Pre-Money Valuation: Everything You Must Know
Pre-money valuation (PMV) is the initial value of a company before any investment. Capital a business receives after its PMV is called post-money valuation.5 min read
Pre-Money Valuation: What Is It?
Pre-money valuation (PMV) is the initial value of a company before any type of investment. The capital a business receives after its pre-money valuation is called post-money valuation.
Why Is Pre-Money Evaluation Important?
- PMV determines the value of company shares.
- Through PMV, an investor can determine the value of a company's shares.
- Through PMV, anyone can calculate the total value of a company.
- Using PMV, the parties involved with an investment can determine how much of the company each party controls after the investment.
How Pre-Money Evaluation Works
Think of PMV as a simple calculation that investors use to weigh the value of becoming a shareholder. A company with a PMV of $10 million that has 1 million shares has value of $10 per share. When an angel investor offers to add $5 million more, the company's worth increases 50 percent to $15 million.
For his $5 million in funding, the investor receives 500,000 shares worth $10 each. He also owns 33.3 percent of the company. Meanwhile, the business has a value of $15 million with 1.5 million shares outstanding. The original owner of the company (the founder) owns 66.7 percent of the shares.
Each sale of shares dilutes the value of a single share of stock. The PMV is a quick way to see how much the ownership interests will change after a proposed investment. One of the most difficult choices a founder faces is deciding how much control they're willing to give up to grow the company.
In many instances, a founder's willingness to own fewer shares of a company will mean a larger profit. The new shareholders will have an incentive to grow the company to protect their investment. As the business grows, the shares increase in value. Holding 1 million shares of a stock worth $50 per share is more valuable than holding all 1 million shares of a stock worth $10 per share.
How to Get a Fair Pre-Money Valuation
- Research previous investments for PMVs with similar valuations and/or business models.
- Investigate the reputation and track record of a potential investor.
- Use convertible debt instead of accepting an investment. It's a loan you can switch to an equity investment at a later date. This strategy is solid for founders who expect their company to become more valuable at a later date.
- Use computer websites and apps with valuation tools like SmartAsset and WorthWorm. The internet offers many research options for proper valuation.
- Negotiate fairly even if the initial offer seems great. The investor has lots more experience in valuations than you. Presume they're trying to get a good deal. You should, too.
- Consider lowering your PMV to entice a better range of investors. Again, you'll make more money if your company is more successful.
Frequently Asked Questions
- What are capped notes?
Capped notes are a form of convertible debt note. They work differently from uncapped notes in that they have a guarantee on the future share structure of the company. Uncapped notes are more desirable for the company.
Consider a company with a PMV of $10 million. If an investor participates in a capped round, they'll get a set percentage of shares. Investing $2 million means they'll own at least 20 percent of the company.
During an uncapped round, the founder can try to get more investors. If they prove the company is worth $20 million, the same investor with $2 million only owns 10 percent of the business.
From the founder's perspective, their business is worth twice as much, but they've given up the same percentage of ownership interest. A capped round is clearly better for the investor.
Putting a ceiling on a valuation is bad. That's why an uncapped round is better for the founder. The goal for a new business is to line up as many investors as possible to increase the valuation.
- What is preferred stock?
The two most popular kinds of shares are preferred stock and common stock. As an investor, preferred stock is more desirable. Owning this kind of stock entitles the shareholder with a higher claim on assets and earnings.
A preferred stock pays fixed dividends and equity. It also offers a higher yield than common stock. Should a company suffer cash-flow issues, owners of preferred stock function as a special class. They have a standing claim on the company's assets.
Other benefits of preferred stocks are:
- Hybrid asset that falls somewhere between a stock and a bond
- Major credit agencies rate them
- More predictable income than common stocks
- Potential (but not guaranteed) voting rights
- Sometimes convertible to common stock when situation is advantageous
- What are pro rata rights?
Many investors want to hold the same ownership percentage as the company grows. Pro rata rights are the mechanism that allows them to do so. These rights allow a person to invest more money as the total value of the company increases.
In the example above, the investor owns 33.3 percent of the company when it's worth $10 million. He paid $5 million for this ownership interest. If the company's worth increases by $10 million, he needs to pay $5 million more to keep ownership of 33.3 percent of the shares. Pro rata rights protect an investor from losing their fair share of the company.
- Where do option pool shares come from?
A private company has the ability to offer special shares to its employees. These shares are a part of the option pool. They're available when the owner of the company determines they want the employees to have an ownership stake in the company. The owner introduces the option pool at the expense of giving up a portion of their stake in the company.
This tactic is usually smart, since workers with a financial stake in the company are more loyal to it. Option pool shares are also effective in luring top talent away from other companies. Startups usually can't compete with the salaries offered by established corporations. By offering stock from the option pool, they persuade good employees that joining a new business will pay more over time.
- How is cost of capital determined?
A potential investor can determine how much of a company they'll own. Determining the cost of capital is a simple calculation. It's the owner's investment divided by the post-money valuation. With this knowledge, an investor can decide whether the cost to buy a portion of the company is a worthwhile endeavor.
If you need help with pre-money valuation, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.