Valuation is an incredibly important yet quite complicated business concept. Even the savviest of entrepreneurs encounter some difficulty understanding valuation and the manner in which it is calculated. This is understandable given that there are various ways to come up with a business’s valuation, not to mention the fact that there are actually different types of valuation. In particular, the notion of pre-money valuation as contrasted with post-money valuation can be quite confusing. Although these types of valuation are essentially the same in that they describe a company’s overall value, they are simultaneously quite different as their impact on investors’ ownership interests varies. Here is a brief look at pre-money valuation as compared to post-money valuation and how the two similar yet not so similar valuation concepts differ.
In the simplest of terms, pre-money valuation is the financial figure used to describe the overall value of a company prior to any capital investments. This type of valuation is generally calculated by evaluating factors such as assets, liabilities, revenue, profits, and a series of other pertinent financial factors, which is often dependent upon the nature of the business and the segment of the economy in which it resides. In addition, the analysis will likely include an examination of the company’s business plan and marketing strategy, the relevant market, competitors in the space, and other external economic factors that will ultimately influence the company’s ability to grow and thrive. Of course, this is in no way an exhaustive list of the many elements that go into a valuation calculation. The important thing to keep in mind here is that this assessment is based on the company’s standing before there are any fundraising rounds.
On the other hand, post-money valuation looks at the value of a business subsequent to the investment of capital, often through some form of fundraising. With post-money valuation, an investor offers a sum of money based on a stated post-money valuation. Of course, this means that there is also an implied pre-money valuation amount inherent in that offer. The value of the shares prior to the investment is simply the pre-money valuation divided by the number of outstanding shares. However, to receive the investor’s capital, new shares must be issued. This means that the overall number of shares increases, which then dilutes the original shareholders portion of the pie.
For example, if there were initially 100 shares worth ten dollars each and an investor offers $500, then the investor will receive 50 shares ($500/$10). Then, there would be 150 outstanding shares with the original shareholders owning its 100 shares and the new investor owning its 50 shares. This means that the original shareholders portion is reduced from 100% to 67%. But, if things go well and more money is invested down the line, the value of the shares should begin to increase as well as the post-money valuation of the company. Thus, even though investors may own a smaller percentage, they do so at a higher value per share.