Pre-Money Valuation Doesn’t Always Mean What You Think It Does

It’s no revelation that many Founders get overly focused on valuation while fundraising. Fred Wilson’s post on Valuation as a Scorecard makes some great points on why it’s an unhealthy metric. I want to tackle a different point. I often see Founders talking about pre-money valuations which, are fairly arbitrary and a bad tool for comparisons.

Typical comment from Founder: “Company X got a pre-money valuation of $10M, so my company should get a pre-money valuation of $10M”.

Here are a few reasons (and I’m sure I’m missing others) why that thinking is problematic:

· The size of the raise. This is a simple point that often gets lost. You’ll probably get a higher valuation if you raise a larger round. Investors typically have a target ownership percentage in mind and don’t expect you to give up majority control in your first round of financing. Thus, you’ll probably get a higher valuation if you raise $5M than you would when you raise $1M. (And no, I’m NOT suggesting that you raise the biggest round possible to drive up your valuation)

· Treatment of the option pool. Most investors will require you to reserve an option pool for stock option grants to future hires. We usually see option pools in the range of 10–15% of the total post-money capitalization. Here’s where it gets tricky: the option pool can be refreshed pre-money or post-money. When it’s refreshed pre-money, the shares are reserved before the financing round is priced and existing shareholders (i.e. the Founders if it’s your first financing) absorb all of the dilution while the investor purchases shares at a lower price per share. Alternatively, when it’s refreshed post-money both the current shareholders and new investors are diluted.

Here’s the algebra, for anyone who cares (skip ahead if you don’t like equations):

Is anyone still reading? Anyone?

· Treatment of convertible notes. Brad Feld wrote a good post on Pre-Money vs. Post-Money Confusion with Convertible Notes. There is no common consensus as to whether note conversions are factored into the pre-money valuation or assumed to convert at the closing of the equity round. It is important to clarify this point with your investors. If the pre-money includes conversion of the notes, you may be getting a far less favorable valuation than your think. I’ll spare you the algebra this time. This post from Cooley gives a pretty good overview if you’re interested.

To make this all more concrete, let’s walk through a quick example comparing two companies: Company A and Company B. The details on both are laid out below:

Note that pre-money valuations are identical. There are only two differences in the key financial terms with the two companies:

· Treatment of the note conversion

· Treatment of the option pool refresh

But, looking at how much of the company the founders own post-financing, we see a pretty significant difference:

Company B gives up an additional 10% equity despite having an identical pre-money valuation. In fact, under these terms, Company B would require an approximately $5.8M pre-money valuation to in order for the Founders to maintain the same percentage ownership as the Founders of Company A.

In short: if you focus too much on pre-money valuation you could be missing the bigger picture. As Rob Go pointed out in his Quick Post on Post-Money Valuations, more and more investors are issuing term sheets framed in terms of post-money valuation. This is a good thing. But, it’s best to look beyond just valuation and understand the whole package:

· Dilution — how much equity are you giving up?

· Structure of the round — liquidation preferences, type of security, etc.

· Qualitative factors — value added by the investors, board composition, protective provisions, etc.

The best way to understand the quantitative, economic aspect of deal terms is to build a waterfall (or payout) diagram. Looking just at the fully-diluted post-money capitalization doesn’t tell the whole story of how proceeds from an exit flow to different shareholders. It’s an important topic, so I’m going to dedicate a separate post. Stay tuned.

Update: I published an eBook called The Founder’s Guide to Venture Capital Finance that covers all of the calculations startup Founders should understand before raising money from VCs or angel investors. It includes much more detail than I can fit in a blog post and dozens of step-by-step examples. Check it out.