LearnVC.com

Pre-money Valuation

Posted on 07. Jul, 2008 by squareroots in Graphical Examples

The first lever to understand is the pre-money valuation set on the company. Where does it come from? It is negotiated between the entrepreneur and investor (angel or venture capitalist). What is it based on? It depends on the stage the company is in, as well as the industry the company is entering.

The simplest way to understand pre-money valuation is to look at the percentage ownership the investor would receive for their investment.

The example begins with a $2M investment on a $3M pre-money valuation. This means that prior to the investment, the company is evaluated by the investors to be worth $3M. Why? Because the investors expect to own 40% of the company. The post-money valuation is the pre-money valuation plus the amount invested. Therefore, if the company is raising $2M and the investor intends to own 40% of the company after the investment the pre-money valuation must be $3M. A common misunderstanding is that the pre-money valuation is derived from a complicated evaluation of the company’s potential earnings, with a discounted cash flow analysis (DCF) of the unleveraged cash flows. The problem is that these projections are almost always wrong. In addition this would put the valuation of the company in the hands of the financial projections rather than in the hands of investors.

So, the “magic” of the pre-money valuation is based not on projections, but a combination of three factors:

1. The percentage ownership described above. 
2. The investor’s experience with previous investments of similarly staged companies (this is the “black-box” aspect of valuations).
3. The competitiveness of the deal, usually reflected in the experience of the entrepreneurs. This is where “serial entrepreneurs” have a marked advantage over new entrepreneurs as they command a higher pre-money valuation.

Tags: Future Investors, New Entrepreneurs, Students