The VC world: Pre-Money Valuation

While not all businesses make money from the start, virtually all businesses have to spend money.  This creates a need for fundraising to cover these costs and finance future opportunities for development and growth.  There are 4 key places this money can come from:

1        Internal Financing

2.       Friends and Family

3.       Angel Funding

4.       Venture Capital and Private Equity

The first two types, internal and friends/family, are usually very straightforward investments.  Either members of the team or close friends or family members of the team invest money into the startup. The terms, if any, are usually very simple.  Unfortunately, these investments are usually small, so as a company grows and develops they must turn to Angel, Venture Capital and Private Equity financing options.  In these cases, evaluation comes into play, which is why this week's discussion will focus on your Pre-Money Valuation.

When you receive outside investment for your company, the investors receive a percentage of your company based on the value of your company at the time of investment, as well as the amount of money that was invested.  This outside investment leads to a significant portion of your ownership of your company being transferred to the investors, so your valuation is very important to all parties involved.

The easiest way to understand this is with an example. A $2 million investment on a $3 million pre-money valuation means that prior to the investment the company is evaluated by the investors to be worth $3 million since they will expect to own 40% of the company.

The post money is equivalent to the pre money in addition to the investment

Post-Money = Pre-Money + Investment

In this specific situation, if the company is attempting to raise $2 million and they would like to own 40% of the company the pre-money valuation must be at least $3 million.

The big lesion here is to have an understanding of what investment size you're looking for and how much of the company you are willing to give up, which are both correlated.

If an investment of $100 is made for 5% of the company; the company is worth $2,000. 

Valuation = (Amount Invested x 100) / Percentage Owned

Valuation = (100 x 100) / 5 = $2,000

If you have any questions about this or other topics in related to Venture Capital, please do not hesitate to comment or send me a message. I will try to work answers into future posts or answer them in the comments below. 

Ashkan Afkhami, co-founder of Greenhorn Connect, will be writing a weekly entry on a variety of different topics related to processes and insight you should know about Venture Capital as an Entrepreneur based on his experience working at the Venture Capital firm, Hercules Technology Growth Capital.