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Pre-money valuations form the basis of all VC negotiations. They’re the key number all sides must agree upon for a funding round to move forward. For angels investing at the seed stage, being able to interpret the pre-money valuation can help you separate good deals from the bad ones.
This guide will examine how VCs determine pre-money valuations, the math behind a pre-money valuation, and how a pre-money valuation influences an investment round.
But first, let’s explain just what pre-money valuation means.
A pre-money valuation is the value of a company before a new outside investment. Pre-money valuations generally form the basis of what a VC’s share in the company is determined to be worth, based on how much they invest.
If I invest $250k in a company that has a pre-money valuation of $1M, it means I own 20% of the company after the investment: $250k / 1.25M = 20%.
Because the pre-money valuation is determined before each round of financing, it will likely change over time. So a company may have a pre-money valuation at seed that’s $3M, but after it’s grown, its Series A pre-money valuation may be $9M.
There’s no hard-and-fast rule around how the pre-money valuation is determined. Often, it’s open to interpretation by both the VC and founder based on the company’s performance, the market they operate in, competitors in the space, and a host of other factors.
With that in mind, let’s look at how pre-money valuations are agreed upon.
Paul Graham once wrote that there’s “no rational way to value an early-stage startup.” That’s because seed-stage companies typically have very few financial indicators to go off of. In some cases, they haven’t even brought a product to market yet.
So what’s an angel investor to do?
There are a few metrics investors use when proposing a pre-money valuation when financials are not readily available. They are as follows:
You’ll often hear pre-money valuation and post-money valuation used together—so it helps to understand the difference between the two. Fortunately, the post-money valuation is straightforward to understand: It’s the pre-money valuation plus the additional capital injected into the company during the fundraise.
Pre-Money Valuation = Post-Money Valuation - Investment Amount
So if I have a pre-money valuation of $4M and I raised an additional $2M, my post-money valuation is $6M. Simple.
If you hear a founder say they’re raising $2M at a $6M post-money valuation, what they’re really saying is their company is currently valued at $4M.
The post-money valuation helps investors understand their ownership stake after they invest in a company. For instance, if you invest $500k in a company at a $2M pre-money valuation, your equity stake in the company is 20% (as $500k is 20% of $2.5M).
However, if you invest $500k at a $2M post-money valuation, your equity stake is 25% (25% = $500k of $2M). Therein lies the subtle difference in pre- and post-money valuations. Listen closely to whether founders use pre-money or post-money valuation, as this will suggest two very different measurements of the value of their business, and thus your potential ownership stake.
To learn more, read our guide on post-money valuations.
Pre-money valuations impact a lot of other deal terms.
Because the pre-money valuation is open to interpretation, investors typically request preferred shares in the company as a safeguard against overvaluation. Preferred shares give investors several potentially important benefits, including a liquidation preference, participation rights, and anti-dilution rights.
Because of these rights, preferred shares are generally more valuable than common stock held by founders and employees.
If the founders and investors can’t agree on a pre-money valuation and there is still investment interest, the founders might issue convertible notes to investors. Convertible notes amount to a loan offered by investors that can convert to preferred stock at a later funding round when a valuation may be easier to determine.
SAFEs are also popular with early-stage investors. With a SAFE, investors generally will convert at a discount or valuation cap at the next equity financing. To learn more, read our guide to SAFEs.
Say I start a company that sells widgets. After a year of growth, I decide to raise a seed round to scale the business. My co-founder and I own 100% of the company with 1M shares outstanding.
We’re seeking $1M at a $3M post-money valuation. In other words, the pre-money valuation is $2M. This being the case, each individual share of the company is worth $2 ($2 x 1M = 2M). In order to raise another $1M, I’ll need to issue an additional 500k shares ($2 x $500k = $1M).
This means I'm giving up a 33% equity stake in the company in exchange for an additional $1M in financing.
After performing your due diligence, you decide to invest $500k in my company, netting you 250k shares. This gives you a 16.67% ownership stake in my widget business ($500k ÷ $3M = 16.67%).
Pre-money valuations are subjective, meaning the negotiation process is key. Negotiate well and you may end up owning a sizable portion of a company with enormous potential.
Of course, you don’t want to strong arm founders into an unfair valuation, as this can get a relationship started on the wrong foot.
As an angel investor, keep in mind that you’re likely to be diluted in future funding rounds as the pre-money valuation grows and larger VCs get involved. This isn’t necessarily a bad thing. As a company’s pre-money valuation increases, the price per share goes up.
Say my widget business went on to raise a Series A at a pre-money valuation of $9M. Assuming no further shares were issued, this would mean your 250k outstanding shares would now be worth $6 each. Said another way, your $500K investment would now be worth $1.5M.