As an early-stage entrepreneur, one of the first things you learn is that the valuation of your company is important. Every Shark Tank episode focuses on the drama and negotiations around valuation. In fact, the beginning of every Shark Tank pitch starts off in the following way:
Entrepreneur: “I am seeking a $## investment in exchange for a ##% equity stake in my company.”
But if you’re just starting, or even been in the game awhile, it’s important to know there’s more to valuation than standing in front of an investor and asking for $## in exchange for ##% equity stake.
In a nutshell, valuation is the financial worth assigned to a business. This sounds simple enough, but you have to remember there are layers to measuring valuation. Let’s dig in deeper and look at a scenario where a company is taking on its first investment capital since they started the business.
Pre-Money and Post-Money Valuation
However, to begin, let’s take a moment to define the two different ways valuation is defined.
Pre-Money Valuation: The valuation of the company right now, prior to investment.
Post-Money Valuation: The pre-money valuation plus the total investment amount.
The Pre-Money Valuation is determined based on a number of factors involving the stage of the business and is negotiated between the entrepreneur and the investor. Additional details on Pre-Money Valuation will be covered in a future blog post.
The Post-Money Valuation is determined based on a mathematical equation outlined below.
Pre-Money Valuation + Total Investment Amount = Post-Money Valuation
$4M (Pre-Money Valuation) + $1M (Total Investment Amount) = $5M (Post-Money Valuation)
Let’s go a layer deeper to understand how this valuation is being measured based on price-per-share, or the price for each share of stock in the company.
Where does the first set of shares come from? Every company has a certain number of shares, which is how valuation is calculated. When a company is first formed, shares are created and issued to the founders. The number of shares originally issued at the formation of the company is arbitrary, but provides the foundation for all future shares.
Since the number is arbitrary, this means the shares originally issued are up to the founder’s discretion, whether that’s 100 shares, 3M shares, 8M shares, etc. There are some best practices around how many shares to issue in order to make the math easier, but generally speaking the number of shares originally issued is arbitrary. As the company takes on additional investment, more shares are added based on a calculation that we will review further in the next section.
Now that we have a better understanding of shares, lets continue with our example of a company receiving their first investment capital. Let’s say the founders decided on 8M shares, which we will now refer to as Pre-Money Shares.
Now we have enough information to calculate the price-per-share.
Pre-Money Valuation / Pre-Money Shares = Price-Per-Share
$4M (Pre-Money) / 8M (Pre-Money Shares) = $0.50 (Price-Per-Share)
Number of Shares
Now that we know the price-per-share, we still need to determine the number of new shares that are issued to the investors. So, how many shares will investors receive for their $1M investment? The formula for calculating number of investor shares is shown below.
Total Investment Amount / Price-Per-Share = Investor Shares
$1M (Total Investment Amount) / $0.50 (Price-Per-Share) = 2M Investor Shares
As seen in the example above, investors will receive 2M shares for their $1M. Now that we know the number of shares to investors, we must now calculate the total Post-Money Shares, which reflects the total number of shares the company will have after the investment.
Pre-Money Shares + Investor Shares = Post-Money Shares
8M (Pre-Money Shares) + 2M (Investor Shares) = 10M (Post-Money Shares)
So, the total number of shares the company will have post investment is 10M.
The last layer is how to calculate the percent ownership for investors and entrepreneurs. As we saw in the Shark Tank example, the entrepreneur is offering a percentage equity stake in their business.
There are two ways to calculate Percent Ownership for the investors.
1. Investment Amount / Post-Money Valuation = Investor Percent Ownership
2. Investor Shares / Post-Money Shares = Investor Percent Ownership
1. $1M (Investment Amount) / $5M (Post-Money Valuation) = 20% (Investor Percent Ownership)
2. 2M (Investor Shares) / 10M (Post-Money Shares) = 20% (Investor Percent Ownership)
As you can see, the percentage ownership comes out to be the same.
Comparing Percentage Ownership
When comparing the percentage ownership for Pre-Money and Post-Money one needs to put together the information we have calculated above. Once that is complete, the comparison can be seen below.
In summary, there are many layers to measuring valuation. Here’s a recap of the formulas we have discussed are outlined below.
· Post-Money Valuation = Pre-Money Valuation + Total Investment Amount
· Price-Per-Share = Pre-Money Valuation / Pre-Money Shares
· Investor Shares = Total Investment Amount / Price-Per-Share
· Post-Money Shares = Pre-Money Shares + Investor Shares
· Investor Percent Ownership = Investment Amount / Post-Money Valuation
· Investor Percent Ownership = Investor Shares / Post-Money Shares
These formulas will help you determine your valuation and equity stake, but they won’t tell you whether you should be raising, or whether you’ve over or under-valued your company. Understanding the competitive landscape and the market, as well as your company’s own value, key metrics, and trajectory for success, are just as important, if not more so, as getting your math right. That’s why being thoughtful, reasonable, and discerning when determining your pre-money valuation is a crucial step — and why considering whether you’re even ready to raise is the most important.
This post is part of the Hyde Park Angels Entrepreneurial Education Series, which brings together successful, influential entrepreneurs and investors to teach entrepreneurs everything they need to know about early-stage investment through events, articles, videos, and more. If you are interested in learning more about similar topics, save the date for “Connecting Corporations and Startups” on September 24.
Photo via Simon Cunnigham, “Valuation”