Imagine an investor wants to invest $200,000 into your business, and in exchange wants 20 percent of the company’s equity. What is the valuation of your venture that is implied by this proposal, before the money was put in?
If you’re scratching your head and can’t say with full certainty, then you are like the majority of human beings on planet Earth – susceptible to confusing the difference between pre-money value and post-money value.
Put simply, adding more cash to a company makes it worth more. Think of it this way: all else being equal, the value of a house would increase if you put a briefcase filled with cash into the living room, and the amount of the increase would be equal to the amount in that briefcase.
- Pre-money value is the value of a company before it receives new investment.
- Post-money value is the value of a company after it receives new investment.
This may seem very simple, but don’t be fooled! The difference can make your head spin if you haven’t taken the time to understand it. Rest assured that sophisticated investors sitting across the table from you in any negotiation will understand the difference very well. You should get your head around two important equations.
Per cent owned by the new investor = new money invested/post-money value
It requires a bit of algebra to solve the initial question that this article posed, but if you think back to high school mathematics, you will hopefully be able to see that:
Putting the quantities we know into this equation gives: 20% = $200,000/post-money value
therefore: post-money value = $200,000 / 20%
therefore: post-money value = $1,000,000
We still need to go further, as the initial question asked for the pre-money value, thus: “What is the valuation of your venture that is implied by this proposal, before the money was put in?”
For this, we need another equation which relates pre-money value and post-money value to each other.
Post-money value = Pre-money value + new money invested
Putting the quantities we know into this equation gives: $1,000,000 = pre-money value + $200,000
therefore: pre-money value = $1,000,000 – $200,000
therefore: pre-money value = $800,000
To solidify your understanding, try changing things around and working out this one for yourself: “Imagine a new investor wants to invest $500,000 into your company at a pre-money value of $1,500,000. What percentage of the company is the investor asking for?”
The importance of understanding what the new investor is asking for during negotiations cannot be understated – getting pre-money value and post-money value mixed up is not only embarrassing (as it betrays that you don’t really ‘get’ financial language), but it could also mean you and the investor are talking at cross purposes and you agree to give away more equity in your company than you meant to, or refuse a deal which is acceptable to you.
You’ve spent a long time building your business to the point of being ready for investment. Take a couple of hours to make sure the difference between pre-money value and post-money value is something you’re 100 per cent sure of.