Understanding Pre-Money vs. Post-Money Valuation
One of the key points of negotiation in any venture capital financing round is the valuation of the company. Valuation can be determined prior to the investment, called the pre-money valuation, or after the investment is made, called the post-money valuation. Whether a valuation is measured on a pre-money basis or post-money basis has a material effect on the capital effects of the financing round, including the pricing for shares issued in the financing round and the scope of dilution borne by current investors.
The pre-money valuation is the valuation used to calculate the per-share price of the company's stock, typically a series of preferred stock, sold in a financing round. As its name suggests, the pre-money valuation does not take into consideration any new money the company will receive in the pending preferred stock financing.
The purchase price for the preferred stock is calculated by dividing the pre-money valuation by the fully diluted capitalization of the company. For example, if the company has a pre-money valuation of $7.5 million and a fully diluted capitalization of five million shares, then it would sell shares of preferred stock in the financing for $1.50 per share. As an example of the post-money effect of this pre-money valuation, consider a scenario in which the investors purchase $2.5 million worth of preferred stock. Those investors will have purchased 1,666,667 shares of the company's preferred stock, representing 25 percent of the company on a post-closing basis, and resulting in the company having a post-money valuation of $10 million.
Once the pre-money valuation is set, the main factor affecting the per-share price then is the calculation of fully diluted capitalization. The fully diluted capitalization of the company typically includes the following:
All issued and outstanding shares of the company's capital stock, including common and preferred stock (or common stock issued upon conversion of preferred stock, if the preferred stock converts to common stock at a ratio greater than 1:1);
All capital stock issued upon the conversion or exercise of all of the company's outstanding convertible or exercisable securities, including all outstanding vested or unvested options or warrants to purchase the company's capital stock; and
All common stock is reserved and available for future issuance under any of the company's existing equity incentive plans, including, in some cases, any equity incentive plan created or expanded in connection with the proposed financing round.
Whether or not a new or expended equity incentive plan is included in the fully diluted capitalization is typically a point of negotiation between the company and the lead investor in the financing round. (This negotiation is often referred to as the "Option Pool Shuffle".) If a new or expanded pool is included in the fully diluted capitalization, this means that only current stockholders will be diluted by such creation or increase. The inclusion of the new or expanded pool increases the number of shares in the fully diluted capitalization, which functionally decreases the price per share in the financing round. If the new or expanded pool is not included, both current stockholders and investors in the financing round are diluted by the creation or expansion of the pool on a post-closing basis.
The post-money valuation is also used to calculate the per-share price of the preferred stock sold in a financing round but, as its name also suggests, the post-money valuation takes into consideration the new money the company will receive in the pending preferred stock financing, as well as any outstanding convertible securities, such as SAFEs and convertible notes, converting into shares of preferred stock as part of the financing round.
The post-money valuation then is equal to the company's pre-money valuation plus the amount invested in the company in the financing round, either in new money or convertible securities. Using the example above, if the company has a post-money valuation of $10 million and the investors propose investing $2.5 million in new money, the functional pre-money valuation of the company is again $7.5 million. If the company has a fully diluted capitalization of five million shares, then it would again sell shares of preferred stock in the financing for $1.50 per share.
However, in this example, if the company also has $1 million in SAFEs and convertible notes converting into shares of preferred stock in the financing round, the functional pre-money valuation of the company is now $6.5 million. If the company has a fully diluted capitalization of five million shares, then it would now sell shares of preferred stock in the financing for $1.30 per share. In this example, notice that the investors investing $2.5 million in new money will still end up with 25 percent of the company on a post-closing basis.
Once the post-money valuation is set, negotiations concerning the calculation of fully diluted capitalization are still relevant, but the main factor now affecting the per-share price is the amount of converting securities functionally lowering the valuation. In particular, the valuation caps, discounts, and interest rates on such convertible securities can all affect the calculation of the per-share price and functionally lower the pre-money valuation.