If you’re involved in startups, you hear about pre-money all the time: “…what was the pre-money of your last round?”, “The pre-money of your last round was a little rich…”
But if you’re new to all this (or you’re not, but don’t want to show your ignorance) this post will hopefully clarify the term a little.
What is Pre-Money?
What it really stands for is “pre money valuation”, and it means, quite literally: “what was the valuation of your company before (new) money is being invested?”.
But… (and there’s always a but) it comes in various flavors and is often more art than science.
Say you’re the founder of a new medical device company. You’ve built a prototype in your garage with some friends and want to start raising money to commercialize the product. After talking to a lot of VCs, you finally get one of them to give you a term sheet for an investment and it says your “pre-money valuation is $3,000,000″.
This implies that all the work you and your friends have put into the prototype, up until the point of taking the investment, is valued at $3,000,000. If it took you a combined 6 months of work, that’s a pretty good deal, but if it took all your spare time over the past 8 years, it’s maybe not such a great deal…
One thing that investors might do to dampen the blow of a low valuation is to add new options to the pre-money, so the termsheet might say: “Firm X will invest $4,000,000 to purchase 4,000,000 shares of preferred stock in Acme Coporation and will invest at a pre-money of $3,000,000 to include an increase of the option pool of 1,000,000 unallocated options.”.
Translating this into plain English means that Firm X buys shares for $1.00 per share (4 million shares for $4 million). They are also adding 1,000,000 new share options to the pool before putting in their money and “hide” them in the pre-money valuation. The value of these million shares is $1,000,000. So in this case the true value attributed to your hard work is not the $3 million that’s stated in the termsheet, but $3 million minus the value of the new options, so the true pre-money is $2 million.
Not sneaky, and fairly common practice. Just something to be aware of.
So, is it always good to get the highest pre-money possible?
Not necessarily… The higher the pre-money, the more ownership you retain as the founders – that’s good. But you also have to look at the future. Say, you’re able to convince your Uncle Ted that you medical device company is worth $20 million today, and that he can buy 0.25% for $50,000. You tell him that eventually the company will sell for $400 million, so his 0.25% might be worth about a million bucks, or 20 times his money. Not a bad, deal, eh?
You’d be right if all you needed is Uncle Ted’s $50,000. However, more likely than not, a medical device company needs tens of millions to get to a $400 million exit event. So besides Uncle Ted, eventually you’ll have to go talk to VCs, which brings us to the next topic: Post-money Valuation. The VCs will tell you in no uncertain terms that the “post” on the last round with Uncle Ted was way too high, and that they only value the company at the previously mentioned $2-3 million. Not the news you wanted to hear… but you need their money… Now you have to go tell Uncle Ted that his 0.25% has gone to 0.025% overnight… a painful conversation…
This example is fairly extreme, but it illustrates the point. A high “Pre” results in an even higher “Post”, where post-money valuation is simply Pre-money valuation + Invested Capital = Post-Money Valuation. Be realistic about your valuation and keep future funding rounds in mind. Typically, VCs will want to own a large chunk of your company (20-40%) and that’s how they triangulate a valuation. Say you’re raising $3 million, that puts your pre-money somewhere between $4.5 million and $12 million. A pretty wide range… The rule of thumb is that the more risk (technology, market, financing) is still left in the company, the larger a percentage investors want for their money.
Do your research and talk to some folks about what typical valuations are for different investment rounds. This differs widely from one industry to the next. Note that every industry has its outliers, with Microsoft’s investment in Facebook valuing that company at $15 Billion or so, but that most companies in an industry are close to the mean. To avoid disappointment, assume the mean for your company and hope to be an outlier (on the high end!): “the market” will tell you where you really stand.
Hopefully this all makes sense to you. If not, or you have additional thoughts, feel free to leave a comment.