By Patrick Rogers / Entrepreneur Middle East
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.