The Valuation Game
(This article was initially published as a post on Karthik Chandrasekar's LinkedIn page. Find the original post here.)
In this blog, we will be explaining the concepts of investment amount and valuations. The most basic of all concepts in an investment process — if you get these basics right then the rest of the process may become relatively easier (not necessarily painless!)
Most investors / VCs and entrepreneurs start the investment (game) conversation with a statement that goes something like this:
Entrepreneur: “I am seeking a $1m investment in exchange for a 20% equity stake in my company.”
Or you will hear the VC say: “We typically invest $2m (or our “sweet spot” is $2m) and we take a minority stake in the startup — typically in the mid to high-teens”
Let us break down the terms in the figure:
The investment or Investment Amount is the actual cash amount the investor will put into your company — so it is also called “New Money”
The Pre-Money Valuation is the value of the company before the investment happens
The Post-Money Valuation is valuation of the company immediately after the investment happens
The Ownership % is the Investment Amount over the Post-Money Valuation, also referred to as Dilution, i.e. we don’t want to give away more than 20% of our company…
So, what comes first? Pre-Money, New Money, Post Money or Ownership %?
It is the New Money!
The New Money is the exact investment amount / the actual cash amount the investor will put into your company; it is also the basis for your business plan
The Valuation of the company is calculated based on a funded business plan — different amount of funding means different plan — so, it comes after the New Money coming in, so, it is called Post-Money or Post-Money Valuation.
So, the Pre-Money Valuation — the value of the company before the New Money came in — is the Post Money Valuation less the New Money — it is a derived number and comes last
Here you can see that the promoter ownership got diluted from 100% to 80%, or by 20%. Remember the promoters did not sell any shares, the company issued new shares which diluted the promoters’ ownership
Once the money is in — it is old money, so, now when a new investment comes in the old investor’s shares get the same dilution as the promoter shares. Take a few minutes and work through this next round of investment — $5M new-money for a $25M Post-Money
Ownership the new investor or New Money gets is 5/25 or 20%
So the older ownership stakes gets diluted by 20% — i.e. reduced by a multiple of 80% or .8 — so, 80% becomes 64% and 20% becomes 16%
Pre-Money is $20M — so with the new round the value of the holders of the old shares went from $10M to $20M — i.e. the value doubled
The Value of the company went from $10M to $25M or 2.5x
That jump in valuation is what each investor is looking for when they invest into startups with an expectation of what the eventual return would be for them and when. All the investment terms that go alongside the valuation and ownership are linked to the differences in yours and their expectations or around the risks or ensuring some minimum returns.
So, how much equity should an investor get for funding a business?
Exactly what their Investment Amount will buy them over the Post-Money Valuation that you can agree that you will create using the funding (Investment Amount)!