There is a surprisingly large number of business finance terms that are prepended with the “pre-” flag: “pre-seed”, “pre-IPO”, “pre-revenue” and, you guessed it, “pre-money valuation.” Perhaps this is because evaluating early-stage business finance is preposterously difficult.
A company’s valuation can be a controversial talking point in the annals of VC boardrooms and the source of much back-and-forth during term sheet negotiations. This pain point has even led early-stage investors to adopt convertible notes as a way to pass the hypothetical valuation torch on to future investors.
In this article, we discuss what a pre-money valuation is, how to calculate it, and when to use it over other valuation figures, including post-money valuations.
What is Pre-Money Valuation?
Pre-money valuation is the calculation of a company’s total equity value before raising a round of financing. When cash is injected into a company’s balance sheet, through a round of financing, the subsequent valuation of the underlying equity increases by the same amount, resulting in a post-money valuation.
Pre-Money vs. Post-Money
Pre- and post-money valuations are two methods of representing the same thing at different points in time: how much the company is worth. Pre-money valuations are typically used to evaluate a company that has been entirely or nearly entirely bootstrapped, or hasn’t yet raised a funding round.
Post-money valuations can be used to describe a company in between funding rounds. This is because many investors will use the previous post-money valuation as a benchmark for evaluating the increase (or decrease, known as a down round) in valuation.
Equity Value vs. Share Price
When a company raises funding through the issuance of new shares, the equity value increases (by the amount raised from the new shares), but the share price remains unchanged. Essentially, the amount being raised determines the number of shares being issued, using the pre-money price-per-share as the cost basis.
When new shares are issued, however, the existing shareholders are diluted in their equity percentage. This is why it’s important to understand how dilution works and consider how your fundraise could impact the existing team’s ownership and voting rights, including your own.
How to Calculate Pre-Money Valuation
Depending on the stage of investment and how much information you have about the terms of the investment, you can calculate the pre-money valuation in a number of ways.
If you know how much was invested and the post-money valuation, you can easily work backwards to determine the pre-money valuation:
Pre-money valuation = post-money valuation – investment amount
Alternatively, if you know you want to raise a certain amount of money and are willing to part with a certain percentage of equity, you can easily work out the pre-money valuation:
Pre-money valuation = investment amount / percent equity sold – investment amount
If you have not raised money and don’t yet know the terms of your next investment round, there are other ways you can calculate pre-money valuation:
Discount Cash Flow (DCF)
The discounting method for calculating valuations uses projections of future cash flows to discount those based on the present value of money. Essentially, you analyze whether a particular investment will net you more money in the future compared to a baseline interest rate of keeping the cash in a safe, interest paying savings account.
If your DCF calculation computes a number larger than the proposed initial investment amount, it will likely be a good investment (assuming your calculations are accurate and the company’s cash flows sustain).
Enterprise Value to Revenue Multiple
Enterprise Value (EV) is calculated by adding the equity value to the debts and subtracting cash. This seems counterintuitive at first glance — why would you add debt and subtract cash? Consider how much a company would cost were you to acquire the entire business outright; you would need to buy the existing shareholders out of their equity and assume all liabilities. Any cash on the balance sheet would offset these expenses.
The EV to Revenue multiple is calculated by dividing the enterprise value by the annual revenues. For example sake, we have a business with $100mm equity, $25mm outstanding debt, $10mm in cash, and annual revenues of $57mm. The EV/Revenue multiple would be calculated as follows:
EV = $100mm + $25mm – $10mm = $115mm
Multiple = $115mm/$57mm = 2.07
The EV to revenue ratio essentially informs someone how long it would take for revenues to repay the total cost of the business. In the example above it would take just over two years for total revenues to exceed the enterprise value, assuming static revenues.
In very early-stage, pre-revenue companies, this metric would rely on many assumptions and negotiations to land on a fair enterprise value and revenue projections.
In the case of a pre-revenue startup where calculating revenue or cash-flow based valuations is impossible, investors and entrepreneurs would look to the market to signal fair value. Some market comparables could be:
- Industry/sector acquisitions
- Recent funding rounds
- Public market multiples
If a competitor has recently been acquired or raised funding, or a number of publicly traded incumbents are trading at similar market capitalizations, these figures can help guide investors and entrepreneurs towards a fair valuation.
Pre-Money and Post-Money Valuation Example
Let’s assume a business recently sold 9.1% of the company’s equity to raise a $1 million seed round at an $11 million post-money valuation. What was their pre-money valuation? There are two ways we can calculate this:
Pre-money valuation (option 1) = post-money valuation ($11,000,000) – investment amount ($1,000,000)
Pre-money valuation (option 2) = investment amount ($1,000,000) / percent equity sold (9.1%) – investment amount ($1,000,000)
In the example’s prompt we were given the post-money valuation, which helped us determine the pre-money valuation in option one. If we weren’t given this information, we could still calculate the pre-money valuation using option two above and then simply calculate the post-money valuation using the result:
Post-money valuation = pre-money valuation ($10,000,000) + investment amount ($1,000,000)
There is another option for calculating post-money valuations, however. Simply divide the investment amount by the percent equity sold:
Post-money valuation = investment amount ($1,000,000) / percent equity sold (9.1%)
To further clarify our example, below is an example table including the general state of the company’s valuation and ownership pre- and post-money:
Raising Your Next Round
We hope this article has provided some useful information towards understanding your valuation and raising funding. As entrepreneurs, it’s important to finance your business at reasonable valuations to avoid unnecessary dilution while still providing investors with a return on their investment.
Pre-money and post-money valuations are easy to understand when given context. Knowing which valuation to lead with will depend on the stage of your business, funding status, and type of investor. If you want a simple way to calculate your pre-money valuation, check out our business valuation calculator.
Once your pre-money valuation is determined, you can use it to raise your round and raise your post-money valuation on EquityNet.