Fundraising is an inevitable part of a startup’s growth curve and there are different stages of funding that it goes through, to expand its services and function at an optimal matrix of performance and profitability. These different rounds of raising funds, pre-seed, seed and series rounds, help it to infuse essential capital at timely stages into the venture which keeps it well aligned to preset business goals and revenue models.
During these funding rounds what is important is the valuation of the startup. What is your valuation? This is a question that every founder needs to be prepared to answer honestly and most importantly, rationally.
So what exactly does this oft-heard terminology valuation actually stand for?
A startup’s valuation actually denotes what it is worth at a particular point in time and it can be influenced by a number of factors:
•Promoter profile and track record
•The market readiness of the product or service
•Proof-of-concept in its market
•Valuations of similarly existing startups
•Customer pool size and business projections
There are various variables and statistical analytics that are considered by investors and founders to arrive at a near-exact estimation. But, to arrive at a figure that all parties can shake hands on, is not really that simple an act composed of mere calculations. It is more of a mixed art of intuitive understanding, human dynamics, a forward going vision, risk taking appetite and a lot more.
Here we look at venture capital methods for startup valuation. pre money valuation and post money valuation are two popular valuation processes.
Pre Money Valuation is defined as the value of a startup before it enters and pitches for a present round of funding. This method of valuation gives investors a fair idea of the current value of the startup enterprise and also helps immensely in pegging the value of each share that is issued. Post-Money Valuation is what the startup will be valued at after it receives an infusion of a fresh funding round.
What is important to note here is that, there has to be clarity in what method of valuation is being used to arrive at the valuation status, since it can significantly impact ownership percentages.
Here is a simple chart to explain the same –
PRE-MONEY VALUATION
Value Ownership
Entrepreneur – 1,000,000 80%
Investor – 250,000 20%
Total – 1,250,000 100 %
POST-MONEY VALUATION
Value Ownership
Entrepreneur – 750,000 75%
Investor – 250,000 25%
Total – 1,000,000 100 %
The chart is to be interpreted as follows:
If the startup is valued at Rs. 1,000,000 pre-money then it is worth more, because it does not include the Rs. 2, 50,000 post money investment. The post-money valuation shows a small percentage change in the entrepreneur’s ownership of 5 percent, but it can represent a tidy sum of money if and when the company goes public.
The difference between a company’s pre-money and post-money valuations is significant since it determines the equity stake that investors are entitled to after the financing round is completed.
Pre Money vs Post Money Valuation
Both the methods are an integral part of startup valuation at an early stage. They hold the key for both the entrepreneur and the investor to come to a common ground of understanding and establishing a relationship of mutual trust.
Let us now see how to calculate the percentage of shareholding basis pre-money valuation. As shared in a chart earlier in this article it is understood that the pre-money valuation component of a company has a bigger say on final ownership percentages. The equation being; the higher the pre-money valuation, the less of the enterprise the entrepreneur will have to give up. Let us assume a startup is raising a new round of funds. Venture capital investors have agreed to come on board with an investment of $10mn in exchange for an ownership stake of 25% post-investment.
Let us assume our pre-money valuation as follows –
pre-money valuation – $4mn
agreed upon PPS (Price Per Share) – $10.00
Giving us a post-money valuation of the start-up – $14mn
i.e. $4mn pre-money valuation + $10mn fund infusion
At this juncture, since the founders are raising outside capital for the first time, the total shares outstanding will be – 400K with 100% of the equity, wholly owned by the founders.
Pre Money and Post Money Valuations ($000s)
| Model Assumptions | ||
| Pre money valuations | Funding round | Post-money valuations |
| Pre-Money valuation $4000 | Investment size $6000 | Pre-Money valuation $10000 |
| Price per share $10.00 | Price per share $10.00 | Price per share $10.00 |
| Shares Outstanding 400 | New shares outstanding 600 | Shares outstanding 1,000 |
| % Founder’s ownership 100% | % New investor’s ownership 25% | % Founder’s ownership 75% |
| Pre-money founder equity $4000 | Post-money founder equity $7,500 |
It is the post-money valuation that gives investors a clear picture of their ownership stake. If an investor invests $500K in a company at a $2 million pre-money valuation, the percentage of equity share the investor will hold in the company will be 20% – as $500K is 20% of $2.5 million.
But, when $500K is dropped into a $2 million post-money valuation, the investor equity stake will be higher i.e. 25%. This being calculated as $500K being 25% of $2 million.
Conclusion
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FAQs
Q. What are the 5 methods of valuation?
A. Asset valuation, historical earnings valuation, relative valuation, future maintainable earnings valuation and discounted cash flow valuation are the five common valuation methods.
Q. What are the 3 ways to value a company?
A. Industry practitioners employ three basic valuation approaches when valuing a firm as a going concern; DCF analysis, comparable company analysis, and precedent transactions.
Q.How do you value a private company?
A. Comparable company analysis, which evaluates the valuation ratios of a private firm to a comparable public company, is the most frequent method for valuing a private company.
Q. What is the rule of thumb for valuing a business?
A. The most typical rule of thumb is a percentage of annual sales, or better yet, sales and revenues for the previous 12 months.
