When it comes to venture capital investment, there’s some confusing terminology that gets thrown around with some equally mercurial mathematics – sometimes these calculations remain a mystery to even the sharpest of founders. The truth of the matter is, a lot of the more basic math behind early investment capital is quite simple, and importantly, it’s the simple stuff that takes up the majority of what a founder should be thinking about.
So what goes into this process, where investment comes in the form of cash in return for freshly minted shares? There are 2 key metrics in this early stage process: “pre-money” and “post-money”, which are descriptive, basic terms.
The “pre-money” valuation is the value of the entire company prior to any investment in the particular round at discussion. So in ridiculously simple terms:
pre-money value = (# pre-money shares) * (share price)
investment = (# shares issued for investor) * (price of shares)
The key thing to note is that different from traditional publicly traded companies issuing shares, the shares that get purchased in a venture investment are ‘new’ shares, which thus means there is a change in the number of outstanding shares.
So this then means:
(# post-money shares) = (pre-money shares) + (shares issued)
In most cases, the only direct effect on valuation of an investment at the early stages is to increase the company’s cash reserves — consequently the valuation is increased by the amount of ‘new’ cash the company now has. This is, logically, the “post-money” valuation, which in simple terms is:
“post-money value” = (investment $) + (“pre-money” value)
The post-investment equity pile is fairly simple too: the percentage of the company owned by investors after an investment is made is simply:
percentage owned = (issued shares) / (post-money shares)
This can also be expressed as:
percentage owned = (investment amount) / (pre-money value + investment)
So what does this look like in practice? Let’s say an investor decides to invest $4 million at a $6 million “pre-money” valuation, this leads to the investor taking a 40 percent slice of the company.
$4M / ($6M + $4M) this can be simplified to 4/10 which is quite obviously 40 percent.
From what we learned above, we also know that the “post-money” valuation is simply $4M + $6M which is $10M.
How about getting the share price? Let’s then say that there are 3 million shares outstanding prior to the investment price, you would then simply say $6M / 3M = $2.00/share.
It is useful to note that the share price is identical before and after the investment.
So if shares issued is equal to (investment)/(share price) then in our example we can say that:
$4M / $2.00 = 2M
You might have noted that the numbers seem more clear from the ownership standpoint with the “post-mine” figures, while determining share price is more simply with the “pre-money” figures, going between the two is easy, and an acceptable process, you only need to add or subtract the investment amount.
When it comes to determining what to do with company shares, you should keep in mind that shares will need to be set aside for an employee stock option plan. When it comes to doing the math with more than 1 investor, if they are investing in the same round, simply treat them as “1 investor” – adding them together for simple math. With multiple investors, if you would like to determine individual equity ownership, simply divide that individual’s investment by the “post-money” figure.
When it comes around to raising another ‘round’ of investment, it is also important to remember that in most scenarios that the next round’s “pre-money” valuation will be at least equivalent to the “post-money” valuation of the previous round.
To raise money you need traction, to raise more money you need to show growth and scalable process. Raise as much as you need to achieve key milestones, and at a valuation that is reasonable and sustainable. Raising early stage capital at too high of a valuation can quickly price you out of follow-on capital or even an acquisition – so keep an eye on long term positioning.
Image credit: CC by kenteegardin