As the owner of a startup, you have a laundry list of things you’re concerned about and raising capital is likely near the top of that list. You need capital to scale and grow your business, but you don’t want to give away too much ownership. With an understanding of the differences between pre-money and post-money valuations, their importance, and how the amount of capital you raise can impact your ownership, you will have a better idea of how much capital you want to raise for your business.
What Is the Difference Between a Pre-Money and Post-Money Valuation?
On the surface, the major difference between these company valuations is the timing. If you think of the timeline of your startup, pre-money valuation occurs first. It refers to a company’s worth prior to any external funding. Conversely, post-money valuation refers to the value of a business after it has received an injection of capital. The value of a company will change with each round of financing. So, investors and venture capitalists will want to know your company’s value at multiple times during its growth.
The Importance of Valuations
Let’s discuss the importance of company valuations. The type of valuation used in negotiations for additional rounds of financing can have a substantial legal and financial impact on your startup for years to come. More specifically, whether you use a pre-money or post-money valuation to secure a round of financing will determine the equity share your investors, founders, and employees have after the startup has received capital. The more capital you raise, the larger portion of your company you’ll likely have to give to investors. Ultimately, raising capital dilutes your ownership. As a result, a point exists where you can raise too much capital during a round of financing.
Your Post-Money Valuation Has Decreased Your Share in the Company, Now What?
It’s highly unlikely you will get ‘free’ money from investors. Giving up a percentage of ownership may help ensure you raise the capital you need to grow your business. This means your post-money valuation will show a decrease in your stake in the company. Yet, in the long run, as you scale and grow your business, the overall value of your company will increase because capital can help you considerably increase the individual value of each share.
Let me give you an example with numbers to make this more clear:
You authorize 1,000,000 shares when you incorporate your company. These shares might be all yours or divided among any other founders you have. For the sake of simplicity, this example assumes you have only one co-founder. Business is going well, but you need more capital to invest in additional equipment, commercial property, and/or employees. An investor comes along and offers you $1,000,000 for a company valuation of $4,000,000.
The pre-money and post-money valuations would be as follows:
- If using a pre-money valuation, founders’ shares are 80 percent of the company, and the investor’s stake is 20 percent of the entire $5,000,000, each share is worth $5.
- If using a post-money valuation, founders’ shares are 75 percent of the company and the investor’s $1,000,000 is 25 percent of the total value of $4,000,000.
Now, let’s assume negotiations have gone well and for this round of capital raise, you are using the pre-money valuation. You close the deal by issuing 200,000 shares (20%) to the investor. So, you have a total of 1,200,000 outstanding shares, making the post-money valuation of your company $6,000,000. Your 100 percent ownership will decrease to 83 percent ownership, but you and your partner still own 1,000,000 shares at $5 per share.
Consult With Skilled Legal Counsel Regarding Valuations
Ultimately, you and any partners you have will need to weigh your options for raising capital. Diluting your shares can give you the capital you need to grow and scale your business, but you might also struggle with the decision of having less ownership. Take the time to consult with a corporate lawyer you can walk you through the legal and financial impact of your decision and help you choose the right path for your business.