and daunting and well out of the comfort zone of most small to medium business owners and founders. Make sure you receive the right advice so that you maximise the value of the business you’ve worked so hard to create, build and grow. If you have any questions regarding selling your business and associated jargon, like pre-money and post-money valuation, please schedule a call, email or call me on 0418 697 701.