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Pre-Money Vs. Post-Money: A Guide To These Key Terms For Entrepreneurs

Pre-Money Vs. Post-Money: A Guide To These Key Terms For Entrepreneurs
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Guest Writer
Co-founder and Principal, Support Legal
7 min read
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Funding rounds bring with them a whole new vocabulary and terms that business founders need to get familiar with, often in a hurry. You’ll probably hear the terms “pre-money” and “post-money” many times during a VC investment round, whether it be in your term sheet, capitalization table, or even during negotiations between the company and its potential investors. As a founder, these terms are central to your bottom line, so you should understand what they mean, what they represent, and how they impact the financing of your company.

First up, why do you need to know about these terms? Valuation will be a big negotiation point between you and your VC investor: valuation discussions are speculative, and will be driven by market forces. Entrepreneurs and investors usually have differing estimates of valuation. Existing shareholders want a high valuation, so they suffer less dilution after the investment round. Investors prefer a low valuation, so they can maximize the ownership percentage they receive for their investment. Valuations directly impact the percentage of the company which existing shareholders will retain and what percentage an investor will receive for that investment. Think carefully about what you mean when you use the terms pre-money and post-money, and how each phrase may support a particular number.

SO, WHAT IS THE DIFFERENCE BETWEEN PRE-MONEY AND POST-MONEY?

Both are valuation measures of companies, but they differ in the timing of the valuation. Pre-money is the valuation of your business prior to an investment round. Post-money is the value of your business after an investment round. Post-money is simpler for investors, but pre-money valuations are more commonly used. So, in a nutshell: post-money = pre-money + money received during the investment round.

Why are post-money valuations simpler? Because the valuation of the business is fixed, whereas in a pre-money scenario, the value of the business can float with variables, like, for example, ESOP (employee Share Open plan) expansion, debt-to-equity conversions and pro-rata participation rights. Pro-rata participation rights are the right, but not the obligation, to invest in future rounds to maintain the same ownership proportion. Convertibles –i.e. convertible loan notes, SAFE (Simple Agreement for Future Equity), KISS (Keep It Simple Security)- are becoming more common for seed investment, and the face value of these instruments are added to the postmoney valuation at the time of investment.

Here’s an example to illustrate this better. You and your co-founder incorporate a company. The company issues 1,000,000 shares which are divided equally between the two shareholders (you hold 50% of the shares, your co-founder owns the other 50%). The company is successful and now you need additional capital. An investor offers you US$250,000 for shares in the company on a valuation of $1,000,000. The ownership percentages of the founders and the investor will depend on whether this $1,000,000 valuation is pre-money or post-money. If the $1,000,000 valuation is a pre-money valuation, the company is valued at $1,000,000 before the investment, and, after the investment, it will be valued at $1,250,000. But if it is a post-money valuation, the $1,000,000 valuation includes the $250,000 investment. In this example, the difference in the founders’ ownership is only 5% (2.5% per founder), but this could represent a vast sum if the company continues to be successful and gets to the point of an IPO.

Image credit: Support Legal.

HOW DOES PRE-MONEY VALUATION INFLUENCE THE INVESTMENT ROUND?

The price per share (PPS) that an investor will pay for shares in your company is determined using the following formula: PPS = pre-money valuation / fully diluted capitalization. The PPS and pre-money valuation are directly proportional (i.e. as one goes up, the other goes up). So, the greater the pre-money valuation, the more an investor will pay for each share, but the investor will receive less shares for the same investment amount. Here’s an illustration again. Continuing the example above of a $1,000,000 pre-money valuation, let’s say the founders together hold 1,000,000 shares (500,000 each). You’ll then need to issue some shares to the investor. Before you receive the investment funds, the value of the shares in your company was: $1,250,000 / $1,000,000 = $1.25 per share. Upon receiving the investment funds, your company will issue new shares to the investor. The number of shares = investment amount / pre-money PPS.

And in this particular scenario, for the $250,000 investment, the investor will receive: $250,000 / $1.25 = 200,000 shares. The company now has 1,200,000 shares, with the founders owning 1,000,000 shares or 83.33% of the company, and the new investor holding 200,000 shares or 16.66% of the company. Now, if things continue to go well, then, before long, you’ll need more capital. A new investor wants to invest $750,000 at a post-money valuation of $2,500,000 (which implies a premoney valuation of $1,750,000). Using the calculations above, the PPS is now $1.46 ($1,750,000 / 1,200,000) before the investment, and the company will issue 513,699 new shares to the investor ($750,000 / $1.46).

After the investment, the company will have 1,713,699 shares, of which the founders continue to own 1,000,000 shares that now represent 58.35% of the company’s shares. Each capital raise reduces the founders’ ownership (i.e. it dilutes their ownership). But, the PPS is increasing each time. Investors from earlier rounds will also experience dilution with each subsequent funding round. They can lessen the amount of dilution by participating in each of those rounds. Pre-money valuation and dilution of your ownership are key concerns as a founder. But remember, owning 10% of a big pizza may be more lucrative than owning 25% of a small pizza– and often, you can’t build that big pizza without investors.

WHY ARE POST-MONEY VALUATIONS RARE?

Short answer: sales psychology. “Anchoring” is a tactic often used in marketing. Consumers focus on the lower number, even if the end result is the same. For example, compare a hotel rate quoted as “$200 per night plus 15% taxes, 5% service fee, and $20 per night government fee,” with another quoted as “$260 per night.” The first rate, with the lower number, seems more appealing, but the total is the same as the second all-inclusive rate. If you are trying to negotiate a $5 million Series A round at $10 million (pre-money valuation) or $15 million (post-money valuation), the pre-money number may seem more appealing for the investor to take back to their partners. Using the pre-money valuation as the anchor lets the post-money valuation float, and the founders may be able to negotiate more favorable terms as part of the investment round.

‘MY COMPANY IS IN THE PRE-REVENUE STAGE. WHY DO I NEED TO KNOW THIS STUFF?’

Well, the valuation approach is particularly important when you have a good idea but few assets. It may not be possible to use accounting measures such as revenue, cash flow, or EBITDA (earnings before interest, taxes, depreciation, and amortization) to assist with a valuation exercise, particularly in the case of startups which are in the pre-revenue stage. We suggest looking to the angel community, which has developed methods that are commonly used by early-stage companies to determine valuations. Angel investors will probably recommend using a blend of methods rather than relying on just one. Where possible, find out what companies with pre-money valuations similar to your business have completed investment rounds. In the Middle East, a source like MAGNiTT provides a wealth of useful market data and information to startups.

VALUATIONS COST MONEY. DO YOU REALLY NEED ONE?

We have seen some founders opting to ignore any form of valuation process, and simply place a premoney valuation on their company after deciding how much of the company they are willing to give up in exchange for the investment they need. The downside to this approach is you offer an unrealistic valuation, and your potential investors think you are unprepared. Remember that investors will also be considering other factors relating to your company, like, for example, your target market, sustainable competitive advantage over competitors, scalability etc. 

Related: Starting Up Right: Three (Legal) Tips For Entrepreneurs In The UAE

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